By Elio Manca, managing director of ITI Funds.

ITI Funds: Investing passively in the Russian markets.

The Russian growth story is in its ascendancy, with economic forecasts indicating the country will grow and strengthen throughout 2018.

Data for January suggest conditions have markedly improved since a slow end to 2017. Independent research firm Capital Economics suggests Russian GDP growth has picked up to more than 2% year-on-year, a significant increase from the 1.5% the country achieved in 2017.

Markets barely moved following Vladimir Putin’s landslide election victory in March, an endorsement of his recent leadership style that suggests a shift toward more orthodox macro policymaking is here to stay.

With Russia-listed companies continuing to offer average dividend yields of 5% and current pay-out ratios expected to increase from 20% to 50% given the government indication, the Russian market clearly should not be ignored as an investment opportunity. The RTS Index – Russia’s main market – currently offers a P/E ratio of 7.7x, comparative to a ratio of 16.5x for the MSCI Emerging Market Index.

With Russia now emerging from the dip in its economic cycle and with equity markets failing to account for any improvement, now seems like a particularly opportune time to invest.

ETFs tracking the Russian stock market provide a cheap, highly liquid and diversified exposure to capture this potential upside. On average, Russia ETFs incur a total expense ratio of 0.65% while Russia-focused active investment funds currently charge between 1% – 1.5%.

So far this year, inflows and outflows in Russia ETFs have been in excess of $1 billion, with investors increasing their allocation to Russia to the tune of around $100 million. Added to this, they are moving away from swap-based ETFs to physically-replicating models.

Only one equity ETF outside of Moscow provides exposure to locally listed shares, tracking the RTS Index, while all the others track narrower indices based on ADR/GDR shares comprising between 15 and 28 companies.

The ITI Funds RTS Equity UCITS ETF SICAV (RUSE LN), launched in February this year, tracks the RTS Index, physically investing in 45 local shares. This offers a greater diversified exposure as well as good liquidity, with the RTS Index being the index that underlies Russian future contracts.

Liquidity

Whilst up to 40% of the RTS Index is allocated to a handful of the largest companies by market capitalisation (notably Sberbank, Gazprom, Lukoil), by investing across Russia’s main RTS Index through an ETF, investors can gain exposure to both larger and smaller-cap stocks. They will also be able to trade on an intra-day basis and benefit from the increased liquidity and reduced market impact that replicating the index offers.

As passive funds are more frequently traded than active funds, it is easier for investors to move in or out of assets in an environment of both liquidity and transparency. The impact on the market is minimalized, with fundamentals driving the share price.

Diversification

Passive funds and ETFs enable investors to buy full replication of “the market” in a single transaction, offering investors superior diversification across industry sectors to the broader indices.

It is true that Russia remains a resource-driven market, accounting for close to 20% of global crude oil and gas exports. However, there are dynamic changes in Russian demographics, reflected in the broad Russian RTS Index. Russia’s consumer sector is benefitting from lower inflation and falling interest rates and now accounts for approximately 6.5% of the index weighting. Meanwhile, the country’s technology sector is experiencing exponential growth, substantial development and international investment.

Buying into a fund or ETF which physically replicates Russia’s RTS Index combines exposure to not only the oil & gas and banking sectors but also to potential returns from others growth areas like agriculture, technology and all other sectors benefitting from Russia’s improving economic cycle.

Opportunities through passive investment

Market strategists forecast that Russia will advance from the low point in its current economic cycle under Putin’s continued leadership. This is reflected in recent economic data and qualified simultaneously by S&P raising the country’s credit to investment grade, in line with Fitch.

Valuations of the Russian market remain outdated and very cheap. As a core approach, an ETF which tracks Russia’s RTS Index provides the cheapest, most liquid and diversified way of accessing Russia’s upside potential.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)