Today marks the first day of trading for the Market Vectors Russia Small-Cap ETF (NYSEARCA:RSXJ), the first exchange-traded product offering U.S. investors exposure to small cap Russian stocks. The new fund from Van Eck will seek to replicate the performance of the Market Vectors Russia Small-Cap Index, a benchmark that includes about 35 small cap Russian stocks. The underlying components are unlikely to be familiar to many U.S. investors; the largest individual weightings are afforded to Pharmstandar, (8%), LSR Group (7.9%), and O’Key Group (6.8%).
RSXJ joins three existing Russia ETFs, the most popular of which is a Market Vectors fund (NYSEARCA:RSX) with nearly $4 billion in AUM. The Market Vectors Russia ETF offers exposure primarily to large-cap firms; about 95% of the underlying index is firms with a market capitalization in excess of $5 billion, with the remainder attributable to firms between $1 billion and $5 billion. The other existing Russia ETFs offer similar exposure. Both the SPDR S&P Russia ETF (NYSEARCA:RBL) and iShares MSCI Russia Capped Index Fund (NYSEARCA:ERUS) are dominated by large-cap companies. “We are strong believers in Russia and many other emerging markets and think that large-cap exposure definitely has its place,” said Ed Kuczma, Emerging Markets Analyst with Van Eck Global. “However, we also believe the best way to gain pure-play exposure to a country’s domestic economy is through smaller companies that derive their revenue primarily from doing business locally.”
International ETFs linked to capitalization weighted benchmarks are subject to certain biases, including a tilt toward the energy and financial sectors (oil companies and banks tend to be the largest companies in any economy, and as such tend to account for significant portions of the underlying portfolios). This tilt is extreme in the case of the Russia ETFs. Energy stocks account for close to 40% of RSX’s assets, and the sector receives even larger weightings in RBL and ERUS (energy stocks make up more than half of the iShares Russia ETF).
The sector allocation maintained by RSXJ is drastically different from those of its large cap counterparts. Utilities, materials and energy receive the largest sector allocations, each making up about 18% of assets. RSXJ also includes material weightings to industrials (15%) and consumer staples (10%):
|Van Eck Russia ETFs|
|Source: Morningstar data as of 4/5/2011 for RSX, VanEck.com as of 4/13/2011 for RSXJ|
The result is that the small-cap ETF complements the exposure offered by existing Russia ETFs that are heavy on exposure to large caps. Aggregate weighting to energy and financials for RSXJ is only about 20%, compared to more than 50% for RSX.
Some investors prefer to achieve exposure to international markets through small-cap stocks, believing that these securities are more of a “pure play” on the markets where they are traded. Whereas large caps tend to be multinational firms that generate revenues in markets around the world, small caps generally derive significant portions of earnings from the home market and as such are more sensitive to local consumption patterns. Though the history of many small-cap international ETFs is relatively short, there is evidence that the return differentials between large cap and small cap products can be significant. Last year, the delta was close to 20% for Brazil ETFs, highlighting the extent to which nuances such as market capitalization can impact the risk/return profile.
Case for Russia
Russia has historically been the black sheep of the BRIC bloc of emerging market economies tabbed to account for an increasingly large portion of global GDP in coming years. Rampant corruption and heavy dependence on the oil and gas industries have scared some investors off from Russian stock markets, and the country doesn’t maintain the same tailwinds from demographic shifts that can be boasted by Brazil, China and India.
But there is a lot to like about Russia as well, particularly in the current environment. Russian stocks are trading at a considerable discount to other emerging markets as measured by both price-to-earnings and price-to-book metrics, potentially creating value if the country’s efforts to diversify its economy and eliminate widespread corruption are successful. Russia’s stock market’s P/E was just 6.6x as of March, reflecting a significant discount to broad-based emerging markets indexes. Moreover, the sharp run-up in energy prices has been a boon to the Russian economy, and the windfall from increased oil and gas revenues is beginning to trickle down through the economy. Analysts expect impressive earnings growth from Russian stocks over the next two years, and there is some evidence that initiatives to grow a local technology industry are beginning to pay off; Belgian investors are the latest to express interest in the technology center outside of Moscow.
Rounding Out the BRIC
With the launch of RSXJ, the ETF lineup now includes small-cap options for each of the BRIC economies. Van Eck (NYSEARCA:BRF) and iShares (NYSEARCA:EWZS) offer small Brazil ETFs, while Guggenheim (NYSEARCA:HAO-OLD) and iShares (NYSEARCA:ECNS) have small-cap China ETFs available. EGShares debuted the first small-cap India ETF (NYSEARCA:SCIN) last year. State Street (NYSEARCA:EWX) and WisdomTree (NYSEARCA:DGS) also offer broad-based small-cap emerging markets ETFs.
RSXJ continues a trend in the ETF industry. As the last several years have seen the introduction of several small cap international ETFs, including products targeting both developed and emerging markets.
Disclosure: Long BRF.
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