ETFs and the Russian market: tracking the trend

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1 ; STRATEGY RESEARCH DEPARTMENT Erik De Poy +7 (495) ext Alexander Nazarov +7 (495) Andrey Klapko +7 (495) ext The emergence of exchange-traded funds (ETFs) has been one of the more prominent trends in Russia equity investment in recent years. Their popularity is an important development, not only with regard to typical portfolio structure, but also investment strategy. ETFs enhance investors ability to hedge global economic and commodities risk, and this has encouraged the use of passive strategies in Russia focusing on beta at the expense of active management. The result has been periods of dampened volatility interspersed with sharp index movements when sentiment reverses, suggesting opportunities for investors to pick up oversold, high-beta stocks. Fund flows track the rise of ETFs. The ascendance of Russia ETFs is most clearly illustrated by the fact that they have seen greater inflows (and fewer outflows) versus traditional funds in each year since 28, as well over the past five years on an aggregate basis. According to EPFR Global, a cumulative $3.27 bln has been invested in Russia ETFs over this period, versus $2.57 bln in non-etf funds, which is remarkable given that the first Russia ETF was launched just six years ago. Is Russia becoming a beta trade? For many investors, Russia is too risky a market in which to chase alpha, but an increasingly attractive market in which to adjust beta. Russia ETFs are increasingly being used by long-short investors pursuing a market-neutral strategy to add or subtract beta (systematic exposure) while relying on pair trades to generate portfolio alpha. NAV and put-to-call ratio new gauges of sentiment. The overnight premium or discount of an ETF s NAV to its traded price can serve as a useful indicator of pre-market sentiment. For judging longer-term sentiment, an ETF s put-to-call ratio can also act as leading indicator. For example, the put-to-call ratio of the RSX Index, the largest and most liquid Russia ETF, is currently at a level of more than 2.6, which reflects very bearish sentiment toward the Russian market. Locally traded ETFs? There has been heightened interest in allowing foreignregistered Russia ETFs to be admitted for trading on the local market. The regulator is currently examining the necessary legislative amendments, and talk continues of the creation and launch of locally registered and traded Russia ETFs. It thus seems likely that at some point perhaps by end 213 ETFs will become a feature of local equity trading, representing another step in the Russian market s evolutionary development. Russia ETF vs non-etf fund flows, cumulative % change, Aug 7 to date 3,% 2,5% 2,% 1,5% 1,% 5% % Aug '7 Dec '7 Apr '8 Aug '8 Dec '8 Apr '9 Aug '9 Dec '9 Apr '1 Aug '1 Dec '1 Apr '11 Aug '11 Dec '11 Apr '12 Aug '12 Dec '12 Russia non-etf flows Russia ETF flows Copyright Gazprombank (Open joint-stock company) All rights reserved 1

2 Flexible alternative to local investment ETFs have increasingly been seen by foreign investors as a viable and even preferable alternative to local portfolio investment compared with traditional funds, largely owing to their structural characteristics that facilitate ease of trading, liquidity and tax advantages. Ease of trading relative to local stock means that Russia ETFs can be used as a means to hedge EM, commodities or global economic exposure. ETFs and the structure of Russia fund flows The impact of ETFs is increasingly being felt on the Russian market through the structure of equity portfolio flows. Based on EPFR Global data, over the past five years ETFs have accounted for 56% of the net inflow of funds to Russia, with the figure reaching as high as 96% in 212. Such figures reflect the global trend favoring conservative indexing strategies and away from traditional, alpha-seeking approaches. The following chart helps illustrate this relative shift toward passive strategies, driven by the trend favoring ETFs. Whereas cumulative fund flows dedicated to active strategies have been consistently greater than for passive strategies since 21, the latter category has increased significantly and is now roughly 8% of the level of active strategies. Russia active vs passive fund AUM, 21 to date, $ mln 1/2/21 31/3/21 19/5/21 7/7/21 25/8/21 13/1/21 1/12/21 19/1/211 9/3/211 27/4/211 15/6/211 3/8/211 21/9/211 9/11/211 28/12/211 15/2/212 4/4/212 23/5/212 11/7/212 29/8/212 17/1/212 5/12/212 23/1/213 13/3/213 9, 8, 7, 6, 5, 4, 3, 2, 1, Russia active flows, cumulative Russia passive flows, cumulative Due to concerns about where the global economy and financial system may be headed, and based on the widespread perception that Russia is primarily a commodities play, investing in Russia seems a high risk-return proposition for many foreign investors. Having to invest locally to gain exposure to many Russian stocks without DRs only increases this risk perception. Unsurprisingly, they have sought out instruments that address these concerns, and ETFs have positioned themselves well to meet this demand. Russia ETF flows, past year ($ mln) and % of AUM 8.% 6.% 4.% 2.%.% -2.% -4.% -6.% Mar '12 May '12 Jul '12 Sep '12 Nov '12 Jan '13 Mar ' Russia ETF flows, past year (rhs) % of AUM 2

