RTS plans raft of new derivatives - Incisive Media

Special Report: russia and hedge fundsCONTENTS1 News2-4 fund profile:renaissanceinvestmentmanagement5 stock loan:asset alliance onwhy lending isn’tconstricted6-7 rts: president olegsafanov in profile9 holding the Forts:Roman goryunovon rTS derivativesmarket10 little steps: therts start marketin profile11 rude health: whyrussia’s is rollingin it12 life after vladimir...13-14 how aurora findsvalue in little gems15 asset alliance’seastern europeanfof marvel16 troika dialogspeaks with hfrRenaissance re-opensthree leading fundsRenaissance Investment Managementis to re-open three of its dollardenominatedhedge funds aimingto take in up to $450m, to add to theroughly $750m already in the hedgefunds it manages out of its alternative-productsgroup in Moscow.Sergey Bubnov, director and headof alternative products, said newtranches for the group’s RenCap(financial institutions), Utilities andpre-IPO hedge funds would appearin the second and third quarters.The group’s pre-IPO fund is seekingup to $150m with a tranche slatedfor April, while the financials fund’sre-opening for up to $200m and utilitiesfund’s taking in of up to $100min new capital are planned for laterin the second quarter.For more on Renaissance, see theprofile on pages 2-4.exchangesRTS plans raft of new derivativesRussia’s main stock exchange, theRussian Trading System (RTS), isto launch deliverable futures contractsfor jet fuel after successfullylaunching the same for diesel, saidRTS president Oleg Safanov.The electronic exchange will alsolaunch “similar futures” in the agriculturalfield. The Moscow-headquarteredexchange has much on itsplate, Safanov said, planningto purchase a stockexchange in the Ukraine,as well.In addition, the RTS,currently a non-profitpartnership with 250members, is working totransform itself into ajoint stock company, andhas issued $30m of shareson behalf of the company.Safanov said he hoped therestructuring of the groupOleg Safanov,RTSwould be completed by the summer.Roman Guryunov, vice-presidentand head of the derivative portionof RTS, known as Futures andOptions on RTS (FORTS, for short),said there had been “substantialimprovement of the legislativeframework” around derivatives inRussia in 2006 and 2007.“At the end of 2006, a law waspassed providing serious legal protectionto all derivatives-based dealson Russian territory,” he explained.“Now that the law has beenpassed by the Duma, and signedby the Russian president, we areseeing it is an effective regulatorymechanism.”For FORTS last year, dailytrading volume grew four-foldand open interest exceeded $5bn,he said, with daily openinterest exceeding $1bn.Conducting 12 launcheslast year, FORTS nowhas 24 contracts, he said.FORTS is also planningto launch weather derivativesin conjunction withweather forecaster andmonitor RosHydromet, aswell as agriculturals coveringsugar and grains.The RTS is in an environmentof extremelyrude health in Russia, whereGDP growth sits at 6.7% as at 31December 2006, according to figuresfrom Bloomberg, and it showsno sign of slowing with quarterlyGDP growth at 6.5%Oil at around $61 has also nothurt the fortunes of the commodities-basedeconomy, nor its governmentwhich imposes a tax onbarrels produced by its drillers.Fleming family buys into ‘Crazy Park’ via DialogDon’t be surprised if you see membersof the Fleming family on thebig dipper at children’s leisure parksCrazy Park, after London’s FlemingFamily & Partners (FF&P) boughtinto the chain via Troika Dialog’sRussia New Growth Fund.Russia New Growth Fund successfullymade a second closingafter raising $68m from six US andEuropean investors, bringing thefund’s capital to $218m.The fund will make equity investmentsin “medium-sized companiesin growing industries driven by theconsumer demand in Russia andother CIS countries,” Troika said.Other new limited partners in thefund include Sofina and the EBRD.Most of these institutions havemade their first commitment to Russianprivate equity, Troika said.Thus far, the fund has made threeinvestments including in Russianfactoring company Eurokommerz,and the national chain of lowermid-market clothing retail storesModis.In other Troika news, a consortiumof investors led by Troika Dialoghas exited Arbat Prestige by sellingits 40% stake to general directorVladimir Nekrasov. Bought for$100m in early 2004, the stake wasin a company whose revenues thengrew from $130m to $350m now.Its initial public offering (IPO)was scheduled for 2006 but has beenpostponed until 2008. Troika Dialogwill be IPO advisor. The consortiumreceived $400m for a 40% stake, onthe strength that all the company’sshares were valued at $1bn.