From Russia With Love: Closed-End Funds

by: Wexboy

A top project for me this year was to evaluate Russian fund investment opportunities. My plan was to work my way through all (related) funds. This approach might seem exhaustive, but as I've discussed before this type of effort's always paid off in spades for me. This includes reading each fund's last few annual reports, and evaluating returns (over 1, 3, 5 & 10 years, if available), the fund's geographic focus, any particular company/sector concentration, and the percentage invested in unlisted stocks.

It's surprising how quickly factors change: Relative discounts and upside potentials, the risk/reward profile of slightly different investment objectives, your own investment thesis, even the appearance of an activist shareholder on a fund register. While I'm all in favor of sticking with a good investment (over-trading's definitely your enemy), ranking and tracking all (related) investment alternatives offers the chance to switch horses at short notice if it becomes attractive enough. Also, you'd be surprised how much this type of peer analysis improves your knowledge and insight when it comes to buying/selling/evaluating your preferred investment.

You'll notice I ignore ETFs. I'm not opposed to them, but I'm wary of some of their specific disadvantages. As long as I can find a good closed-end fund or two, I'll generally prefer them to an ETF. Occasionally, a sector or country becomes interesting to me, and it's neglected enough to prompt some decent fund discounts - an extra bonus! Right, let's walk through the funds I've identified (for more global/detailed stats and commentary, see my full blog post):

First, there are 3 ex-Soviet satellite countries worth considering as an alternative: Ukraine's often lumped in with Russia but, despite having important agribusiness and steelworks sectors, it doesn't really have comparable natural resources sector. Two other markets in the region that better mirror Russia's cheap valuation and heavy concentration in natural resource stocks are Kazakhstan & Mongolia:

Tau Capital (OTC:TAUPF): Tau's a UK AIM listed closed-end fund, investing primarily in Kazakhstan (66%), and also in Russia & Central Asia. Unlisted stocks comprise 37% of its portfolio:

Discount to NAV: 35%

1 Year Return: (18)%

3 Year Cum. Return: 12%

2008 Return: (43)%

Ukraine Opportunity Trust and Origo Partners are both UK AIM listed closed-end funds offering exposure to Ukraine and Mongolia, respectively.

Next, we'll consider Russia & Eastern Europe funds, a sector that never made much sense to me. First, it's not much of a coherent 'region' these days. As far back as the fall of the Berlin wall, Eastern European nations have been desperate to escape their Russian bear-hug, and to embrace Europe instead. Can you blame them ... ?! I recall when these funds were born, the average punter was terrified of Russia, so the fund marketing guys thought throwing Eastern Europe (and Turkey..?!) into the mix would be a great way to allay investor anxiety and suck them in.

Every time Russia was flavor (and performance) of the month, funds could boast about their Russian allocation - and when Russia was doing a Red October, they could just waffle on about Poland and Hungary instead ... In the end, with 50-75% usually allocated to Russia, Eastern Europe's a sideshow, Russia was always going to dictate whether you had a good year's performance or not... But let's take a closer look, and see if anything interesting turns up:

Morgan Stanley Eastern Europe Fund (NYSE:RNE): RNE's a US listed closed-end fund which invests in Russia (57%) & Eastern Europe:

Discount to NAV: 11%

1 Year Return: (24)%

3 Year Cum. Return: 73%

5 Year Cum. Return: (13)%

10 Year Cum. Return: 250%

2008 Return: (64)%

Central Europe & Russia Fund (NYSE:CEE): CEE's another US listed closed-end fund which invests in Russia (72%), Eastern Europe & Turkey:

Discount to NAV: 9%

1 Year Return: (12)%

3 Year Cum. Return: 67%

5 Year Cum. Return: (1)%

10 Year Cum. Return: 323%

2008 Return: (53)%

Baring Emerging Europe (OTC:BRIMF): BRIMF's a UK listed closed-end fund which invests in Russia (63%), Eastern Europe & Turkey:

Discount to NAV: 7%

1 Year Return: (23)%

3 Year Cum. Return: (1)%

5 Year Cum. Return: 4%

10 Year Cum. Return: 319%

2008 Return: (23)%

East Capital Explorer and Eastern European Trust are Swedish and UK listed funds that you should also consider as alternatives.