3 Russia ETF flows, 3m ($ mln) and % of AUM % 2.% 1.%.% -1.% -2.% -3.% -4.% -5.% -6.% Dec 26 Jan 2 Jan 9 Jan 16 Jan 23 Jan 3 Feb 6 Feb 13 Feb 2 Feb 27 Mar 6 Mar 13 Mar 2 Mar 27 Russia ETF flows, 3m % of AUM (rhs) Characteristics of ETFs There are several advantages of investing through ETFs versus index mutual funds: 1. Enhanced price discovery. ETFs trade throughout the day, allowing investors to quickly determine NAV, whereas a mutual fund s value is provided just once per day, usually at the end of a trading session. 2. No recordkeeping fees. ETFs are not required to maintain records for shareholders. This is unlike the case with mutual funds, especially if they have many small accounts. 3. Tax efficiency. ETFs are generally more tax efficient than index mutual funds, as they can exchange ETF shares for a basket of actual stock. This is considered an in-kind transaction and thus is not a taxable event for the ETF. By comparison, to meet redemption requests an index mutual fund must sell stock to raise cash, which is a taxable event. 4. Lower management fees and transaction costs. Although there are trading fees associated with ETFs, they are typically much lower than those associated with an index mutual fund. For example, the management fee of the RSX (Market Vectors Russia, the largest Russia ETF) is.62%, and for the most liquid ETF (SPDR S&P 5) the fee is just.9%. ETFs have only a couple of disadvantages compared with index mutual funds: 1. Higher license fees. ETFs usually pay higher license fees to S&P than do index mutual funds. 2. Divergences between closing NAV. The pricing of ETFs traded in a foreign market can be stale, i.e. their price cannot react to overnight events between markets due to time differences. This leaves investors exposed to the inability to react on a timely basis to information that has an effect on ETF quotes. ETFs represent a claim on physical shares, with investors who purchase an ETF certificate entitled to claim redemption in exchange for the underlying stock. The creation and licensing process is regulated by the US Securities and Exchange Commission, while the US Depository Trust Clearing Corporation monitors trading and the process by which stock is transferred to an ETF holder. ETFs versus traditional fund investment Over the past five years, the cumulative percentage change in Russia ETF AUM has far outpaced that of traditional mutual funds. Of course, the scale of the rate of growth results from the low-base effect (see front-page chart), but as the following table indicates, Russia ETFs have actually performed better in terms of cumulative flows over the past five years on both annual and aggregate bases. 3

