Russia ETFs in Focus

The week between Christmas and the new year is traditionally a quiet one on Wall Street, with volumes plummeting as traders enjoy a long vacation and many large firms shut down altogether. Indeed, the post-Christmas week of 2009 has seen little action, with most major benchmarks lacking direction in light trading. Russia, on the other hand, has been a hotbed of activity, with several major developments unfolding this week that could have a major impact on the country’s financial markets as the calendar turns to 2010.

Russia positioned itself to reenter the international capital markets by repaying the last of its Soviet-era debt in an exchange for cash and sovereign Eurobonds. Finance Minister Alexei Kudrin has indicated that Russia could issue at much as $18 billion in Eurobonds in 2010, joining a handful of Latin American emerging markets expected to tap international debt markets next year.

At a time when concerns about public finances are sweeping across Europe, Russia is moving in the opposite direction. Standard & Poor’s recently raised its sovereign outlook on Russia from negative to stable and affirmed its BBB rating. “I think there will be high demand” for Russia’s Eurobond, said John Chambers, chairman of Standard & Poor’s sovereign-rating committee. “It’s a solid investment-grade credit.”

Russia’s investment grade rating from all three major firms is believed to be sound due to its $440 billion in gold and currency holdings.

Unexpected Restrictions

Also this week, Prime Minister Vladimir Putin announced measures to curb the inflow of speculative capital, a reversal of rules that were implemented in 2006 to encourage foreign investment. “We now have conditions that attract inflows of speculative capital,” said Putin. “We have to change the rules in order to make the country less attractive to speculators.”

Despite cutting interest rates ten times since April, Russia’s refinancing rate remains at 8.75%, an attractive level to foreign investors facing near-zero rates in their home countries. “It flows in quite well, it works here, but then it causes problems, because if a crisis hits, it leaves quickly,” said Putin, who declined to give specifics on the new restrictions.In addition to creating potential for a currency crisis, the speculative inflows make Russian exports less competitive in the global market.

The CurrencyShares Russian Ruble Trust (XRU) has exhibited significant volatility in recent weeks, falling by nearly 13% over a three week stretch beginning in late November. XRU then recovered to gain nearly 8%, and has been fluctuating on a daily basis.

Russia ETF Options

As one of the world’s largest developing economies and a member of the BRIC bloc, Russia is afforded a modest allocation in most diversified emerging markets and BRIC ETFs (although the exact percentage can vary significantly). But for investors looking for pure play exposure to the Russian economy, the Market Vectors Russia ETF (RSX) offers more targeted exposure.

RSX seeks to track the performance of the DAXGlobal Russia+ Index, a benchmark composed of about 35 publicly-traded Russian equities. Not surprisingly, RSX is tilted towards commodity firms, with almost 60% of the fund’s assets given to the oil & gas and iron & steel industries. The fund is dominated by large caps, but does give about 20% of its holdings to companies with a market capitalization of less than $5 billion.

Investing in the Russian equity markets isn’t for the risk averse. After losing almost 75% of its value in 2008, RSX has surged by more than 135% in 2009. Despite this extended rally, the fund is about 40% below its January 2008 price.

2010 Outlook

Assessing a potential investment in Russia heading into 2010 is a challenge. The repayment of Soviet debt leaves the country on relatively solid financial footing (especially relative to Europe), but continued dependence on energy prices for government revenues introduce significant risks.

The regulatory environment for foreign investors, which had improved significantly in recent years, appears to be clouding over once again. In other words, Russia is an emerging market, full of economic potential if markets continue to develop but also full of countless risks and potential pitfalls.

Disclosure: No positions at time of writing.