An increasingly wide group of institutional investors, high-net-worth individuals and retail investors are providing the new capital to make Russia the world’s best performing equity market so far this year. The MT-50 share index is up nearly 200% in dollar terms, while the RTS index of 22 leading stocks has risen 166%. Demand continues to be funnelled through American Depository Receipts (ADRS), which have kept the blue chips active. However, newly-formed Russian equity funds are exploring lesser-known shares, and there is an expanding universe of attractive and undervalued companies.
Investors entering the market for the first time include global emerging market equity funds, US and European insurance companies, Swiss banking institutions, university endowments, and a wide assortment of US and European-based mutual funds.
Most of the hedge funds, the mainstay of the Russian stock market since the advent of privatization, have also been big Russia buyers. They range from the small Caxton Corporation and Moore Capital to the well-known Tiger Management, New Century Holdings and George Soros’s colossal Quantum Fund.
Soros, who once referred disparagingly to Russian “robber capitalism”, revealed in July that the Quantum Fund had made a $980 million investment in Svyazinvest, the telecom holding company that has controlling interests in 85 of Russia’s regional telecom companies. He has also expressed interest in bidding for a controlling stake in the state oil holding company Rosneft, which is to be fully privatized this autumn. A spokesman for the oil company said recently that Soros funds are prepared to spend about $1 billion on Rosneft, which is most prized for its role as the government’s agent in production-sharing deals.
Another important hedge fund was gathering capital recently for a tradeable securities fund. New Century Holdings had $700 million invested in the region, mainly in private equity, public securities and property, before setting up its latest fund to invest in public securities.
Some market participants predicted earlier this year that hedge funds were beginning to sell their positions in Russia and were searching for fresh pastures. Instead they stayed put and trounced their peers over the first half of 1997. “Many emerging market equity funds earned their strong returns (better than 40% in the first half of the year) from investing in Russia,” says Nicola Meaden, chief executive of Tass Management, a London-based firm that tracks hedge funds and their performances.
Managers of the top global emerging market equity funds have also been pouring money into Russia for much of this year. The biggest investor on this block is Capital International, whose London-based portfolio advisers have exceeded the $1 billion mark in their allocations to Russia via four funds. This is more than three times the amount allocated at the end of the third quarter last year and still represents only just over 6% of assets under management. “We favour a bottom-up approach,” says Koenraad Foulon, a portfolio manager for Capital International. “We invest in good companies and we don’t tend to trade.”
Another major advocate of Russia among these global emerging market equity funds is Grantham, Mayo, Van Otterloo (GMO), based in Boston. For a blue-blooded asset management company, GMO sits surprisingly close to the cutting edge of investing. It has the largest chunk of its portfolio ($250 million or 12%) allocated to Russia.
Five funds managed by Morgan Stanley Asset Management have also been major buyers. Morgan Stanley had more than $200 million invested in Russia during the second quarter of 1997 and this has certainly risen significantly following third-quarter buying and the asset manager’s investment in Svyazinvest.
Even the arch-conservative US pension funds are warming to Russia. The trend-setter was the State of Wisconsin Investment Board, which has been one of the most active pension funds in Russia for some time. At one point it had an 8.7% stake in the Templeton Russia Fund, a closed-end country fund that has been trading on the New York Stock Exchange at a big premium to net asset value. But Wisconsin has divested from Templeton and is rumoured to be making a more daring move into the underlying shares of Russian companies.
Brokers in Moscow say that an assortment of pension funds have recently become very active in Russia, including those of British Petroleum and General Motors. Scottish Widows Investment Management, which has long had a little invested in Russia, is reportedly adding to its holdings.
Some market observers see the Moscow-based Brunswick Group’s recent joint venture with SBC Warburg as an attempt to improve its marketing of Russia to US, European and Asian pension funds. The venture, Brunswick Warburg, will fuse the primary and secondary equity and corporate finance activities of both firms in Russia.
Several US university endowments have also displayed strong interest in Russia. The $8 billion Harvard University endowment, managed by the Boston-based Harvard Management, is bolder than most college endowments since it invests directly in Russian companies instead of through hedge funds or dedicated Russian equity funds. Following steady investment in Russia over the past year and thanks to some hefty capital appreciation, Harvard’s fund managers had to sell some of its holdings to keep its weighting below 10%. Princeton and Yale universities also have endowments active in the Russian market.
Fund managers are finding a ready source of capital eager to increase exposure to Russia in the Arabian Gulf. There are funds managed by the governments of Kuwait and Oman and an assortment of family trusts and high-net-worth individuals. A slew of Korean institutions, unlike their Japanese counterparts, have invested in Russia. Regent Fund Management was among the first to tap into this group through its $12 million Golden Tiger Fund, a closed-end equity fund open only to Korean institutional investors.
Brunswick’s Loren Bough says that a wide range of new international investors from other emerging markets are entering Russia. “Latin American investors are comfortable with countries coming out of hyperinflation,” says Bough, head of trading for Brunswick Securities, the New York subsidiary of the Moscow brokerage firm. “There are plenty of Latin American banks interested in Russian blue chips.” Latin American players making waves in the Russian equity market include Pactual Capital, Banco Bozano Simonsen and Garantia Bank.