4 Russia ETF vs non-etf fund flows, cumulative, past 5y, $ mln Non-ETF flows ETF flows past 5y 2,574 past 5y 3,274 past 4y 2,45 past 4y 2,69 past 3y 416 past 3y 1,594 past 2y -1,838 past 2y -1,187 past 1y -731 past 1y -453 Index performance and Russia ETF flows Looking at the post-crisis correlation of index and fund flow performance, the RTS picked up in 21 at a time when Russia ETF flows were broadly positive on a weekly basis (see chart below). After peaking in spring 211 as fears about the Eurozone debt crisis mounted, the index began an extended decline accompanied by sharp redemptions from ETF investors. Then, after the announcement of further easing measures by global central banks, ETF flows and the RTS picked up in unison. This rough correlation broke down in spring 212, with the RTS continuing to rise as ETF flows became choppier and mostly negative. The past six months of relatively flat ETF flows has coincided with range-bound RTS performance. Cumulative Russia ETF flows vs RTS Index since 21, $ mln 5, 4,5 4, 3,5 3, 2,5 2, 1,5 1, 5 Jan '1 Mar '1 May '1 Jul '1 Sep '1 Nov '1 Jan '11 Mar '11 May '11 Jul '11 Sep '11 Nov '11 Jan '12 Mar '12 May '12 Jul '12 Sep '12 Nov '12 Jan '13 Mar '13 Russia flows, cumulative RTS Index (rhs) Benchmarking pressure The trend favoring investment through ETFs over the past several years is clear, but the question then becomes: how firmly entrenched is it? After all, asset management fees have been coming down, effectively reducing one of the chief competitive advantages offered by ETFs. We believe the answer may be found in trends within the market environment and the money management industry itself. Due to heightened competitive pressures, fund managers feel an increasing need to not underperform their benchmark. This motivation is understandable considering the recent deplorable track record among active fund managers nearly two thirds of US mutual funds underperformed their benchmarks in 212, and the figure among US hedge funds was even worse. Indexing strategies, often through the use of ETFs, help them achieve this primary goal of meeting at least benchmark performance, with outperformance decreasing in importance from the standpoint of justifying management fees. Types of Russia ETFs Russia ETFs concentrate primarily on ADRs and GDRs, which cover most of the country s blue chips and usually offer superior liquidity relative to local shares. For example, the top 15 constituents of the RSX, the most highly-traded Russia ETF, are dominated by Russia s largest listed companies and comprise 82.4% of total holdings. The remaining constituents of the RSX comprise 31 mid-cap companies (MCap $1-5 bln), with small-caps accounting for just.5% due to poor liquidity. 2,5 2, 1,5 1, 5 4

5 That said, a dedicated small-cap ETF (RSXJ) has been launched that targets the most risk-acceptant investors. There are several Russia-dedicated ETFs reflecting varying risk appetites and investment styles. As the following table indicates, the most popular ETFs are those that track a benchmark index comprising large and mid-cap stocks, and that are unleveraged. The two leveraged Russia ETFs (RUSS and RUSL) are relatively unpopular, with average daily volumes being just a fraction that of the larger passive funds. Russia ETF universe Name Bloomberg ticker Style MCap, $ mln 3d avg vol, $ RSX Market Vectors Russia ETF RSX US Large and mid-cap, tracking 1,28. 3,8 ERUS ishares MSCI Russia Capped Index Fund ERUS US Capped, tracking RUSL Direxion Daily Russia Bull 3x Shares RUSL US Leveraged RUSS Daily Russia Bear 3x Shares RUSS US Leveraged RSXJ Market Vectors Russia Small-Cap ETF RSXJ Small-cap, tracking RBL SPDR S&P Russia ETF RBL US Weight capped, tracking Source: Bloomberg Impact of EM ETFs When considering the impact of ETFs on Russia, one should also consider the impact of EM ETFs. Over the past 12 months, more than half of the total inflows to EM funds (~$55 bln) have arrived through ETFs, including roughly one third of the overall amount YTD (~$27 bln). As the following charts show, EM ETFs have also become a very popular instrument for investors who seek exposure to EM growth but are more limited in terms of risk exposure (e.g. to individual countries or regions). EM ETF flows, cumulative, $ mln 16, 14, 12, 1, 8, 6, 4, 2, Apr '7 Aug '7 Dec '7 Apr '8 Aug '8 Dec '8 Apr '9 Aug '9 Dec '9 Apr '1 Aug '1 Dec '1 Apr '11 Aug '11 Dec '11 Apr '12 Aug '12 Dec '12 EM ETF flows Thanks to proportional allocations from the EM fund category, Russia equity flows can be net positive in any given week, even when Russia-dedicated funds record outflows. The impact that EM ETFs can have in this regard is on volatility. While indexing activity through ETFs can periodically dampen volatility, they can also magnify market moves, as ETF investors are not subject to lock-up periods common to mutual or hedge funds. This creates the potential for extended periods of sideways trading in a market, interspersed with sharp upward or downward spikes. In other words, ETFs can periodically act to suppress market volatility, like energy stored in a coiled spring, but can also quickly release this energy when sentiment reverses. 5

