THE SPRING BLIP has become something of a tradition in emerging markets. For the past three years, the market has come roaring out of the blocks in January, only for something to dent its confidence around March or April. Two years ago it was fears of US interest rate rises; last year it was hedge funds problems with Ford and General Motors. This year it was fears of rate rises again in the US, Japan and the eurozone.
The MSCI fell by about 12% in two weeks in February, with particularly steep falls in the Middle East, where markets were down 40%. Russia, one of the more liquid emerging markets, was also quite badly hit, with a loss of 5% in a day.
But it has also become something of a tradition for emerging markets to recover their vim around June or July, and have a strong even record-breaking second half of the year. Thats how it has been for the past few years, as record amounts of institutional money flow into emerging market portfolios, attracted by higher yields and improving macroeconomic fundamentals. The volume of capital flowing into Russia, for example, has never been higher. In January, $1.4 billion flowed in, compared with an average over the past few years of $240 million a month. Last year, the RTS was one of the best-performing markets in the world, rising 83% and outperforming every western market.
But at least one specialist fund manager, Red Star Asset Management, is saying that Februarys correction wasnt a blip but the beginning of the end of emerging markets latest 14-month bull run, and a sign that tougher times lie ahead.
The question you have to ask is how long this perfect storm will continue, says James Fenkner, one of Red Stars founders. Since the 1998 crisis in Russia, long-only funds have made a lot of sense, because we were in an asset re-rating situation. But the market has in many ways now re-rated. Its not the same story going forward. The bull run can go on longer of course, but if youre building a business, do you want it to be long only, like most other Russia funds? We want to build a business thats sustainable in the bad times as well as the good. The company has therefore set up that rare thing in the Moscow investment universe a long/short fund.
|Tim Seymour, James Fenkner and Tim McCarthy: Rising stars in Red Square|
All three had successfully set up business units at Troika, and the brokerages owner, Ruben Vardanian, was slowly giving equity to senior managers like them, but the three felt they wanted to set up their own business. They negotiated a generous seed financing package with a US multi-strategy investment firm and launched the company in April 2005.
Hedge fund misnomers
McCarthy says: There are around 100 so-called hedge funds operating in Russia, but in fact theyre almost all long-only. So theyre charging hedge fund fees, while still being full volatility. Theyre not really adding value. We thought, this is probably the most inefficient market in the asset class, we want to add value, focus on the inefficiencies, arbitrage them, while also taking part in the upside.
The fund model they developed, which is based on a previous Troika fund, involves two portfolios a core, long-only portfolio, and a satellite portfolio made up of relative-value pairs and other market-neutral arbitrages. When the managers are positive about the market, as they were in December, for example, they will allocate, say, 80% to the core portfolio and 20% to the satellite. In February, by contrast, when they thought the market had passed its zenith, they reversed those allocations.
As a result, they have a beta of 0.05% on the RTS, so were basically flat as Fenkner says, compared with between 0.8% and 1.2% for most other Russia funds. At the same time, they still have 0.29% alpha. Were an absolute returns fund, which is something pretty unique to the region, says McCarthy. Were trying to bring in a steady rate of return, of around 4% a month.
Fenkner has a good reputation as an analyst Bill Browder, CEO of Hermitage Capital, says: When he was chief strategist at Troika we all made money off his strategies, so I wont be surprised if his new fund does well and Red Star has a strong research team, with four other analysts, and 234 discounted cashflow risk-adjusted models for individual stocks. Fenkner says this is probably more than any brokerage. The models cover 97% of the market. Another important part of its marketing appeal is its office in New York, which Seymour runs.
Most of Red Stars capital is invested in relative-value pairs. The managers particularly like going long on energy companies preferred shares while shorting their common shares. Most preferred shares trade at a pretty big discount to common shares, because they are seen as more vulnerable to abuse by majority shareholders, says McCarthy. That has been an important factor over the last 10 years, as oligarchs try to get control of companies. However, by this stage they already have control of these companies, so voting rights are less important and dividends are more so. Thus we expect to see the gap between preferred and common shares decrease. Red Star is at present shorting common shares for Tatneft and Surgutneftegaz.
The fund also takes long positions in its core portfolio. For example, it has made good returns from investing in Rosneft subsidiaries while the company is buying out minority investors in subsidiaries before its IPO, scheduled to take place around July.
Wary of muggers
That IPO, which sources say is being lead managed by ABN Amro, Dresdner Kleinwort Wasserstein, Sberbank and Morgan Stanley, is set to be by far the biggest Russian IPO yet. The government hopes to raise between $15 billion and $20 billion from the IPO. But the flotation could be controversial for some western investors, who still feel stung by the governments seizure of Yukoss main asset, which ended up being owned by Rosneft. It seems like they have mugged us and are now trying to sell us back our wallet, says Angelika Millendorf, head of Raiffeisen Capitals emerging Europe fund. Rosneft became associated in foreign investors minds with the dreaded Siloviki, politicians from the old military or security services, often seen as strongmen. Rosnefts chairman, the FSB (Russian security services) apparatchik Igor Sechin, is seen by many Moscow businessmen as the arch-Silovik.
Red Star is tight-lipped about the likelihood of success for the IPO, although Fenkner says: If it is placed, it will clearly be a landmark deal for Russia. In general, though, he says, foreign investors have got more comfortable with the Siloviki, and with the increasing role of the government in some parts of the economy.
The traditional view is that the state is not the most effective manager of businesses, Fenkner says. However, what the market appreciates now is the lowering of risk that the presence of the government as a shareholder brings. After all, governments like Russia and Kazakhstan are wonderful credits, so its advantageous for investors if they are involved. He gives the example of car manufacturer Avtovaz, whose share price rose sharply after the state acquired a stake in it last year.
And investors now seem comfortable with what Fenkner terms the twilight of the oligarchs. He says: Oligarchs provided a service, they helped rationalize industries and brought efficiencies to them. But they werent able to provide everything, and a fundamental issue with investors is stability. The state having a share helps ease that concern. He adds that the acquisition of Sibneft by Gazprom last year helped give a lot of confidence to investors because, unlike the Yukos debacle, the change in ownership was done in a civilized manner, at a fair price.
Of course, investors inclination to have confidence in the government as a joint shareholder depends a lot on who is in charge of that government. Both the business community and the wider population have great faith in president Vladimir Putin. Fenkner says: His main achievement is to bring back something that many Russians feel was lost in the 1990s a belief in systems, a belief in tomorrow, that you will still have a job tomorrow, and a bank account, so its predictable enough to take out loans and make investments.
But could that trust disappear when Putin steps down from the presidency in 2008? McCarthy thinks not. Putin has built strong enough systems to outlast him, he says.
Some bankers disagree with this hypothesis. One head of corporate finance at a Russian bank says: I think if anything Putin has weakened institutions hes weakened the Duma, and made it more of a rubber stamp than a proper scrutinizer of legislation; hes weakened the regional governors; hes weakened press independence; and he has failed to improve judicial independence.
Still, Red Stars positive take on post-Putin Russia doesnt stop it being bearish when it comes to its assessment of capital inflows. The massive capital flows that have come into emerging markets over the last five years are going to start to dry up, says McCarthy. Rates are going up in western markets and Japan, and the yield curve is getting flatter, so there is less incentive to go into riskier assets.
He says history would suggest that there is likely to be a hard landing but that local funds, a growing proportion of the market, could pick up some of the slack as western funds pull money out of emerging markets. Still, Fenkner says ominously: There are now billions of dollars in local retail money in the market. The government would be sensible to remind them that markets can go down as well as up.