Most investors in Russia are, however, less at ease in tricky markets than the Latin Americans. For these more conservative types, purchases of American Depository Receipts provide a solution. ADRs are reassuring because they are traded offshore and represent a fixed number of a foreign company’s underlying shares. They are also designed to avoid Russia’s clearing and settlement problems, and the US Securities and Exchange Commission’s (SEC) requirements on depository and custody.
Since the first Russian ADR was launched in January 1996 (for Lukoil) the popularity of the instrument has blossomed. By mid-July a total of $6.05 billion had been invested in Russian ADRs, according to Chris Sturdy, head of European depository receipts for the Bank of New York (BNY), which is the depository for all Russian ADR programmes.
Many Russia-dedicated funds hold Lukoil, Tatneft, Mosenergo or Irkutskenergo ADRs in their portfolios, but the instruments have had the broadest appeal among global and international fund managers which don’t specialize in Russia. They have also attracted the interest of the heavily regulated pension funds.
According to research by Technimetrics, a New York-based company that tracks institutional investment through SEC filings: “Investors with large Russian ADR holdings at the end of the second quarter included the usual cast of institutional characters, including Fidelity, Fleming, Foreign & Colonial, Merrill Lynch, Montgomery and Morgan Stanley Asset Management.” Far more interesting is the fact that less familiar names came up, like Massachusetts Financial Services, Janus Capital Corporation, Neuberger & Berman Pension Management and Wachovia Capital Management.
ADRs have done a great deal to raise international investors’ awareness of Russian companies, according to BNY’s Sturdy. A company announcing it intends to launch an ADR programme immediately catches the attention of international investors, resulting in a surge of liquidity for most enterprises. Russian issuers with ADR programmes were among the best performers last year and strong ADR buying was behind the blue-chip rally and the boom in the equity market in late June and early July.
A total of 17 Russian companies had issued depository receipts in various forms by early August, including Russian blue chips such as utilities UES, Mosenergo and Irkutskenergo, and the oil and gas majors Lukoil, Chernogorneft, Tatneft, Surgutneftegaz, and Gazprom. Most are Level I issues that don’t raise new capital for the companies.
In July, Salomon Brothers recommended that investors take profits on ADRs following their recent run-up in prices. According to Danielle Downing, Salomon’s London-based emerging Europe strategist, Russian ADRs have appreciated (on a market cap weighted average basis) by 114.5% for the year. The average p/e ratio for Russian ADRs was 16.5 at the beginning of July, compared to 9.7 for the market as a whole. Downing thinks many ADRs are now trading at emerging market comparables. As many as 15 more companies could have ADRs by the end of 1997, Downing says. Nearly 9% of Russia’s total market capitalization is now held offshore in ADRs. That figure could rise to 15% by the end of the year.
As the international and global equity funds grow comfortable with Russian risk by investing through ADRs, they are becoming more adventurous. “We have noticed a dramatic increase in accounts that have procured custody in one way or another and are beginning to invest directly in Russian companies,” says Brunswick’s Bough. “There is a big incentive for this since the perception among investors is that the highest returns are in a Russian stock before it gets to ADR form.”
It is perceptions like these that have led to an increase in funds entirely invested in Russia. By mid-1997 there were more than 60 dedicated Russia funds, according to Boston-based investment newsletter, Russia Portfolio. The funds are involved in publicly-traded securities or private equity. The value of the assets under management for investing in Russia then exceeded $6 billion.
But with all the new capital ready to mobilize, managers of dedicated Russia funds are scrambling to launch new funds or raise more capital with tranches of existing funds.
In August, Moscow-based Hermitage Capital Management was raising money for a second fund to complement its existing $820 million Hermitage Fund. The fund was the best performing dedicated Russia fund this year, recovering gains of nearly 200%. Hermitage II will provide more of the same, in that it follows exactly the same strategy as the original fund, investing in companies with low valuations which the manager feels are on the verge of being discovered by the broader market.
Hermitage managing director William Browder says the new fund is necessary to protect existing investors from dilution. It will have a two-year lock-up, after which redemptions will be permitted on a quarterly basis.
Brunswick Capital Management, the London-based asset management arm of the Brunswick Group, raised $125 million from European and US institutional investors for a fund focusing on second- and third-tier Russian equities. The Dublin-listed fund, known as the Brunswick Russian Capital Appreciation Fund, closed in mid-July, having raised $25 million more than the original target figure of $100 million. Its investment strategy will be to buy into relatively unknown companies in such sectors as food processing and packaging, steel, oil and telecommunications.
“The Brunswick fund was designed to catch a wave of interest for investing in second- and third-tier stocks, and we wanted to tap a few new sources in Europe and the US,” says David Geske, director of the private equity group for BV Capital Markets in New York, which helped Brunswick raise capital for the fund. He goes on: “In other fund placements we’re definitely seeing more pension money.”
In the US, demand for Russian stocks by retail investors has been huge. The best evidence of this is the amount of retail capital that has flooded into the Lexington Troika Dialog Russia Fund, the only open-end Russia country fund in the US. The fund had around $40 million in early June, but by the end of July this had risen to $141 million. After receiving good publicity for reaching the 100% mark in total returns this year and posting the best performance so far in the crowded field of US open-end mutual funds, the fund was taking in about $6 million per day at the end of July.
Investors have been calling Lexington asking if they can expect another doubling of the fund’s net asset value over the second half of the year. Such has been the irrational exuberance that the fund’s directors would almost welcome a correction in the market.
