How worried should investors be about the tension in Ukraine and Russia?

Scott Kubie, CFA, CLS Chief Strategist

The overthrow of the pro-Russian government in Ukraine and the subsequent intervention by Russia in select parts of Ukraine has been unsettling. I believe the events should worry investors a little, but not too much for the following reasons:

1. Exposure to Ukrainian stocks is rare for most portfolios since Ukraine is classified as a frontier market.  Furthermore, there is no Ukraine allocation in the iShares MSCI Frontier 100 ETF.
2. The biggest near-term risk is Russia, in response to potential sanctions, penalizing foreign investors. Russia is just under 5% of the MSCI Emerging Markets Investable Market Index and is a large portion of any allocation to Eastern Europe. Russian P/E multiples are very low, so the political risk in Russia is at least partially represented in the price.
3. It is also possible Russia may respond to potential sanctions by penalizing foreign companies doing business in Russia. For instance, Russia is PepsiCo’s second largest market and they also have assets in Ukraine. 

The greater worry is Russia continues to be belligerent towards its neighbors. While I believe there is some modest risk that this could continue, there are some key lines in the sand. Belarus is already supportive of Russia. Our NATO allies Latvia and Estonia border Russia whilst other NATO allies Poland and Lithuania are separated only by Belarus. I believe it is highly unlikely Russia will run the risk of a negative interaction with NATO. More likely is Russia will seek to protect its key interests and maneuver Ukraine into the Russian orbit.

There are always geopolitical risks affecting international markets. Smart investing isn’t to worry about them excessively, but to make sure valuations reflect a reasonable premium for the ups and downs of the world in which we live.

Matt Santini, CLS Portfolio Manager

I would add that markets tend to act irrationally on the initial trade when governments implode. We saw this in Greece and Egypt. Often times buying opportunities are presented, but that is not always the case.

When the literal dust settles investors need to be reminded that reaching for returns in loosely regulated and often corrupted markets comes with outsized risks. That, to me, is where the worry presents itself. In order to allocate to Russia, you must be willing to absorb roughly 50% more risk than the broad market. That is not your typical value investing. On a risk adjusted basis, realizing the expected returns from the Russian market will continue to be daunting with or without exogenous forces.

Paula Wieck, CLS Manager of Investment Research

The most important reason –the region is dirt cheap!  The region was already attractive, but the recent crisis has bought Russian equities to extreme oversold readings.  The Moscow exchange, MICEX, trades at less than half the level of the overall emerging markets index and a third of the level of most developed markets.  In addition, Russia is rich in natural resources, and has a highly-educated and very technically able workforce for an emerging market economy.  Government debt is less than 10% of GDP, and consumer debt, while on the rise, is still low overall.

While domestic markets continue to grow expensive and cyclically mature, you can expect us to be adding exposure to areas such as Russia through the use of diversified emerging market ETFs which have unique quality and valuation statistics compared to the emerging markets universe.

Emerging market investing refers to the practice of investing in a developing market of a foreign nation.  The pre-requisites of this practice include a market within the foreign nation along with some form of regulatory body.  Emerging markets involve greater risk and potential reward than investing in more established markets. Diversifiable risks for emerging markets include, but are not limited to, political risk, currency risk, and liquidity risk.

The Moscow Exchange, or MICEX, is the largest securities market in the Russian Federation.   Established via a merger in 2011, the exchange encompasses several markets including a securities market, derivatives market, money market, FX market, precious metals, and an over-the-counter derivatives market.  The securities market tracks over 1,400 securities from over 700 issuers.

International investing is an investment strategy where investors chose global investment instruments.  International investing can be accomplished utilizing a variety of investment vehicles including, but not limited to, ETFs, American Depository Receipts, or a direct investment in a foreign stock exchange.  Diversifiable risks include, but are not limited to, political risk, capital risk, and liquidity risk.

Frontier Markets refer to markets within developing countries that are considered pre-emerging.  Diversifiable risks for frontier markets are similar to the risks of emerging markets, but to a higher degree.  These risks include, but are not limited to, political risk, currency risk, and liquidity risk.

The iShares MSCI Frontier 100 ETF is an exchange traded fund which tracks securities from frontier markets which meets certain liquidity and investability criteria set by iShares.  Although the ETF strives to track 100 securities, the actual number may vary slightly depending on the number of eligible securities.  The ETF’s parent index is the MSCI Frontier Markets Index.

The MSCI Emerging Markets Investable Index (or MSCI EM IMI) is a composite index which tracks performance of large, mid, and small cap firms across 21 emerging markets countries.  The index tracks 2,635 constituents covering 99% of the free float-adjusted market capitalization in each country.

P/E, or the price-to-earnings ratio, is a valuation method obtained by dividing the market value per share by the earnings per share.

0516-CLS-3/12/2014

0490-CLS-3/11/2014