Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Morningstar Analyst, Monika Dutt, to talk about Russian equities.
Hi, Monika.
Monika Dutt: Hi. Thanks for having me.
Wall: So, Russian equities are an incredibly compelling investment prospect at the moment. Emerging markets have done very well over the last couple of years outperforming developed market equities. But Russia has lagged and it's also coming from a very low base. So, the opportunity for upside is still there.
You did a paper recently looking at the best ways to gain exposure to this asset class, to this geographical region and found that passive funds were not the best way to go. In fact, it paid to pay for actively-managed funds and then you got more outperformance. So, perhaps I thought you could briefly summarise some of the contributing factors to that conclusion.
Dutt: Absolutely. So, investors in Europe can access Russia via active funds or via passive funds. And in our study, we found that passive funds are highly concentrated at the sector and stock level. They allocate approximately 40% to 60% toward energy and single stocks can go up to 20% of the weight in the portfolios. So, the top three holdings, Sberbank, Lukoil and Gazprom, actually make up half of their portfolios. Active funds are a lot more diversified and diversification is a something that we look for, because diversification is the only free lunch in finance.
Wall: And having a look at some of those specific funds, we rate – our Morningstar fund analysts rate one passive fund and a number of actively-managed portfolios. Starting with the passive fund, it actually has a Negative rating from you and the team. What's gone into that decision?
Dutt: Certainly. So, we rate the Lyxor Dow Jones Russia ETF and as you said, that has a Negative rating. As mentioned, it's highly concentrated at the sector and the stock level. This fund is the largest fund, which is why we chose to rate it. And it actually tracks a benchmark which only covers GDRs. So, these are stocks that trade on foreign non-Russian exchanges and it only includes 12 stocks. These are mega-caps, state-owned enterprises.
Wall: And that speaks to that point of concentration. And those actively-managed portfolios presumably have more diverse portfolios and have more stocks within those portfolios. What are some of the actively-managed portfolios and are there any amongst them that we positively rate here at Morningstar?
Dutt: Sure. So, we actually have four funds that are active and that we rate positively. And we like these funds because they are more diversified at the sector and stock level. But what they also do is they move further down the cap spectrum. So, they have a smaller cap tilt. And also, they screen for corporate governance risks. As you know, Russia scores really low on corporate governance. So, it makes sense, it's like a sensible approach to screen for corporate governance. And these are some of the key reasons why we feel like active funds have an edge.
Wall: And when we talk about whether to go active or passive within any type of region or asset class, price is a hugely contributing factor to that decision. In this particular case, Russia, is it the case that what you are paying for you are remunerated for it in terms of profits, in terms of performance and so far, it is worth paying that extra bit in order to get better performance?
Dutt: Yes, because the differential between active and passive is quite large in terms of ongoing charges within the Russia equity space. But given their higher prices, they still have been able to outperform passive funds on a risk-adjusted basis over time.
Wall: Monika, thank you very much.
Dutt: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