“Troika Dialog has always soughtto build a model of business developmentthat benefits all concerned,”said Pavel Teplukhin, chairman ofthe Troika Dialog AM board.news in briefCowan joins Auroraas Magol steps downAurora Russia, which invests in equityor equity-related instruments in smalland mid-sized private companies inRussia, has appointed to its board ofdirectors Christopher Cowan. CowasjiMagol has stepped down from hisposition as a non-executive director.Cowan has more than 40 years’ experiencein finance roles including morethan 13 as a group finance director,firstly with Jardine Matheson Holdings,then with Avis Europe. Mostrecently, he was CFO of CreditTrade,a credit-derivatives broker. Cowan willchair Aurora’s valuation committeeand sit on its audit committee.For more on Aurora, see page 13.Russia tops EM chartsRussian hedge funds continue to topEurekahedge’s emerging marketstables over 12 months, taking 11 ofthe top 12 positions when differentshare classes are counted separately.Russian Opportunities Fund is topin the 12 months to 31 January,according to Eurekahedge, producing102%, followed by Firebird RepublicsFund with 59.01% and Diamond AgeRussia Fund’s 36.95%.Thereafter came Russian Prosperity(36.52%) and Firebird Avrora(36.05%), Ashmore’s Russian EquityFund (32.85%) and Firebird NewRussia (32.34%) and UFG RussiaSelect (31.15%) and Spectrum RussianGrowth Fund (26.92%).Over the same period, the RTSindex returned about 61% accordingto Bloomberg. But beware – averageannualised volatility for emergingmarkets hedge funds was 10.83%, notundershot by any Russian-focusedfund in the top 25.But wait, there’s more!!!If you enjoyed this report on Russia,then stay tuned! In coming months,we will be producing similar reportson carbon, Asia, and returning toSouth Africa for our annual survey.If conversely there is a topic youwould like us to cover, do let usknow by emailing david.walker@incisivemedia.com or solomon.teague@incisivemedia.com,and we will more than happy toaccommodate your requests. Indeed,it is (almost) our very raison d’etre...

fund profile: renaissance investment managementRenaissance: ready for businessRenaissance Investment Management is a rather intriguing fund manager, offering hedge fundsclosed and open-ended, property, long-only and private equity, all specialised in niches reflectingthe managers’ areas of expertise. The good news is, the Moscow firm is on a growth trajectoryaiming to grow assets and its investor base in 2007 as David Walker discovered over a cuppa...While the bread and butter ofMoscow-headquartered RenaissanceInvestment Management’s(RIM) clientele is currently Russianhigh-net-worth individuals andsome of Russia’s domestic pensionfunds, the alternative products divisionwith an eclectic range of hedgefunds is readying itself to diversifyits investor base and also grow itsassets by up to 60% in the comingmonths of 2007.As emerging markets Russiahedge funds generally havetaken off and have shownlittle sign of slowing,Renaissance InvestmentManagement is reopeningthree of thedollar-denominatedhedge funds in thealternative productsgroup, and aims totake in up to $450min new money, to addto the roughly $750malready in the hedgefunds the diversifiedgroup manages out of itsalternative products groupin Moscow.spare headroomSergey Bubnov (pictured,right here),director andhead ofalternativetive products, said new tranches forthe group’s RenCap (financial institutions),utilities and pre-IPO hedgefunds would be put to market in thesecond and third quarters.The group’s RIM Pre-IPO Fund isseeking up to $150m in new moneywith a tranche slated for April, whileRenFin, the firm’s financials fund’sre-opening for up to $200m and theUtilities Fund’s taking in of up to$100m in new capital are planned forlater in the second quarter of2007. Renaissance InvestmentManagementruns an eclecticmix of funds,i n c l u d i n ghedge andl o n g - o n l yfunds, andniche productsinproperty.Bubnove x p l a i n sthat theM o s c o w -headquarteredfirmhas a seriesof divisionsspanning various producttypes and asset classes. RenaissanceInvestment Management’smanaged accounts business is currentlytaken care of by the fixedincome and equities teams, whoalso oversee the Russian mutualfunds in a separate division, startedabout 18 months ago.The group also runs open-endedhedge funds, including a Europeanlong/short portfolio, for internationalclients, run by Jack Arnoffand Jury Ostrowski, formerly ofPictet Asset Management.Add to this a small propertyoperation and Renaissance showshow diversified it is.While the mutual fund portion ofRenaissance Investment Management’sbusinesses provide investorswith diversified access to Russia’slisted stocks, the unit that SergeyBubnov oversees is more focusedon the non-listed sphere.