Zaks Investment Advisory Service

How Americans Can Invest in Russian Stocks

Today, we will conclude our series of programs about Russia. In the previous two programs, I described the positive economic changes witnessed in recent years. I also touched on several structural problems that could potentially weaken future growth. Despite all the difficulties, the Russian economy has grown in recent years and share prices on Russian stock markets have followed along. Over the past five years, the RTS index has shot up by a factor of 6.5, or 550 percent. For comparison: the S&P 500 index rose by about 50 percent over the past five years. It is quite likely that future growth on Russian markets will slow. Moreover, it goes without saying that the Russian stock market is riskier than the one in the United States. One should remember that over the course of one year, between October 1997 and October 1998, the RTS index lost 92 percent of its value. The market’s structure has changed substantially over the past 10 years. Still, the RTS index has just lost nearly 20 percent in a matter of days, between January 14 and 23, 2008. One should keep this in mind. But despite all their problems, Russian markets remain an attractive investment. What opportunities do American investors have?

As is usually the case, there are quite a few of them. A person could invest in American Depository Receipts (ADRs), which are the near equivalent to individual stocks issued on foreign exchanges. Most Russian companies that chose to issues shares abroad did so in London rather than New York, the reason being that American exchanges require a lot more documentation, something that Russian companies prefer to avoid. Nevertheless, several companies have issued ADRs in New York, ones like Gazprom; LUKoil, an oil giant; the steel company Mechel; the MTS (Mobile TeleSystems) and Vimpel phone companies; and the dairy manufacturer with the amusing name, Wimm-Bill-Dann. There are more Russian companies in London – about 20 of them. Their trade volume is very thin, and they are all but inaccessible to US investors. But this is not a very significant problem: I would not advise my clients to directly invest in individual Russian company shares anyway. These companies lack sufficient information about them, which makes them too risky. Instead of individual ADRs, it makes sense to purchase either mutual funds or closed-end funds, or exchange-traded funds, especially since these are readily available.

Two of the best-known mutual funds trading in Russian shares are ING’s Russia Fund (LETRX), and the Third Millennium Russia Fund (TMRFX), which is managed by World Funds, Inc. The Russia Fund is much larger than Third Millennium, but in essence the two vary little. The largest investments made by both funds are in Sberbank and LUKoil. Gazprom is in third place at one, and Norilsk Nickel at the other. Both funds showed outstanding results in 2007: the Russia Fund grew by almost 30 percent, and Third Millennium – by 28 percent. This is better than the RTS index (the Russian equivalent of S&P 500), which does not happen that often. Technically, the Russia Fund slightly outpaced the index not just in 2007 but also, on average, over the past six years. Why technically? Because in real terms, from the investor’s standpoint, this is not the case. The Russia Fund is fairly expensive. To buy it, one first has to pay a so-called “front load” of 5.75 percent, which means that if you invest $10,000 in the fund, you will only have $9,425 working for you and $575 going to pay the commission fee. By the way, I talked about mutual fund fees in one of my previous programs. Moreover, the RTS index does not account for dividend payments made by Russian companies. If one weighs both factors, it turns out that the RTS index grew by more than the investor’s real return in Russia Fund. Six-year results at the Third Millennium Fund were slightly worse than the Russia Fund’s.

The assets of two closed-end funds, those of Templeton Russia (TRF) and The Central Europe and Russia Fund (CEE), are primarily made up of Russian company shares. Templeton was one of the first investment firms to invest in stocks of Russian companies. On average, Templeton’s results exceed those of all other funds, both open and closed-ended. Just as its name would suggest, The Central Europe and Russia Fund invests in stocks of former Eastern Bloc countries, so it is not exactly a purely Russian fund. Investors must bear in mind the peculiar nature of closed-end funds: sometimes they trade at a price above their net asset value (what is called “at a premium”), and sometime – below (“at a discount”). The spread at Templeton Russia can be enormous, ranging from +40 percent to –5 percent over the past 12 months. An investor’s real return thus depends on the premium or discount at the time of the purchase.

More recently, a new exchange-traded fund appeared on the market called Market Vectors Russia (RSX). We’ve discussed exchange-traded funds in the previous programs here and here. Like all ETFs, it follows an index – in this case, an index created on Germany’s largest stock market in Frankfurt. Since the number of different actively traded Russian stocks is relatively small, this ETF resembles the already-mentioned open and closed-end funds: its assets include shares of Norilsk Nickel, LUKoil, Gazprom, Sberbank and so on. The ETF has a two-fold advantage over mutual funds: one does not have to pay a front load to make the initial purchase, and its annual expense ratio is much lower. In this respect, they are also cheaper than closed-end funds. In addition, the ETF’s price is usually very near the net asset value, something, as we have just mentioned, that cannot be said of closed-end funds.

And with this, we will draw today’s program to a close. Next time, we will talk about a country whose markets have gained more over the past five years than those of either China or Russia. This was Sergey Zaks. Thank you for your attention and until next time.