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IT’S NOT SO very long ago that the average Russia hedge fund manager had little to worry about. Just still being in a job was a good start. Now, after years of stellar returns on the Russian stock market, managers are awash with concerns. Where to find a properly qualified nanny, the price of a decent bottle of wine in Moscow’s top restaurants, and how to convince erstwhile classmates at public school reunions that being a Russia hedge fund manager doesn’t mean you’re a spiv. Ah, the slings and arrows of making an outrageous fortune.
Last, but by no means least, there’s the added pressure from clients to continue to produce the triple-digit returns that many hedge fund have been able to deliver in recent years. Although there is a wide variety of investment approaches among the hedge funds that invest in Russian equities, the one common strand is that producing the sort of returns that have been seen recently will become increasingly challenging. This common stance apart there are widespread differences between the attitudes of different firms about the correct approach to investing in Russia.
Take the thorny issue of investor activism. William Browder and his team at Hermitage Capital Management, which has more than $3 billion of assets under management, has become famous for his principled opposition to robber-baron aspects of some Russian corporates and has been vociferous in challenging murky practices. As a result he has been banned from entering the country.
However, Eric Kraus, managing director of the Nikitsky Fund, believes that an activist stance is not conducive to producing returns for investors. "It may be good for a fund manager’s ego, but it’s not necessarily good for his clients," he says. "We consider it to be, even at best, an expensive waste of time, at worst it can be deeply counterproductive. We feel that our investors’ best interests are served by having the fund align itself with the interests of management – not trying to force change on an unwilling reference owner with interests radically different from our own."
Kraus adds that activist investment in Russia is suitable primarily for venture capital funds or others willing to take equity stakes of more than 25% in return for board representation. "Nikitsky does not take management stakes in any company, though we will, of course, support activist investors with our votes," he says.
Michail Kart, managing partner at Marcuard Spectrum, takes a simple view on corporate governance abuses. "If we don’t like something a company does, we simply sell out of it," he says. But he adds that in recent years there’s been a massive overall improvement in corporate governance – "owners now understand that’s it’s easier to comply with investors’ requirements than it is to try to rob them". Although in principle applauding Hermitage’s stance, Kart says that in practice small fund management groups such as Marcuard Spectrum simply cannot afford the management time and effort involved in adopting an activist stance.
Florian Fenner, managing partner at UFG Asset Management, is another activist investment agnostic. "Activist investment presupposes a system where you can rely on the courts to back you up, which is still a questionable proposition in Russia," he says.
Improvement
Nikitsky’s Kraus, who was once one of the most vociferous critics of corporate ethics in Russia, believes that while the notion of corporate governance might have been an oxymoron in the 1990s, the more egregious practices are now a thing of the past. "The cumulative success of Russian IPOs in the west means that more and more managers see this route as a realistic exit, which gives them an incentive to be more investor-friendly," he says. He adds that while good corporate governance is an undoubted positive, it’s by no means a be all and end all in terms of determining whether Nikitsky decides to invest in a company or not. "The best opportunities are often to be found not in those companies with the best current governance, but rather where an improvement in practices is under way," he says.
There is also a wide diversity of opinions about the relative merits of taking long or short positions. Although Hermitage’s Browder famously believes that if you want to be short, you don’t want to be in Russia, James Fenkner, managing partner at Red Star Asset Management – founded in 2005 and so one of the most recent additions to the Russia hedge fund universe – believes that while a long-only bias has worked well over the past couple of years, funds with a long/short component will increasingly come to the fore in terms of investment return performance. Since its inception in 2005, Red Star’s assets under management have more than doubled to exceed $100 million.
"Long-only has been the right strategy in the last 18 months or so, but the Russia story is changing – it’s not just a cheap play any more, so we believe that increasingly you need to have a long/short approach," Fenkner says. He adds that the ideal conditions for a long/short approach are when you have a deep, inefficient and choppy market. "The market here in Russia is deep and inefficient, and is beginning to become increasingly choppy." He says that on so-called Terrible Tuesday in February, Red Star’s long/short mix worked well and that the firm’s portfolio of shares ended five basis points up on a day when the market lost 3.5% overall.
