The invasion of Ukraine and the needless suffering being inflicted on its citizens is rightly dominating our attention in the UK and many other parts of the world.
As people digest the longer-term consequences of Vladimir Putin’s aggression and the response of EU and NATO members, investors will naturally raise questions about their exposure to Russia through their own investments.
Thirty years since the end of the Soviet Union, Russia has long been an established part of emerging market asset classes and hence securities issued by Russian companies and the nation’s government will be found in many clients’ portfolios.
The question therefore facing the owners of these securities is what should they do with these holdings?
Few UK investors will have direct holdings in Russian securities and so, when thinking about owning Russian investments, it is important to clarify what we mean. Exposure to Russia is likely to fall into four categories.
First are holdings in ADRs/GDRs (American/global depositary receipts). These are securities listed on developed market exchanges that are designed to track the price of individual Russian companies such as energy company Gazprom and financial services company Sberbank. The second are funds dedicated to Russian securities, typically equities. These are likely to be the most obvious form of Russian investment in a client’s portfolio.
The third are funds that have exposure to Russian securities as part of a broader asset class, for example, emerging market equities or local currency emerging market bonds. It is worth noting that while Russia is a huge country and geopolitically important, its capital markets are relatively small, with the equity market accounting for approximately 3 per cent of emerging market equities and 5 per cent of local currency emerging market bonds before the latest crisis.
The final type of exposure is through the Russian investments of Western companies. A good example of this is BP, which owns circa 20 per cent of integrated energy company Rosneft.
Some investors will wish to exit Russian holdings on moral grounds, including BP with its plans to offload Rosneft, others will address the situation from a purely financial perspective. When viewed in the latter way, each of the structures mentioned above present different challenges and potentially different opportunities for investors.
As many Russian-focused funds have suspended trading, investors have no choice but to continue to hold their exposure at the current time. Other structures remain open, enabling investors to make a choice about the future of their exposure.
When thinking about what to do with these latter holdings, the first thing to note is that with Russian stock markets closed and capital controls in place, there is an absence of liquidity in Russian assets.
This has a number of consequences. The first is a lack of price discovery as it is difficult to know what others are prepared to pay to buy Russian assets when there is virtually no trade. This leads to a wide range of price estimates and a high level of volatility. When coupled with very poor sentiment, the distribution of these price estimates is naturally skewed to the downside.
Alongside the lack of price discovery, the inability to trade these assets creates further downside pressure as liquidity tends to be highly valued among investors, with illiquid securities typically trading at a discount. The combined impact of this can be seen clearly in the price of ADRs/GDRs that track the price of individual Russian securities, with Gazprom – Russia’s largest company by revenue – down more than 96 per cent at the time of writing, despite continuing to supply gas and oil that is priced in US dollars.
Although it is impossible to set a clear fair value on Russian securities at the current time, the downward pressure from illiquidity is likely to result in prices falling below a pessimistic estimate of fair value. Therefore, investors now selling emerging market funds in order to remove Russian exposure are likely to receive poor value for the risk they are removing from their portfolio, as, following the fall in the price of Russian securities, these assets now account for a very small portion of the broader emerging markets.
The question therefore becomes: should investors increase their exposure to Russia?
Leaving aside the moral question, logically, the belief that the current price to exit a holding is too low must be accompanied by the belief that excess returns can be gained by buying Russian securities.
However, given the lack of a direct access point being open to investors at present, expressing a positive view on Russian assets would probably require investing in a broad emerging markets fund that currently carries little Russian exposure. Acquiring a meaningful holding in Russia could therefore unbalance a portfolio by increasing the emerging markets position too far for the risk tolerance of the client.
It is therefore likely to be better for most investors to seek exposure in other equity and bond markets that are now attractively valued due to the recent falls in price, but are not likely to be highly correlated with Russia over the long term.
This provides us with a great reminder that the robustness of your portfolio construction is as important as the expected returns of your underlying holdings.
Dan Kemp is global chief investment officer at Morningstar
