Avtovaz Dilemma Show Challenges For Russia ETF

As global investors have regained their appetite for risk, many emerging market ETFs have surged in 2009, recording gains of more than 100% in many cases. Van Eck’s Market Vectors Russia ETF (RSX) is one of these funds, nearly tripling between March and October before pulling back slightly in recent weeks. But while increased demand for natural resources, a global recovery in commodity prices, and thawing relations with the U.S. have boosted Russian equities, Russia is still very much an emerging market, and as such faces some strong challenging obstacles in the current environment.

A recent article in the Wall Street Journal highlights the dilemma currently facing OAO Avtovaz, the largest automaker in Russia that counts the government among its largest shareholders. While U.S. automakers have improved their financial health largely through aggressive cost-cutting measures and mass layoffs, political pressure from the Kremlin keeps many state-owned Russian companies from taking similar steps. Company executives reportedly claim that Avtovaz needs to shed more than 25,000 jobs to become competitive, but the Russian government has reassured workers that there are no plans to do so.

The wave of bailouts in the U.S. has turned the government into one of the largest shareholders in several of the country’s largest companies, including General Motors. While the challenge of evaluating investments in companies that are essentially an arm of the federal government is a new one for U.S. investors, it is relatively commonplace in many emerging markets.

Avtovaz isn’t a holding of RSX, but the only Russia ETF available to U.S. investors does have several components that are majority-owned by government entities. State-owned entities with material weightings in RSX include (all weightings as of October 30):

The inclusion of companies that are partially-owned by the Russian government isn’t necessarily be a red flag for investors, but it should be considered when contemplating an investment. State-owned companies may in fact have less risk on the downside, because they are backed by the deep pockets of the government (although this backing won’t always prevent bankruptcies). But the major disadvantage is the fact that these corporations won’t always be run for the benefit of shareholders – a situation that is currently playing out at Avtovaz. With the government calling the shots, the economic value created by the company has the potential to be diverted from shareholders to other stakeholders (in the case of Avtovaz, employees).

Among the risk factors that are typically associated with economies classified under the “emerging” tag is government intervention. When companies aren’t free to make maximize profits – such as being prohibited from downsizing the workforce – shareholders can potentially be disadvantaged.

Russia’s commodity-rich economy is undergoing rapid political and economic change, making it a potentially attractive opportunity, especially for those seeking to identify investments that maintain low correlations with developed markets. As mentioned above, these factors have made one of the best performing equity ETFs in 2009, outperforming most developed markets by a wide margin.

There are a number of reasons to believe that Russian equities will continue their strong performance going forward: rising oil and gas prices could boost revenues, while potential improvements in political stability could foster a pro-business climate. The potential for big gains is very real, but so too is the risk. For investors with the stomach for it, RSX is an interesting option, especially as concerns about a new era of hyper-inflation mount.

Disclosure: No positions at time of writing.

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