Now, let's turn to the dedicated Russia funds:

Vostok Nafta Investment (OTC:VNHIF): Vostok's a Swedish listed closed-end fund, focused solely on Russia. It's a pretty concentrated fund, with over 50% in its top 3 holdings: TNK-BP Holding (OTC:TNKBF), Black Earth Farming (OTC:BLERF) & Tinkoff Credit Systems. Approx. 10% of its portfolio's in unlisted stocks. Longer term shareholders have done better than the poor investment record suggests - in a previous incarnation, Vostok achieved v substantial returns as a Gazprom investing vehicle. I recommend you read their annual reports - they provide some fascinating and informative Russian commentary on both a macro and a micro basis:

Discount to NAV: 19%

1 Year Return: (19)%

3 Year Cum. Return: (70)%

2008 Return: (63)%

Templeton Russia & East European Fund (NYSE:TRF): TRF's a US listed closed-end fund which, despite the name, appears to be primarily Russia-focused. It has 87% invested in Russia, with another 8% in Ukraine. It's managed by Mark Mobius, who has a stellar long-term record with his Templeton Emerging Markets Fund (NYSE:EMF):

Discount to NAV: 6%

1 Year Return: 18%

3 Year Cum. Return: (44)%

5 Year Cum. Return: (5)%

10 Year Cum. Return: 457%

2008 Return: (72)%

There are plenty of other overseas funds to consider: EOS Russia, ENR Russia Invest, Aurora Russia, Prosperity Voskhod Fund, Renaissance Russia Infrastructure Equities and JPMorgan Russian Securities. These are Swedish, Swiss and UK listed. Except for the JPMorgan fund, all have unlisted stocks in their portfolios (a common feature of most Russia-focused closed-end funds).

So why the interest in Russia?

Well, pretty much any emerging/frontier market's preferable to those in the developed world these days! Everywhere I look, I see better growth, better demographics, better government finances, lower debt and no currency debasement... And all this for stock market valuations similar to/cheaper than Western markets. There are a number of particularly attractive markets - for example, I've highlighted Vinacapital Vietnam Opportunity Fund (OTCPK:VCVOF) on my blog as a great Vietnamese fund opportunity. With my continuing bullish view on oil and other commodities (and the inflation risks posed by global QE), Russia presents another compelling market opportunity.

So how does Russia stack up these days? Well, first one needs to realize how far it's come. In the past 10 years GDP's more than quintupled, it's become a Top 10 global economy, and average GDP per capita (in nominal terms) is around $16,700. This $17 K goes pretty far in what's still an emerging market, and explains the booming Russian middle class, something many investors have under-estimated.

The Russian economy's in excellent shape: Inflation's at a post-Soviet era low of 3.7%, unemployment's at 6.6%, GDP's forecast to grow 3.5%, and the rouble's estimated to be 20-30% under-valued on a PPP basis. Perhaps the Russians are winning in the end..?! Oil, natural gas, metals and timber account for over 80% of Russia' exports. From a government perspective, things look good also, with the budget deficit forecast at about 1% of GDP, the Debt/GDP ratio's around 10% and Russia's FX/gold reserves have topped $500 billion. For investors, Russia's looking pretty tasty too, with market capitalization near $1 trillion, daily trading volume at $6 billion, and valuation standing at a 6.6 P/E, a 1.1 P/B and a 1.9% dividend yield.

I'd have preferred to see a higher GDP growth rate (amusing versus what we see/can expect from the US & Europe!), but the Russian economy's now about $1.9 trillion and can't escape the law of large numbers. However, the stock market's rock bottom valuation more than compensates. Even if you think a low P/E's deserved (which I don't, in this case), this low valuation offers an asymmetric risk/reward scenario as newsflow develops, unexpected events occur, and sentiment changes ...

I wasn't particularly fazed by the political uncertainty, and protests, in the lead-up to the elections. Despite the media hoo-hah (trying to scare up a story where one didn't really exist), it was obvious Putin would win. There was a small risk, at worst, he might have been forced to build some alliances, and make some concessions, to attain and consolidate victory. But, of course, that wasn't necessary in the end. There's nothing particularly alarming about the social/political protests either - I see no real sign of a fundamental rejection of government, the focus appears to be on political corruption, the lack of political choice and election fraud, the wish for a greater/more organized democratic voice/input etc.