One of the hotly debated topics among Russia-dedicated funds is the growing influence of the Bric (Brazil, Russia, India, China) investment theme on market behaviour. In line with this, a growing number of mainstream emerging market fund managers have stopped trading smaller, thinner markets to concentrate on the bigger, deeper markets. When the Chinese stock market tanked and dropped by nearly 10% on February 27, the shock waves were soon felt in Russia, where the markets lost 3.5% on the same day and slipped by another 10% in the following week. UFG’s Fenner says that based on economic fundamentals there should be no correlation between the Chinese and Russian markets. "Given the strength of the Russian economy and of the Russian equity market there should be no fundamental correlation between Moscow and Shanghai," he says. But in practice, he adds: "The big Russian blue chips are all part of Bric-focused portfolios and so investors liquidating positions in one market can have an effect on the performance of other markets in the same portfolio."
Kart at Marcuard Spectrum agrees that while the actual fundamental linkage between the two markets is tenuous, market sentiment, not market technicals, often drives performance. "We think that the market performance correlation between the likes of China and Russia may increase as a result of the Bric focus," he says. "The market sell-off in February was sentiment-driven – the economic risk here in Russia is minimal."
Nikitsky’s Kraus says: "In February Russia merely reflected rather than amplified the volatility that we saw around the world."
| "We feel that our investors’ best interests are served by having the fund align itself with the interests of management – not trying to force change on an unwilling reference owner" |
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In terms of future market performance, most Russia hedge fund managers are agreed that although there should continue to be strong growth in the overall market, the ability to stock-pick will increasingly come to the fore if investors are to enjoy the sort of above-market performance they have come to expect from hedge funds. Fenner says: "Over the last couple of years Russia was a cheap asset – you bought and you prayed. But the time has now arrived when the easy money has been made and you need a proper manager." Red Star’s Fenkner agrees: "Russia’s not expensive, but it’s certainly not cheap and you have to be able to pick the right sectors and the right companies."
As he points out, although the overall market is up 200% over the past couple of years, there are still some stocks that are down by as much as 80%. "You don’t want those in your long book," he says.
Kart at Marcuard Spectrum believes that the choppiness of the Russian market in late February was a good opportunity for those pursuing a hedging strategy. "We’re extremely happy with volatility," he says, adding that the firm had bought a put on the market back in January. "We believe that 2007 will demonstrate the value of a long/short investment strategy."
Kraus at Nikitsky says: "We use shorting for profit, not as a hedging tool. We short highly liquid, blue-chip assets, which are fundamentally overpriced."
While the relative merits of hedging will continue to be fiercely debated, for those who believe that shorting is a legitimate tool, the most important factor is being able to source appropriate instruments to implement that approach.
Marcuard Spectrum’s Kart says that the derivatives market in Russia is becoming more sophisticated and more competitive as new entrants enter the market and that this is making the whole hedging process a more viable option. Kart’s colleague Richard Stevenson, director of sales and trading, says: "Turnover in RTS futures, for example, is now running at $150 million a day and single-stock options are widely available on the top 10 to 15 Russian stocks." He adds that one of the most welcome recent developments has been the clampdown on margin lending by the Federal Securities Commission, which has had positive, albeit largely unintended, consequences for the derivatives market in Moscow. "By clamping down on margin lending the FSC forced a lot of people into the RTS futures market, which has been a positive development for the equity market as a whole."
Nikitsky’s Kraus agrees that the regulatory authorities are playing an increasingly positive role. "Before the FSC clamped down on margin lending, there were some accounts that were seven or even eight times leveraged," he says. "That sort of practice can cause markets to go into free fall, which is clearly not healthy. The FSC used to be known as a toothless shark, but now the shark has grown teeth."
Despite improvements in the general availability of derivatives, some managers would like to see further improvements in single-stock options in particular. "Liquidity is still very poor and the bid-offer spreads are still too wide," says UFG’s Fenner.
Despite the market wobbles of late February the hedge funds contacted by Euromoney remain upbeat about future market performance in Russia. What’s the underlying premise for this widespread view?
One reason is politics. Although Russia is a bête noire with the liberal intelligentsia in the west, president Vladimir Putin’s strong-man approach has had real benefits for some sectors. Fenkner at Red Star says that the politics in Russia are particularly positive for two sectors that have been relatively unloved in recent years – telecoms and utilities. "There’s a need to cut costs and raise tariffs in both sectors, and with a monolithic government it’s easier to do this than under a democratic one," he says, adding: "Pro-business policies have created an increasingly attractive investment environment in these sectors."
