Russian stocks have become compelling for many investors, owing to their low valuations. The forward price-to-earnings ratio of the MSCI Russia Index is currently around 6x compared to 13x for the broad MSCI Emerging Markets Index.
Valuations have been depressed for a host of reasons, ranging from weaker commodity prices, Western sanctions resulting from the annexation of Crimea, ageing demographics, and poor corporate governance standards among state-owned enterprises. Despite these risks, contrarians argue that Russian equities now offer a compelling value proposition that is hard to ignore.
Russia Funds Covered by Analysts
At the end of 2017, there were 64 funds available for sale in Europe in the Morningstar Russia Equity category, with consolidated assets under management of approximately €9.5 billion. Around €8 billion were invested in 53 active funds, with the remainder in 11 passive offerings.
Morningstar analysts rate five active funds. Of these, four are medallists and one carries a Morningstar Analyst Rating of Neutral. With combined AUM of €2.8 billion, these five funds account for more than one-third of all assets invested in active Russia equity funds. Meanwhile, of the 11 Russia equity passive funds on offer, only the largest, namely the Lyxor Russia GDR ETF, has a Morningstar Analyst Rating, and it is Negative. This rating reflects our conviction that the ETF will underperform its active peers over the long-term.
Narrow Portfolios
Most active Russia equity funds are benchmarked to the MSCI Russia 10-40 Index, which covers large- and mid-caps. The index spans across 22 stocks, including depositary receipts, preferred shares and local shares. Stocks are capped at 10% and those that weight more than 5% cannot in aggregate represent more than 40% of the portfolio. This not only makes the index a handy guide to comply with UCITS diversification rules for active equity funds, but by tilting the portfolio toward smaller-caps, it also limits exposure to state-owned enterprises.
Rated active Russia equity funds tend to be benchmark aware. That is, their portfolios do not look very different from the benchmark to which they are referenced. Three out of the five rated funds hold almost all the benchmark names. The Neptune and Prosperity funds hold considerably fewer index names and, unsurprisingly, have a significantly higher active share.
While most active Russia equity funds benchmark themselves against the MSCI Russia 10-40 Index, no passive fund currently tracks it. Market liquidity is likely to be a key reason.
The indices that passive funds currently track also apply caps to individual holdings, ranging between 10% and 30%. That said, the top three holdings usually account for more than half of the index weight. The only exception is the DAXGlobal Russia, which applies a firm 10% cap on single stocks and thus limits the combined weight of the top three holdings to 30%.
Interestingly, the top three holdings of all these indices – Russia’s largest bank Sberbank and energy conglomerates Gazprom and Lukoil – have been the same over the past two decades. However, their individual weight in each index has dramatically changed over that period. For instance, Sberbank has seen its weight in the MSCI Russia more than double to 23%. Gazprom has lost nearly a third of its weight and currently accounts for 13% of the index, whereas rival Lukoil has increased its weight from 11% to almost 14%. While Gazprom and Sberbank are state-owned enterprises, Lukoil is not.
Compared to passive offerings, rated Russia active funds allocate less weight to their top three holdings.
Energy Heavy
Market-cap weighted Russian equity indices suffer not only from single stock concentration, but also from heavy sector concentration to energy. For example, the MSCI Russia Index exposure to oil and gas stocks has fluctuated between 45.4% and 94.8% over the past 20 years.
While exposure toward energy has decreased during the past decade, it remains substantial, typically accounting for approximately half of the index weight. Meanwhile, as of writing, industrials, consumer discretionary, healthcare, information technology and real estate are not represented at all.
By contrast, active Russia equity funds have underweighted their exposure toward energy by 10% and 20% relative to the MSCI Russia 10-40 and MSCI Russia, respectively, during the past decade. This may have partly shielded them from the downside to Russian energy stocks when oil prices tumbled in mid-2014. As of now, their average exposure to the sector is 30%.
In the five-year period to the end of January 2018, the MSCI Russia Index has lagged the average fund in the Morningstar Russia equity category by an annualised 1.52%. Portfolio attribution shows that the index’s exposure to energy detracted the most from performance relative to category peers during the period.
Governance Issues Persist
Another reason that is likely to have given active Russia equity funds a performance edge is their corporate oversight activities. Many of Russia’s biggest companies are state-owned enterprises, which tend to suffer from poor corporate governance. By moving further down the market-cap spectrum, limiting their exposure to state-owned enterprises and screening for corporate governance risks, active managers have been able to add value.
It’s not surprising that active Russia equity fund managers tend to consider the quality of corporate governance in their current and prospective holdings. According to Morningstar’s Sustainability Atlas, Russian companies receive some of the lowest corporate-governance ratings in the world.
All five-rated active Russia equity active funds apply an initial corporate governance screening, but the approach and its overall impact on the final stock selection can differ substantially. For example, at the Neptune Russia & Greater Russia Fund it is the least pronounced, while at the HSBC Global Investment Funds - Russia Equity and JPMorgan Funds - Russia Fund, corporate governance and management quality get considerably more attention.
Higher Fees Shouldn’t Deter Investors
Passive investing in Russian equities is clearly cheaper than active investing. Most passive funds have ongoing charges between 0.50% and 0.65%, apart from FinEx Russian RTS Equity ETF, which has an ongoing charge of 0.90%, and Horizon Access Russia Cap, which is by far the most expensive passive offering.
Active funds rated by Morningstar analysts are more expensive. Ongoing charges for the clean share classes hover between 1.05% and 1.37%, except for the Prosperity fund which charges 2.46%. However, the hurdle of the higher fees shouldn’t deter investors, as these funds have proved their worth by generating higher value than cheaper passive offerings.