Not to belittle it, but this is exactly what you'd expect from younger/well-educated/better traveled people, and/or a burgeoning middle class. It may take some years, but their aims will eventually be subsumed into a more coherent and better organized democratic/political movement. But, for the moment, protest's an intoxicating (considering Russia's history) step for many towards broader democracy. Putin's been smart enough to recognize this, and it explains why he hasn't responded more forcefully to the protests. I think it will also be a key inspiration for his domestic strategy during this new term of government.

My only disappointment with the election run-up was the lack of any real retracement in the market! I'd hoped this would occur, and present better buying opportunities. Once again, look to the markets, rather than the media, if you want to be better informed of a political outcome..!

So, macro looks excellent, what funds make sense on a micro basis? First, I'll discard the Ukraine/Kazakhstan/Mongolia funds. Yes, their discounts (to NAV) are attractive, but this mainly reflects their exposure to unlisted stocks. There's nothing unique or compelling enough about these funds to warrant choosing them over a decent Russia-focused fund. I'll keep my eye on Origo Partners as a China-focused play, however (even as it becomes more Mongolia-focused, its portfolio companies are dependent on China as an end-market).

I've highlighted my distaste for Russia & Eastern Europe funds, but let's take another quick look. East Capital's 34% discount to NAV's attractive, vs. an average 9% for the other funds, but its poor NAV history eliminate this fund for me. Of the rest, Central Europe & Russia Fund and Baring Emerging Europe are the obvious stand-outs for longer-term performance. If you're not US resident, the Baring fund might be preferable to CEE which is a US closed-end fund (and it performed significantly better in 2008).

Now to the Russia funds: In terms of their poor long-term performance, I'm discarding EOS Russia, ENR Russia Invest, Vostok Nafta Investment and Aurora Russia. Prosperity Voskhod Fund's been a decent performer, but Templeton Russia & East European Fund and JPMorgan Russian Securities are better known and have much longer histories. Of these two, long-term performance's neck-and-neck. If you're US resident, I'd opt for TRF - otherwise, the JPMorgan fund might be the better choice, with a much larger market cap. Surprised by this point? - don't be! Most investors inevitably buy the largest cap fund/stock, and so should you, unless a smaller cap fund/stock offers significantly more upside potential.

Renaissance Russia Infrastructure Equities is a bit of a special case. Its discount is attractive, Renaissance is admired as a Russian (and increasingly, African) expert, but its NAV history is mixed and it's got a 25% exposure to unlisted stocks. However, it offers a fairly unique proposition - exposure to Russian infrastructure. Yes, infrastructure companies/funds haven't lived up to their promise in the West. But blame cash-strapped governments, and the credit boom, for that! Governments needed low costs and high returns from infrastructure projects/deals, while PE fund mind-sets and cheap credit justified ever-escalating prices. Poor projected returns on equity then required increasing levels of debt to justify the deals, thereby exacerbating the financial risks involved. In emerging markets, it's a very different story - infrastructure's rightly regarded as an equity growth play, not a bond-like investment to be grossly levered up.

This opportunity exists in other markets too (Vietnam Infrastructure, a U.K. listed fund on a 45% discount is enticing), but Russia offers an interesting political dimension. I think two key planks of Putin's developing/new strategy will be a i) a wave of privatization to decrease the role of the state in the economy, and more importantly, ii) a substantial and sustained investment in infrastructure projects. This investment's required anyway, but what a marvelous 'story' it will be to seduce and appease the Russian public - everybody loves the effects of a spending spree! It will promote growth and employment, offset any potential hiccups in oil/natural resource revenues and/or global growth, and the government has the robust finances and debt capacity to fund it.

I now have a 5.3% Russian fund allocation, and may well increase it further exposure further. If we see a substantial spike in oil (and/or commodity) prices, I may then consider reducing my overall Russian exposure (hopefully, taking profits!?).

** Call me distrustful, but long-term fund returns one finds around the web often don't appear the most reliable to me ... I prefer to calculate returns myself directly from NAV histories. Note all funds don't report on a calendar year basis, so 2008/long-term returns aren't completely apples-to-apples. Also, for U.S. funds, I've included annual distributions in my return calculations, but haven't assumed a dividend reinvestment effect.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. NOTE: I am LONG JPMorgan Russian Securities (JRS:LN) and Renaissance Russia Infrastructure Equities (RIEL:LN)