Alex Nowacki in Warsaw -

Having weathered a horrendous year of geopolitical and macroeconomic instability, Russia-focused exchange-traded funds (ETFs) are enjoying a strong rebound. But even as investors pile in, fund managers warn the moment in the sun might not last long.

The perfect storm that hit investors in Russian assets in the wake of the Kremlin’s annexation of the Ukrainian region of Crimea in March 2014 served as something of a test of the robustness of the ETF model in emerging markets, say fund managers.

ETFs, essentially index-tracking mutual funds that are traded on exchanges continuously like equities, are potentially exposed to a serious liquidity mismatch between their assets, which may not always be easy to offload at a short notice, and their shares, which investors can sell at any point. This worry is especially prominent in emerging markets, where risks tend to be larger than in the developed countries, liquidity lower and a relatively large proportion of foreign portfolio investors in the overall market can make for enhanced volatility.

So the developments in Russia over the past 12 months have given grounds for concern that ETF investors could dump their holdings at a rate that would force fund managers into panic selling, leading both to greater market volatility and fund insolvencies, warns a manager at one of the largest ETF firms. As the markets fretted about the mounting tensions and even the prospect of war, economic sanctions followed, both from the US and, more painfully, from the EU. But it was the simultaneous rapid slide in the price of oil that really sent the Russian ruble into a tailspin, forcing Russia to mobilise its foreign-exchange reserves and created the potential for market panic.

But nothing of the sort materialised, note several fund managers. Even as some Russia-focused ETFs lost half their value, in line with the ruble’s dire performance, investors mostly held their nerve. When more investors want to sell shares in an ETF than to buy them, the fund turns to an “authorised participant” (AP), usually a bank, which acts as market maker: the AP sells shares it holds in the ETF to the fund and in return receives a bundle of the underlying assets, known as a “redemption basket”. Even when the ruble seemed in free-fall in the final weeks of last year, trades between investors comfortably outnumbered the so-called “primary trades” between the funds and their APs, say several fund managers.

Since they are not stock pickers, instead passively tracking underlying indices, ETFs have little influence over the performance of individual funds, though they offer retail investors relatively cheap exposure to interesting assets thanks to low management fees. These tend to be slightly higher in emerging-market ETFs, which can have higher operating costs due to lower liquidity and harder market access, including higher fees for trades. But the differences tend not to be very significant and management fees remain well below the 1-2% typically charged by mutual funds.

Return of interest

Although the performance of each fund is determined by the underlying index, fund managers can show their reading of the market by choosing assets to underlie specific funds. Thus Direxion Investments, a US firm, has set up a Daily Russia Bear 3X fund, whose performance has unsurprisingly been reverse to that of most Russia-focused funds. After healthy gains last year, the fund is down nearly 50% since the beginning of 2015 (see table). In stark contrast, Direxion’s triple-leveraged Daily Russia Bull 3X fund has seen a 16% jump in the year to date, while still remaining at a mere quarter of the value it boasted 12 months ago.

As leveraged plays on an already volatile market, both Direxion funds are openly high-risk, high-return propositions, says a manager with the firm. As of March 6, the fund’s 52-week range was $9.44-64.70, reflecting the potential for wild price swings.

Volatility is high even for the largest of Russocentric ETFs, Market Vectors Russia ETF, which invests in large-cap Russian stocks. Its performance over the first two months of this year put it at the top of the global league tables, although it was more subdued during March. The fund’s assets were up 19% in the January-February period, while the number of shares outstanding soared 14% to an all-time high of 107.3mn, driving total assets up to $1.88bn. ETFs investing in Russian stocks and bonds collected $222.2mn in February, according to Bloomberg, leading emerging markets by a wide margin.

Market Vectors is glad it persisted with the Russian market through the annus horribilis of 2014 and has since seen a return of interest, says Ferat Oeztuerk, a manager at the firm.

While the share of Russian assets has declined over the past 12 months across the funds managed by Market Vectors, that has not been true for all funds or asset categories, says Oeztuerk. Since the beginning of this year, investors have shown themselves keen to take advantage of the extremely low valuations of Russian equities. Stocks on the Russia Trading System (RTS) trade at 5.9-times projected 12-month earnings, less than half of the levels for even the poorest performers among developed markets.

Investing in Russia can often seem like a leveraged bet on oil prices, notes Oeztuerk, but Market Vectors is keen on the potential of the Russian consumer. With consumer spending at a mere 50% of GDP, among the lowest of all big economies, there is potential for those companies that cater to the Russian consumer.

But a manager at Black Rock, the world’s largest manager of ETFs, retorts: “That is an extremely optimistic view”. He explains that the country’s extreme disparities in wealth make for a small group of high spenders with second homes in London and savings parked in tax havens, while many people can ill afford to buy anything but necessities. And the fragile fiscal position means the state will struggle to support incomes in the way it has over the past years, which will also put a lid on consumer spending growth. “There are strong structural reasons for the low contribution of consumer spending to the Russian economic growth,” he says. “Like it or not, Russia remains primarily a play on the oil price.”

Volatile days are here to stay

While the past 12 months have been extreme, wild swings of sentiment are nothing new to managers of Russia-focused funds, says the manager at Black Rock, whose iShares MSCI Russia Capped fund has returned 9% since the beginning of the year, while remaining nearly a quarter down on a year earlier. Russian funds have long displayed elevated volatility even by emerging-market standards, with Black Rock’s product over 1,000 basis points (bp) more volatile than is typical for its other funds.

The Market Vectors Russia ETF has a three-year standard deviation of over 27% or 1,200bp higher than the average for the MSCI Emerging Markets Index over the same period, the manager points out. “That is the price of investing in Russian ETFs,” he says. “I don’t think it’s going to change in the near future. It’s not for the faint of heart.”

Investors have been cheering a stronger ruble and firming oil prices, but the recent “farce” of President Vladimir Putin’s disappearance from public view for a week, which prompted widespread speculation about his health, a coup or even death, served to underline the continuing political risks, says a fund manager at Vanguard, one of the world’s largest ETF managers, which does not run a purely Russian fund.

Moreover, the country remains fragile from a macroeconomic standpoint with high inflation, continuing recession and a wobbly currency. The central bank reserves are down 26% on a year ago, the Vanguard manager notes. “You may like what happened in February, but you can’t give me a good reason why it couldn’t be reversed in a week,” he says, referring to the ruble’s 14% gain in that month. Last year, the Russian currency was down 46%.

Russia-focused EFTs offer investors a great opportunity for quick returns that many, especially small investors, may struggle to find, says the Direxion manager. Equally, however, they require an ability and willingness to absorb large short-term losses, which may be recouped over a longer time period. “One of Direxion’s funds is going to be a star performer at any given time,” says a fund manager at another firm. “But you may not necessarily make any money, unless you can tell, which one. And that, to me, seems impossible.”

Until, perhaps, someone comes up with an ETF that instead of tracking a Russian stock or bond index has an index of its volatility as its underlying asset. But that would be an entirely different financial product.