“Here, we are very much theopposite, providing access to activemanagement to people who wantexposure to opportunities outsidethe public markets,” Bubnov says.“It’s niche opportunities or arbitrageopportunities or other instrumentswhere we seek extra valuethat can be generated by activemanagement,” he adds.“With the extra tranches we’relaunching, we want to be atmore than $1bn this year,”Bubnov says. Complementaryto its aim to satisfy investorsfor all asset classes, Bubnovsays Renaissance InvestmentManagement also offers differentliquidity in its products– for example T+3 for sharesin its closed-ended, listed vehicles,to standard redemptionterms for its open-ended, nonlistedhedge funds.(On the coin’s obverse side,having closed-ended vehicles alsobenefits the manager, tying up cashin the vehicle once subscriptions tothe fund have been made.)fixed income with arussian twistRIM’s Russian including CIS fixedincome hedge fund (RenaissanceRussia Debt Fund) is managed byElena Kolchina (pictured, next page),RIM’s director and head of fixedincome products.Since its March 2006 launch, ithas returned 14.7% annualised onannualised volatility of 3.9%.It is a fund that draws on themanagers’ experience of the Russianand CIS fixed income market,and in particular of domesticissues, where the market is not aslarge, for example, as that of Russianfirms issuing Eurobonds, andwhose issues are not rated by firmssuch as Standard & Poor’s.Investors may feel a lack ofexternal guidance, such as providedby Standard & Poor’s, could leave amarket difficult to value.Difficult to value, counters Kolchina,is good to trade where extensivelocal experience can be broughtto bear on trading and portfolioconstruction.“Our fund is invested mainly inbonds that do not have ratings,”says Yevgeny Minkin, senior portfoliomanager and co-manager ofthe fund.“Our domestic market, made upmainly of bonds denominated inroubles, is not rated so far becausedemand for these bonds is not high,and they issue domestically somaybe do not need to go for (typicallyrated) Eurobonds.”“We manage around $1bn (inthe strategy) mainly through DMAaccounts,” Kolchina says, addingthe fund itself holds about $13m.“The fund is a combination of topdownand bottom-up analysis,” sheadds, “mainly fundamentally drivenand long-biased.”It carries no leverage, as Kolchinaexplains the healthy returns fromRussian fixed income have meantgearing is not the necessity it is forsome non-Russian peers, where thesmall gains that can be eked outof each trade must be magnifiedthrough borrowing.The fund targets 12% in dollarterms and invests mainly in shortandmedium-term issues. Theaverage duration of the portfolio isaround two years.“In terms of risk/return and the

fund profile: renaissance investment managementRenaissance: the eclectic houseopen and ready for (new) businessportfolio, Russia and fixed incomeremains one of the best plays,” Kolchinasays.While she concedes that higherabsolute returns can be earned inother local markets such as Turkeyor Egypt, for example, she saysRussia is much stronger fundamentallywhile the market offers “goodliquidity and great diversification.“Russian bonds provide fundamentaland stable investmentsand, at the same time, Russia sndits companies are in the process ofimproving their credit quality, andthat is why you can participatein the economic growth we see inRussia.” (Russia is now rated BBB+by Standard & Poor’s.)RIM’s fund is predominantly corporatebonds, with some sovereignswith commensurately lower yields.“There are lots of corporatebonds in a market that is liquidand large by international standards,and where you can get bothliquidity and diversification,” Kolchinaadds.“Russian companies have juststarted to build their history. TheRussian market is generally underleveragedcompared to internationalstandards, while there is greatdemand and in and outside Russia.”The sectors on offer to Kolchinarange from consumer and retail– closely linked to Russia’s recentconsumer boom – to the financialsector and industrial firms.Kolchina and her team musttherefore be discerning – she notesthe RIM Russia Debt Fund preferssmall and mid-sized companiesthat have experienced high growthrates, are improving their corporateand financial structure and withrevenue growth of 50%.Where credit quality could beimproved over two years, Kolchinaand the Renaissance Russia DebtFund fund takes an interest.“We are in the market every daywe know the companies very welland meet them regularly, and haveaccess to shareholders and all thedecision-makers,” Kolchina adds.The international demand forRussian issues falls away whenit comes to local bonds, Kolchinanotes, an area the RenaissanceRussia Debt Fund in concentrateson. Where it gets involved in theEurobond market traded on internationalmarkets, the fund mayengaging in arbitrage.Yevgeny Minkin adds foreigninvestors may be less active in thelocal market as they may lack custodyarrangements for local issues.