The iShares MSCI Russia Capped ETF (NYSEARCA:ERUS) invests across the largest and most important Russian companies. The fund has been a big winner with its outsized exposure to key commodity and oil and gas stocks driving an impressive 35% return this year. The bullish momentum is supported by several fundamental tailwinds with the local economy benefiting from a post-pandemic recovery. We are bullish on the ERUS ETF into 2022 which offers targeted exposure to an attractive segment in emerging markets that can continue to outperform. The potential for a strengthening Ruble currency against the Dollar can likely add an incremental return going forward.
The ERUS ETF technically tracks the 'MSCI Russia 25/50 Index' which features constraints limiting any single stock to 25% of the total and a rule where the sum of all stocks with a larger than 5% holding total no more than 50% of the portfolio. This is an effort to limit the concentration of the fund to just a few names. Nevertheless, ERUS is top-heavy with just the top three holdings representing 45% of the fund, reflecting the country's relatively small stock market and the importance of commodities in the economy.
Indeed, 46% of the fund holdings are classified as in the energy sector, followed by financials at 21%, and basic materials at 16%. Among the top positions, PJSC Gazprom (OTCPK:OGZPY) with a 19% weighting is a state-owned energy company with the largest share of Russia's local gas market and also a major exporter in the region. Sberbank of Russia PJSC (OTCPK:SBRCY), another state enterprise, is the largest financial institution in the country and represents 14% of the fund. PJSC LUKOIL (OTCPK:LUKOY) with a 13% weighting in ERUS is a publicly-owned private company and recognized as a global major integrated oil company.
Again, the theme here is the heavy tilt towards commodity names. Other oil & gas names include PAO NOVATEK (OTCPK:NOVKY), PJSC Tatneft (OTCPK:OAOFY), and PJSC Rosneft Oil Company (OTCPK:RNFTF). PJSC Mining and Metallurgical Company Norilsk Nickel (OTCPK:NILSY) "Nornickle" with a 4% weighting in ERUS is also an important stock in the fund. The company is the world's largest producer of refined nickel, palladium, and number four in terms of platinum production which is benefiting from strong demand and elevated precious metals prices.
The good news is that this unique composition has been a key part of the fund's strong performance this year. While Gazprom gaining over 80% this year contributed to the fund's gains, the strength has been widespread into stocks in different sectors. Yandex N.V. (YNDX) with a dominant share of local internet search has gained momentum representing a regional tech player. There is a sense that the strength in export industries has added a boost to the local economy into broader financial conditions. Sberbank of Russia, returning over 47% year to date is capturing many of these tailwinds.
Russia Macro Update
The country's Central Bank, "Bank of Russia" recently updated its medium-term forecast across key economic indicators. Compared to a 3% GDP contraction in 2020, the Russian economy is set to rebound between 4% and 4.5% this year. The story here is an otherwise V-shaped recovery from the Covid pandemic with indicators like household consumption and gross fixed capital formation now above the pre-pandemic records. For 2022, the outlook is for resilient momentum with a GDP growth forecast between 2.0% and 3.0% considering what will be a more difficult year-over-year comparison period with economic conditions normalizing.
(source: Bank of Russia, highlights from author)
On the other hand, elevated inflation has been a challenge, including the latest reading at above 6% for October. The trend echoes dynamics observed in other parts of the world which goes back to pandemic-related supply chain disruptions as well as the energy pricing environment. The Bank of Russia has been proactive with several rate hikes this year taking the monetary policy reference rate to 7.5% compared to a low of 4.25% in 2020. The expectation is that the consumer price trends will stabilize soon and trend lower through next year and 2023.
One of the implications of the rising rate environment in Russia amid continued economic growth has been a stronger Russian Ruble currency against the U.S. Dollar. The Ruble has appreciated around 12% over the past year which is a bullish tailwind for the ERUS ETF that can gain an incremental return from the stronger currency. Companies within the portfolio generating revenues and earnings in the Ruble currency become more valuable all else equal.
There's a lot to like about Russia with the entire economy benefiting from what has been a renaissance in the energy sector. Fundamentally, strong pricing for oil and gas is generating strong cash flows and earnings for the underlying companies in the ERUS portfolio. We are bullish on energy and believe an improving global macro outlook through 2022 will ultimately be positive for the broader Russian economy.
Our bullish case for ERUS is that not only will the oil stocks continue to perform well, but that the holdings in diversified sectors like financials and industrials still represent good value if the Russian economy outperforms. A new cycle of investments towards energy and mining into the country can further support economic indicators including the labor market and consumer spending. The Russian Ruble currency also looks undervalued in the current commodity pricing environment.
In terms of risks, a potential deterioration to the global macro outlook accompanied by sharply lower commodity prices would likely send shares of ERUS lower. The fund's concentration in the energy sector means it will remain sensitive to the market pricing environment of oil and gas. With Russia, there is also a question of geopolitical risks considering ongoing sanctions by the neighboring European Union and the United States. Headlines related to the Russian government being accused of facilitating international cybercrimes can also limit sentiment towards investing in the region.
Overall, ERUS is a high-quality fund that provides investors exposure to some important foreign companies not widely held or with shares only available in thinly traded OTC issuance. We believe the fund can work as a long-term core holding to supplement energy and emerging markets equity exposure by overweighting Russia. The fund pays a semi-annual dividend that currently yields around 3.6%, which is variable depending on the distributions of the underlying companies.
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