6 RTS volatility index, 21 to date Jan '1 Mar '1 May '1 Jul '1 Sep '1 Nov '1 Jan '11 Mar '11 May '11 Jul '11 Sep '11 Nov '11 Jan '12 Mar '12 May '12 Jul '12 Sep '12 Nov '12 Jan '13 Mar '13 RTSVX Index Source: Bloomberg, Gazprombank estimates These periodic spikes in volatility driven by ETF selling can create buying opportunities for investors in oversold, high-beta Russian stocks. The following list shows the highest-beta names in the Russian equity universe. Highest-beta Russian stocks Stock Beta vs index Mechel 1.94 S&P 5 NLMK 1.64 FTSE 1 LSR Group 1.63 FTSE 1 MMK 1.62 FTSE 1 Yandex 1.46 S&P 5 TMK 1.45 FTSE 1 VTB 1.42 FTSE 1 Sistema 1.32 FTSE 1 Globaltrans 1.23 FTSE 1 Sberbank pref 1.16 MICEX Sberbank 1.15 MICEX UC RUSAL 1.8 Hang Seng Dixy Group 1.2 MICEX Source: Bloomberg, Gazprombank estimates ETFs as a gauge of sentiment ETFs have generally been a lagging indicator of sentiment toward an asset class, with inflows and outflows tending to follow the trend already established by traditional mutual funds. However, it is interesting to note the activity in options on the most liquid Russia ETF (RSX). During the market sell-off in spring 212, the put-call ratio on this ETF reached very high levels approaching 2.4 (a reading of 1. implies neutral sentiment, which predominated for the subsequent seven-month period when the market was essentially flat). The downward move in the Russian market over the past month has been accompanied by another strongly bearish reading of more than 2.6 suggesting that sentiment toward the market is decidedly bearish. Alternatively, for contrarian investors such a high reading may be seen by as a bullish signal. In any event, tracking the trend in this ratio can serve as a useful means to gauge sentiment. 6

7 RSX Index put-to-call ratio, past year /3/12 15/4/12 6/5/12 27/5/12 17/6/12 8/7/12 29/7/12 19/8/12 9/9/12 3/9/12 21/1/12 11/11/12 2/12/12 23/12/12 13/1/13 3/2/13 24/2/13 17/3/13 RSX Index put to call ratio, past year Source: Bloomberg, Gazprombank estimates Traders in particular can follow the daily difference between an ETF s NAV and its current price as a gauge of overnight sentiment. This difference can now accompany other indicators such as futures on foreign equity indexes or oil prices as a way to help determine the likely direction of trade at the open of the Russian market the following day. Russia ETFs are traded on the NYSE and not on the local MICEX Exchange futures market, unlike the RTS Index contract, which is actually the most liquid instrument in the Russian equity universe. The key difference, of course, is that ETFs represent a claim on a physical basket of stock, where RTS futures are purely a derivative instrument. Both, however, possess characteristics allowing them to be used for hedging purposes depending on portfolio structure and limitations. Risk adjustment features Most investors using Russia ETFs as part of an integrated portfolio strategy are attracted by their pure indexing features. For the four most actively traded ETFs, beta (calculated as performance of an ETF relative to its proprietary benchmark) fluctuates by fractions of a basis point from 1.. This indicates that the managers are closely adhering to their proprietary benchmarks, although the ETFs themselves will have a beta that is virtually equal to that of the RTS Index (currently 1.24 versus the Dow Jones Industrial Average). However, for those seeking to adjust their active stock exposure, two specialized ETFs are available. The RSXJ small-cap ETF shows a beta of 2.3, while the RBL SPDR ETF (MCap weighted) shows a beta of around The difference in performance between the indexing and specialized ETFs is striking: while the performances of all Russia ETFs are in negative territory over the past 12 months, the specialized funds have performed nearly three times worse. Russia ETFs: beta and price performance comparison Bloomberg ticker Adj. beta 12m performance RSX Market Vectors Russia ETF RSX % RSXJ Market Vectors Russia Small-Cap ETF RSXJ % ERUS ishares MSCI Russia Capped Index Fund ERUS US % RBL SPDR S&P Russia ETF RBL US % RUSL Direxion Daily Russia Bull 3x Shares RUSL US % RUSS Daily Russia Bear 3x Shares RUSS US % Note: data as of March 29 close * beta is calculated relative to proprietary benchmark Source: Bloomberg 7