“Our fund offers access to ourexperience in Russian corporates,”Kolchina explains. “Those sittingin London do not know these companies.Russian fixed income willcontinue to be a good play in termsof risk and return.“If you like fixed income, youmust invest in Russia and the bestway is our fund,” she says.financial focusMarina Chekurova and SergeyNazarov are directors of RenaissanceInvestment Management’sRenFin fund, dedicated to investingin the financial sector and with athree-year life but with an optionfor shareholders to extend this.Closed to new investors after“significant oversubscription” inNovember 2006, and with about$200m, RenFin is about 50%invested already, and its managersare in late-stage negotiations forinvesting the remaining 50%.Chekurova notes they expect tobe fully allocated, to 10 deals, withinabout six months.The fund, which was trading at a20% premium to its net asset valuein late February and whose value isreported at cost between semi-annualrevaluations, is predominantlyinvested in the equity of unlistedRussian financial-sector firms. Mostof the deals in the fund’s pipeline areproprietary transactions.Presently, RenFin has four longterminvestments and three shortterm,liquid stocks. Sberbank stockis held for cash-management reasonsand the fund also holds Kazcommerzbank.“The reason for our main focus onunlisted is, Marina and I have beenin the sector for more than 10 years,and that gives you a feeling for whatare the right partners to approach,”says Nazarov.He and Chekurova have the lengthof experience to have seen the firmsin more trying times, adding to theelegance of their insight.“In 2001, no-one was investingin Russia’s financial sector and theEuropean Bank for Reconstructionand Development (EBRD) was theonly investor in the financial sectorand that was a great sector in termsof getting the contacts in the Russianfinancial field.”Chekurova and Nazarov havescreened about 350 financial firmsbefore deciding on investees.“It gives you a good understandingfor the scope and is one reason wecould invest so quickly,” says Chekurova.(Bubnov adds RenaissanceInvestment Management’s recruitingof managers who have an existingpipeline of investees when they join,and who are effectively ready to startrunning portfolios on Day One is anadvantage of RenaissanceInvestment Management.)Nazarov differentiatesRIM’sfinancial-sectorfund to peersthus: “ManyW e s t e r nfunds claimthey havea Russianfinancialsectorexposurebecausethey holdS b e r b a n kstock. ButSberbank correlatesmorewith the marketbut not the Russianfinancialsector’s fundamentals.”He notes Sberbank’sstock moveddown in May 2006together withthe stock market’sbenchmarkRTSindex.Russia’s financial-firm landscapeis fundamentally different to theUK’s for example. Nazarov notesmergers and acquisitons typify thesector in Russia, managers maybe wanting to cash out themselveswithin two to three years, andthere is a large weighting to retailbanking operations.(Nazarov adds, growth in retailbanking last year exceeded 40%and the average bank’s assets areprobably split around 40% corporateand 60% retail.)There is also a broad divergencebetween quality management ofsome smaller financial firms inRussia and companies that maybe, to put it frankly, inexistence for questionablepurposes.Of around 1200banks, Nazarovnotes “abouthalf are genuinefinancialinstitutions.”The RenFinfund clearlya v o i d sthe otherhalf.“We canhelp shareholdersinthe managementof thequalityb a n k schange

fund profile: renaissance investment managementRenaissance: the eclectic houseopen and ready for (new) businesscertain things and make much betterin terms of corporate governanceand access to capital markets. Withintwo to three years, we need to raisethe exposure for strategic investors,or for an initial public offering (IPO),”Nazarov adds.Checkurova notes trade sales toRussian or foreign investors are feasibleexits for the fund, as are managementbuyouts, with IPOs perhapslimited to the country’s top-30 investmentbanks.RenFin fund targets banks providingreturns on earnings of atleast 25%, possibly those developinglending to small- to mid-sized firms,and active in Russia’s fast-growingretail-banking sector.RenFin is not the only investorfocusing on the sector, as Nazarovnotes it has been joined by foreigninvestors eyeing off Russian banks.“The cases where foreign banksacquired Russian banks over the lasttwo to three years were at four to fivetimes book value. We do not invest inthose names and we do not pay morethan 1.5 times book and six to eighttimes earnings on average,” Checkurovasays.“We have shareholder agreementsin place and nominate our representativesto the supervisory boards ofinvestees.