The Top Russia-ETF Value Play

Russian equities have been hit hard in recent weeks, putting Russia-focused ETFs in play.

In a recent interview with Jim Rogers, the legendary commodities investor told ETF.com that he's optimistic on Russia and that its "neglected" equity market was cheap. Well, with all the tension recently involving Russia, Ukraine and Crimea, Russia's stock market has gotten even cheaper.

On March 3, 2014, the MICEX Index, which tracks the 50 largest and most liquid Russian stocks traded on the Moscow Exchange, plummeted nearly 11 percent. Two weeks later, the index still sits roughly 11 percent below its closing level on Feb. 28, 2014.

In line with Rogers' observation, if you look at the price/earnings multiples (P/E ratios) of Russia ETFs compared with those of other ETFs focused on the emerging markets in general or on the collection of the BRIC countries, Russia all by itself currently looks like a steal.

Source: ETF.com; as of 3/17/14

Of course Russia can get even "cheaper," depending on how the situation in Ukraine plays out.

But for those considering a Russia ETF to buy on the "cheap," it's imperative to know what you're getting, because Russia ETFs are not created equal.

The Three Practical Choices

Investors looking to tap directly into Russian equities through ETFs have three practical choices: the Market Vectors Russia ETF (RSX | C-65), the iShares MSCI Russia Capped ETF (ERUS | C-92) and the SPDR S&P Russia ETF (RBL | D-69).

Van Eck was the early bird in the space with its launch of RSX in April 2007. RSX holds the lion's share of all assets in the segment, with over $910 million, and more than $120 million in RSX shares changes hands on most days.

iShares' ERUS is not as popular as RSX, but it has $204 million in assets and trades more than $8 million a day—decent by most standards. Even though RBL launched eight months before ERUS, in March 2010, it lags behind in assets, with only $14 million.

The fourth and newest of the bunch, the VelocityShares Russia ETF (RUDR | F-76) has only $2 million in assets. According to our ETF.com analytics, RUDR is at high risk for closure and barely trades (the last execution was on Dec. 26, 2013, for 200 shares), so I'll leave RUDR out of the mix for now.

So how do the three main Russia ETFs differ?

In terms of cost, not much. They all charge between 59 and 62 basis points—between $59 and $62 per $10,000 invested, or within 3 basis points of one another. With regard to trading costs, RSX clearly leads the pack. RSX trades at penny-wide spreads (4 basis points), whereas ERUS and RBL trade at 9-12 basis points spreads, on average.

Where they really differ, however, is in exposure. And this is where the Russian market gets a bit quirky.

If you look at sector breakdowns below, you'll see some big differences.

As expected, the Russian market is dominated by energy, mostly from state-owned oil and gas companies, like Gazprom and Lukoil.

Still, you'll notice that energy and financials get a haircut in RSX, which overweights basic materials and utilities. Overall, RSX is more spread out in sector weightings relative to ERUS and RSX.

So what gives, being that they're all cap-weighted and target 85 percent of the Russian market cap?

The key to understanding RSX's differences lies in its index methodology, which differs from ERUS on two major fronts.

For starters, RSX caps any one holding to 10 percent. This significantly reduces the fund's weighting in Gazprom and Lukoil to 15 percent, combined. Meanwhile, ERUS and RBL each have close to a 30 percent combined weighting in those two state-owned oil and gas giants.

Secondly, and more importantly, many Russian companies choose to incorporate and/or list their shares outside of Russia for a host of reasons, including taxation and regulatory and listing requirements.

ERUS is significantly impacted by this fact because it tracks an MSCI index, which assigns securities to countries based on incorporation and primary listing. Therefore, many prominent Russian companies, including some high-growth tech stocks, are ineligible for inclusion into ERUS.

Meanwhile, RSX and RBL select their constituents based on country of incorporation, headquarters and/or revenues, as opposed to where a stock is primarily listed.

I'm personally a big fan of MSCI, and here at ETF.com, we even benchmark our international ETFs to MSCI's Global Investable Market Indices (GIMI) for our analytics tool because we believe in their rigorous, replicable and transparent methodology.

That said, I think MSCI's strict rules-based methodology can also work against it in certain markets. And Russia and China are two countries where I think MSCI's GIMI index falls short.

Immediately coming to mind is ERUS' exclusion of Yandex, Russia's dominant search engine and the equivalent of Google, because the company is incorporated in the Netherlands and lists its stock in New York.

Ironically, the iShares MSCI China ETF (MCHI | B-39) excludes Baidu, "China's Google," along with all the other U.S.-listed Chinese Internet companies, for similar reasons around incorporation and listing.

But is anyone going to argue that Yandex is not Russian?

Yandex is probably more Russian than Google is American, based on revenues and its primary-market base. Currently, Yandex carries a 4.5 percent weighting in RSX and 2.8 percent in RBL.

Besides Yandex, we also have a slew of other companies that are excluded from ERUS that would otherwise add diversification to a Russian portfolio that's heavily dominated by the energy sector.

The list includes mobile telecom giant MegaFon, retailers X5 Retail Group, O'Key Group and Mail.Ru Group, to name a few.

I fully expect MSCI to eventually launch an "All Russia"-type index, which would include all these other Russian companies. Until then, I'll steer clear of an MSCI index-based Russia ETF, like ERUS.

At the moment, RBL and RSX offer the most comprehensive coverage of the Russian market. Benchmarked against the MSCI Russia Investable Market Index, RBL and RSX also both carry less market risk—specifically, betas of 0.85 and 0.87, respectively.

Between RBL and RSX, RBL provides the most "marketlike" exposure because it doesn't cap any holdings below the 25 percent allowable limit by RIC rules. Still, that also means RBL is top-heavy in energy and, moreover, its lack of assets is also somewhat of a concern.

Overall, RSX is currently the most "expensive" of the bunch, with a P/E of 6.36. But its broad coverage, stability and superior tradability make it our "Analyst Pick" for the Russia segment.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.