8 Locally traded ETFs? Following the State Duma s approval in June 212 of amendments to the law on investment funds, there has been heightened interest among financial regulators in allowing foreign-registered Russia ETFs to be admitted for trading on the local market. In part, this initiative represents an effort to stimulate local trading activity following a more than 44% YoY plunge in equity volumes on the Moscow Exchange in 212. The Federal Financial Markets Service is currently examining the necessary administrative amendments, and talk continues of the creation and launch of full-fledged Russia ETFs (locally registered and traded). The key to the success of ETFs traded in Russia relates to administrative restrictions; even if the regulator gives its approval, local investment companies often face restrictions on the amount or ability to hold foreign stocks. That said, it seems likely that ETFs at some point perhaps by the end of 213 will become a feature of local equity trading, representing another step in the Russian market s evolutionary development. 8

9 Gazprombank HQ: 16/1 Nametkina St., Moscow 11742, Russia (Office: 63 Novocheremushkinskaya St.) Alexey Demkin, CFA Acting Head of Research +7 (495) [email protected] Equity Research Equity Strategy Erik DePoy +7 (495) ext Andrey Klapko Alexander Nazarov Metals & Mining Natalia Sheveleva +7 (495) , ext Chemicals Aleksei Astapov +7 (495) Market and equity technical analysis Vladimir Kravchuk +7 (495) ext Quantitative analysis, IT development Production team Equity product department Konstantin Shapsharov Managing Director, Head of Department +7 (495) [email protected] Banking Andrey Klapko +7 (495) ext Utilities Dmitry Kotlyarov +7 (495) Consumer & Retail Vitaly Baikin +7 (495) ext Timur Semenov +7 (495) ext Pavel Mishachev +7 (495) , ext Oil & Gas Ivan Khromushin +7 (495) Alexander Nazarov +7 (495) Transport & Industrial Aleksei Astapov +7 (495) Telecoms, Media & IT Sergey Vasin +7 (495) ext Dmitry Selivanov Tatyana Andrievskaya +7 (495) Debt product department Pavel Isaev Head of DPD + 7 (495) [email protected] Fixed Income Research Alexey Demkin, CFA Head of FI +7 (495) [email protected] Strategy Alexey Todorov +7 (495) ext Credit research Yakov Yakovlev +7 (495) Yury Tulinov +7 (495) ext Ekaterina Zinovyeva +7 (495) ext Andrey Malyshenko Equity Sales & Trading Trading Debt capital markets Fixed Income Sales & Trading Sales Alexander Pitaleff, Igor Eshkov Andrei Mironov Maria Bratchikova Head of equity trading Head of DCM, ED Head of FI S&T, ED +7 (495) (495) (495) (495) Artyom Spasskiy Denis Voynikonis Sales Vera Yaryshkina +7 (495) (495) Ilya Remizov +7 (495) Svetlana Golodinkina Artyom Belobrov +7 (495) Sebastien de Prinsac +7 (495) (495) Dmitry Kuznetsov +7 (495) (495) ) Roberto Pezzimenti +7 (495) Trading Elena Kapitsa +7 (495) Dmitriy Ryabchuk +7 (495) Electronic trading department Maxim Maletin Head of Electronic trading +7 (495) [email protected] Gazprombank Invest (MENA) S.A.L. Gazprombank s building, Dbayeh, Lebanon Hrant Balozian Head of Investment Banking , ext. 121 [email protected] Rawad Hakme Head of Capital Markets , ext. 123 [email protected] Racha Saadeh Capital Markets Associate , ext. 122 [email protected] Copyright Gazprombank (Open Joint Stock Company). All rights reserved This report has been prepared by the analysts of Gazprombank (Open Joint Stock Company) (hereinafter Gazprombank) and is based on information obtained from public sources believed to be reliable, but is not guaranteed as necessarily being accurate. With the exception of information directly pertaining to Gazprombank, the latter shall not be liable for the accuracy or completeness of any information shown herein. All opinions and judgments herein represent solely analysts personal opinion regarding the events and situations described and analyzed in this report. They should not be regarded as Gazprombank s position and are subject to change without notice, also in connection with new corporate or market events that may transpire. Gazprombank shall be under no obligation to update, amend this report or otherwise notify anyone of any such changes. The financial instruments mentioned herein may be unsuitable for certain categories of investors. This report should not be the only basis used when adopting an investment decision. Investors should make investment decisions at their own discretion, inviting independent consultants, if necessary, for their specific interests and objectives. The authors shall not be liable for any actions resulting from the use of this report. Any information contained herein or in the appendices hereto shall not to be construed as a solicitation or an offer to buy or sell any securities or advertisement, unless otherwise expressly stated herein or in the appendices hereto.