“Contrary to some privateequity funds who invest and thensit back and wait for the value oftheir investment to grow, we playan active role in bringing up thosebanks to a level they need to be,”Nazarov says.fledgling firmsNatalia Ivanova (pictured, left), adirector at Renaissance InvestmentManagement, manages the firm’sPre-IPO fund, which, she says,“provides investors with access toilliquid opportunities with higherreturns and risk.”The fund is listed on Bermuda’sstock exchange and with sharestradeable on the International BulletinBoard, at the London StockExchange.It seeks to take minority stakesin Russian firms in which it invests,and not minority stakes. [ER???]The fund is 70% invested in ninedeals, and the managers have madeindicative bids for a further 25%.The firms, as the fund’s namesuggests, are aiming to list onpublic markets, mostly in Russiabut occasionally further afield.“The way we approach ourinvestments is to do full due diligenceand negotiate shareholderagreements, and we try to create astructure using English law to protectour interests and mitigate risk.We are offering companies capitalto grow before they IPO…and weprovide a reference price to dealwith institutional investors.”Ivanova says while the managerswill look at all sectors, “we prefernew-economy companies like technology,media and telecoms (TMT),where the return cannot fall so muchas well as consumer companies andbanks.” Given the fund’s three-yearlife, Ivanova adds the RIM Pre-IPOfund needs a relatively short time tomarket for investee firms.Ivanova is running the fundduring what could be described as asweet spot for Russian public markets.“We are in an IPO boom andwe expect it to run for the next twoyears,” she says.While the fund is investing inlong-term holdings when comparedto some hedge funds, its investorscan buy and sell shares in the closedendedstructure with RenaissanceCapital acting as market-maker.The fund with an independentadministrator offers a daily NAV calculationand Ivanova strives to offerinvestors as much information oninvestee firms as possible.(Pre-IPO will compile a largemanagement report in March “toshow investors what’s going on sothey don’t have to sit there for sixmonths waiting.” )RIM’s Pre-IPO Fund competeswith hedge and private equity fundsfor deal flow, however, Ivanova sayshedge funds will often want tochange investee companies’ management,to which Russian ownersnot wanting to give up equityupside may be averse.“Hedge funds can buy the samedeals but they do not get accessto the pipeline we do, they mainly“Contrary to some private equityfunds who invest and then sit backand wait for the value of theirinvestment to grow, we play anactive role in bringing those banksto a level they need to be at.”sergey nazarov, renaissance investment managementaccess the pipeline from investmentbanks.” The firm’s Pre-IPO Fundenlists consultants to conduct tax,legal and financial due diligence onpotential investees.the power of ambitionThe rationale behind the RussiafocusedUtilities Fund of RenaissanceInvestment Management,explains Sergey Bubnov, its manager,is to profit from what he callsthe “most ambitious power sectorreform ever attempted.”Russia’s government beganreforming the sector a few yearsago by separating competitiveparts of the business, such as generationand supply, from the naturalmonopoly that is the grid.The former vertically integratedregional utilities were unbundledinto generation, transmission, distribution,supply and maintenance.Subsequently, these wereremerged along business linesinto larger companies.For the $1bn-plus firms created,Sergey Bubnov says liquiditycreationresults in an expectedupside of at least 100%.Since the fund’s March 2005launch, it is up over 200%, andup over 25% in 2007.And value-creation throughconsolidation is to be complementedby even-greaterupside expected from privatisationof sector companies,which is starting tounfold.The first big governmentsale is slated for March, andanother 15 for 2007. The company’sUtilities Fund holds more than 5%in two firms and 1% or more inthree more, Sergey Bubnov says.Hold 25% of a firm and you havea significant advantage of getting acontrolling stake, Bubnov says, asthe State looks to sell off its stakein stages.“Privatisation started in earnestthis summer,” says Bubnov, “andthat sent investors crazy.”As the primary mechanism forthe privatisation of shares hasbeen by proportional distribution,one can only get control by buyingshares trading in the secondarymarket, “shares which are heldby us or by our competition,” soboosting demand for limited supply,Bubnov says.True to hedge fund practice, theutilities-focused fund can also goshort and employ leverage, but istypically long-only.

