Small cap ETFs provide 'better' access to Russia

Small cap ETFs may be a better way of accessing Russia's economy than investing in large cap funds, according to Morningstar’s Ben Johnson.

Johnson, director of European ETF research at the firm, said broader benchmarks tend to have an international focus, while small caps often provide more direct exposure to the fundamentals of a domestic economy.

Market Vectors Russia Small Cap, for example, shows a significantly reduced weighting in energy compared to most other Russia ETFs, and a substantial pickup in domestic sectors such as industrials and healthcare.

Johnson said: "For a more concentrated bet on the advancement of the domestic Russian economy, it may pay to have a look at moving down the spectrum of market capitalisation."

The latest BlackRock data revealed single country Russia ETFs have seen inflows approaching $3bn in the first four months of this year. This compares to $6.2bn of outflows from broad emerging market funds.

Investor sentiment has also been diverging on the constituent BRIC countries.

China and India ETFs have collectively lost money this year, while Brazil has made only modest gains.

Johnson said: "Russia is not showing the same signs of frothiness that are currently being exhibited by its BRIC cohorts."

He also argued that with the price to earnings ratio for MSCI Russia trending slightly below its 10-year average, the country's equities have a higher discount rate and rising commodity prices have proved a tailwind for the economy.

As the Russian economy has matured in recent years, however, its appeal as a source of portfolio diversification appears to have diminished.

Morningstar data shows correlation between the MSCI Russia and MSCI World has increased from 0.66 over the last decade, up to 0.81 over the last three years.

Johnson pointed out the country ranked 154th out of 178 countries in Transparency International's 2010 Corruption Perceptions Index and warned that limited liquidity remained a concern, as with many emerging economies.

He said: "As ETFs provided more access to less liquid markets it is important to keep in mind that there are still risks pertaining to the liquidity of the underlying."