Power company RAO UES, for example, is expected to be a prime beneficiary of reforms and is widely tipped to be one of 2007’s star performers. "RAO UES is an example of extreme undervaluation," says Fenkner. "It’s the biggest and cheapest utility in the world." Fenkner believes that by the time Putin leaves office in 2008, the share price could be as much as 50% up on current values. UFG’s Fenner agrees that 2007 could be the year of RAO UES. "It’s still trading below replacement value at the moment because of the low tariff regime, but there’s no doubt that the government will choose to go down the higher-tariff route." He adds that Russian electricity reforms are pretty liberal compared with such countries as Spain, where political meddling has bedevilled the proposed takeover of Endesa.
Kart at Marcuard Spectrum is also enthusiastic about the electricity sector, which will witness the sale of several regional companies in 2007. "The whole sector is undervalued and needs capital markets funding," he says. "To get that the government will need to let investors make a decent return on their investments."
Hedge fund managers say that in addition to a stable, albeit increasingly authoritarian, political climate, other domestic developments are having an increasingly positive effect on the country’s equity market. "There used to be a lack of a domestic investor base, but that is now changing," says UFG’s Fenner. "The fact that Sberbank was able to place $8 billion in its IPO shows what’s now possible. That wasn’t the case two years ago."
Despite Sberbank’s share price doubling last year, Fenner still believes that the stock offers further upside potential. "People complain that price/book valuations for banks like Sberbank are too high," he says. "But you shouldn’t look at trailing P/B value, you should look at forward P/B value – when a book is growing at 35% a year there’s still value to be had."
Fenner says that in a multi-year growth sector such as banking there is also value in smaller players than Sberbank, such as Vozrozhdeniye Bank. "Russia’s still a barbell market in every sector," he says. He believes that the continuing bread-and-butter banking services nature of Russian banks is a key strength not a weakness. "At Russian banks you can tell where they make money – and it’s not from sub-prime lending," he says.
Nikitsky’s Kraus is another banking sector fan, both of the whales, such as Sberbank, and relative minnows such as Bank of Moscow. "Sberbank lives off deposits and lending, not prop trading," he says, adding: "While Bank of Moscow is aggressively growing its mortgage lending business. I like that because at the end of the day you can’t drive an apartment away."
Broadly bullish
So are there no clouds on the horizon? Marcuard Spectrum’s Kart says that inevitably the presidential elections in 2008 will bring added political risk to the investment equation, which could dampen investment inflows. But for the most part Russia hedge fund managers remain broadly bullish about the future.
"In 2005 and 2006 we saw strong market performances, driven mostly by local players, which are the engine of growth," says Kart, adding that the fast-growing mutual fund industry in Russia is providing increased liquidity, which is helping to underpin market performance. He acknowledges, though, that despite growing foreign interest in Russia, plenty of institutions are still wary of the country’s equity market. "We started seeing foreign institutional money coming back into the market at the end of 2005, beginning of 2006, but institutions’ enthusiasm for risk has been hit by the memories of the market crash of 1998," he says.
But what would happen if oil prices were to take a bath? "Since 1999, many people have found this to be a convenient reason not to be invested in Russia. Meanwhile the market has surged 20-fold," says Nikitsky’s Kraus. For Kraus there are two salient reasons why a lower oil price would not have the effect it had in 1998. First, Russia now has the world’s fourth-largest foreign exchange reserves, standing at $350 billion, in addition to an oil reserve fund of $108 billion. Especially since a collapse in oil prices would be deflationary, this extraordinary fiscal situation would leave the government a free hand for aggressive pump-priming measures in the unlikely event that it were to become necessary, says Kraus. He adds: "Secondly, it is simply not going to happen. The secular rise of China and India has permanently altered the global petroleum balance. Massive industrial growth in the developing countries is the primary driver for Russia’s economic resurgence and is not likely to reverse in the coming decades... and a medium-term sell-off will not abolish the European winter."
So next time you turn the heating up at home, remember to call your broker at the same time and buy Russian oil stocks to help you pay your bills.