Where some investors see escalating risks, others see bargains.
As Russia's standoff with the West over Ukraine unfolded, with mutually detrimental sanctions flying back and forth further darkening the country's already dim economic outlook, many people couldn't get their money out fast enough.
In the first six months of 2014, the Russian government reported that $75 billion was moved out of the country -- more than in all of 2013. Other estimates put that number, which captures not only investments but also Russians moving their money out of the ruble, even higher. The European Central Bank said in May that about $220 billion in capital had flowed out of Russia so far in 2014 and President Barack Obama said Aug. 6 that between $100 billion and $200 billion had shifted out of Russia since the conflict began. In July, Malaysia Airlines Flight 17 was shot down over eastern Ukraine, deepening the conflict and raising fears about the unpredictable ways it could affect the global economy. At the end of July, the United States and Europe responded with the toughest sanctions yet targeting Russia's energy, defense, and banking sectors. Investor concern over Russia was running so high by that point that index provider MSCI Inc. created a separate emerging markets investment benchmark without Russia for investors who wanted nothing to do with the country.
But that kind of pessimism smells like opportunity to some investors.
Investment from U.S. funds fell from $42 billion at the end of last year to $37 billion at the end of March, according to data provider eVestment. By the end of June it was back up to almost $41 billion. That number could climb even higher as more funds report.
Alexander Branis, director of Prosperity Capital Management (RF) Ltd., one of the largest hedge funds focused on Russia, says investors have pulled out about 5 percent to 7 percent of the $3.4 billion fund recently. A much smaller group, though, is putting more money in. Russia, he says, is cheap now.
"We have clients that have added to their portfolios: one U.S. university endowment, one large pension fund from Northern Europe," Branis told Foreign Policy from Moscow.
"If you focus on the long term, you have potential to make a lot of money."
Started in 1996, Prosperity has always focused on Russia, with only 10 percent to 15 percent of its assets in Ukraine and Kazakhstan. Branis says this latest kerfuffle over Ukraine isn't changing their strategy; in fact, they've weathered far worse economic times in Russia. Nonetheless, the firm has suffered. At the end of July, the company's flagship Russian Prosperity Fund was down 7.3 percent from the beginning of the year, though Branis noted that is a better return than funds based on the broadly used MSCI Russia index produce.
The firm could see even harder times if the United States and Europe expand sanctions in response to Russia's support of separatists in eastern Ukraine. Branis said his firm owns some Sberbank stock, which is already sanctioned. The bank was barred from issuing new debt or equity in Western markets at the end of July. But Branis doesn't expect that the bank's existing debt and equity will be targeted because it would hurt shareholders more than Moscow. That's not his only reason for brushing off sanctions -- Russia is not as blameworthy for the conflict as officials in Kiev and Washington suggest, he proffered.
"I don't think there is a lot of credible evidence that implicates Russia," Branis said. "I don't think there is something so credible that you could base the next round of sanctions on it."
The Russia-based funds are not alone in their bullishness. Kopernik Global Investors, a Tampa-based firm started just last year, is also betting on Russia. Founder Dave Iben told Bloomberg he was buying Russian stocks he saw as trading at half of what they're worth. The firm's flagship $890 million mutual fund has 15 percent of its assets in Russian companies, including 4 percent in Russian energy giant Gazprom and 3 percent in Sberbank. Iben spelled out his philosophy on Russia in a recent conference call.
"I believe that when people get really, really, really negative on something it almost always proves to be overblown," he said, according to a transcript of the July 23 call. "And now there's a lot of emotion in Russia. I'm not saying it's wrong. I'm saying I suspect time will show that it's overdone."
Wade O'Brien, senior investment director with U.S.-based Cambridge Associates, said it makes sense that value investors with long-time horizons are scooping up Russian assets while everyone else is selling them.
"When something that was already fairly inexpensive on a relative basis sells off sharply on the basis of macroeconomic concerns, it's not unusual that value funds will go in and buy stocks," O'Brien said.
Other money managers aren't pulling out of Russian investments entirely, but are shrinking their stakes. The head of a smaller fund based in London, who didn't want to be named, said he reduced Russia investments from 15 percent to 5 percent of the portfolio. However, he will continue investing in Russia, unless Europe slaps more restrictions on Russia or Moscow limits how much money can leave its borders.
"We're always reassessing things, but as long as they don't do anything that precludes our ability to operate, we would do it," he said.
Still, most investors are focusing on the overall economic picture in Russia, which is bleak. Economists worry that President Vladimir Putin's retaliatory sanctions are driving a faltering economy closer to recession. On Aug. 7, the Kremlin banned some U.S. and EU agricultural products, heightening fears that the country, which imports 40 percent of its food, could see prices spike. On Aug. 11, the Russian government reported that the economy had its worst quarter in over a year, as growth continues to slow. Russian GDP expanded only 0.8 in the second quarter of 2014 compared to the same time last year, Bloomberg reported Aug. 12. The Russian Micex stock index is down 6 percent from the beginning of the year.
Although some investors are making contrarian bets, said Tim Ash, head of emerging-markets research at Standard Bank Group, buying into Russia long term is not a common strategy.
"I think other investors are just seeing this as a paradigm shift in the Russian story -- negative," Ash said. "The relationship with the West has been significantly damaged, and will be difficult to rebuild."
The result will be a less friendly environment for foreign businesses and declining investment and growth, Ash said.
Money managers are also constantly changing strategies as the Ukrainian crisis unfolds. Therefore, its full effect on foreign investment in Russia might not be clear for months. Investment research firm Morningstar estimates that U.S. funds allocated just 1 percent of their assets to Russia at 2013's end; that amount fell only slightly by the end of June.
Some money managers who earlier this year saw opportunity are now shifting gears. Luz Padilla, head of the emerging-markets group at DoubleLine, oversees about $3.6 billion. Her emerging-markets bond fund grew 11.2 percent between Aug. 1, 2013, and Aug. 1, 2014, beating returns posted by 96 percent of her peers, according to a Bloomberg analysis.
At the end of March, she saw potential as Russian assets' prices fell after Putin annexed Crimea. She told Fortune magazine that she boosted the funds' holdings of Russian bonds by a full percentage point after the West first sanctioned Russia in March. But then DoubleLine analysts attended IMF meetings in mid-April and conferred with Russian experts, leading her to reverse course. Mark Christensen, who helps manage the firm's emerging-markets portfolio, said the Russian banks and economists he spoke to changed his mind.
"Despite the rebound in the market, they still anticipated that the crisis was going to last longer than people were expecting," he told Foreign Policy. "We just came to the conclusion that the Russia/Ukraine crisis and the price volatility wasn't going to go away anytime soon."
By the end of June, Christensen and his team had reduced the funds' exposure to Russia drastically, to less than 2 percent from more than 13 percent at the end of last year.
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