Short shrift for Eastern Europeanstock loan nay-sayersstock loanAsset Alliance’s Daniel Axmer argues that borrowing of stock in Eastern Europe is not the hardtask it was for hedge fund managers in days of yoreStock-shorting is a relatively new practice inEastern Europe. Only in the last couple ofyears, as the regional markets developed andmatured, have hedge funds started to look atshorting opportunities.Equity markets have grown substantially tothe point where, today, the aggregate marketcapitalisation of regional markets is about $1trn.Historically, the only way to short regionalcompanies was through ADRs/GDRs (American/globaldepository receipts), in which manyof the large companies in Eastern Europe havefairly sizeable programmes listed predominatelyin London and New York.However, recent developments both in localmarkets and derivatives have increased thenumber of shorting possibilities with the resultthat it is now possible to borrow stocks locallyin the Czech Republic, Hungary and Turkey.prime brokers to the rescue!The prime brokers have also contributed animportant part to the development of regionaltrading and now offer derivative instruments onsingle stocks, baskets and indices.Usually, hedge funds facilitate stock borrowthrough the stock-loan desk at the prime broker.In instances where the prime broker may nothave a specific stock or the cost is too high, themanager may borrow from other brokers withwhom they have a credit line. The brokers obtainthe shares from either their own inventory orfrom third parties willing to lend out the shares.These third parties tend to be large long-onlyfunds or institutional clients whose investmenthorizons tend to be longer than the hedge fund’sand are thus willing to lend in order to generateextra income.Borrowing locally is still not as efficient as borrowingADRs/GDRs because, in some cases, thelocal markets may have regulatory or other barriersto lending. However, this is now changingand more prime brokers are working with localmarket authorities to facilitate borrowing.Borrowing is very different across theregional markets. Many large Eastern Europeancompanies have ADRs/GDRs listed abroad,which are the easiest to borrow and the hedgefunds’ preferred instrument.Russian companies, in particular, have largeand long-standing ADR/GDR programmes, aswell as a significant volume of floating shares.The larger Polish, Hungarian, Czech Republicand Turkish ADRs/GDRs are all easy to borrowup to a certain size. Local differences occur.russian variations on a themeShorting locally in Russia is difficult due to regulatoryand legal barriers, so hedge funds preferto use the ADRs/GDRs. In the Czech Republic,shorting is easily done locally in large nameslike Cez, Telefonica, Komercni Bank, Zentivaand a handful of others. The situation is similarin Hungary for the larger stocks including Mol,Magyar and Gedeon Richter, which tend to havesignificant borrow.In Poland, shorting is still complex due toregulations, so ADRs/GDRs are mostly used.Shorting locally in Turkey is relatively newbut possible in large liquid stocks, while in thenewer and smaller Eastern European marketslike Ukraine, Kazakhstan, Romania, Bulgariaand others, it is more or less impossible to shortlocally at this stage.However, a number of stocks from thesecountries have ADRs/GDRs listed.Borrowing small-cap stocks tends to be fairlyunusual. To borrow stocks with market capitalisationbelow $1bn is possible but it would beexpensive and it could potentially expose a positionto a short squeeze. The prime broker wouldassess the feasibility of borrowing by lookingat the liquidity, diversity and size of borrowpool, and the volatility of the underlying stockto evaluate if the stock is shortable.so, emma chisit?The cost of borrow has changed rapidly overthe last years as well. A few years ago, ADRs/GDRs typically cost 500bps-600bps to borrow.Now, borrow cost is around 50bps-300bps.Russian ADRs/GDRs tend to be the cheapestand usually cost between 50bps and 150bps followedby Czech and Hungarian stocks. Polishand Turkish stocks are most expensive and cancost as much as 500bps.Naturally, with the growth of the market, therange of derivative products available to hedgefunds has grown as well and now includesbasket products, contracts for difference(CFDs), exchange-traded funds (ETFs), swapsand options. Most Eastern European countriesalso now have a derivatives, exchange althoughthe liquidity and breadth of products differbetween them.The local futures markets in both Poland (theWIG 20 futures contract traded on the Warsawexchange) and Hungary (the BUX index futuretraded on the Budapest exchange) are liquid andhave good turnover while Russian and Czechfutures can be traded on the Austrian FuturesExchange but they are not that liquid.The Turkish futures exchange (TurkDEX)can offer ISE-30 and ISE-100 futures contractsthough liquidity is still limited.There are a couple of ETFs in the region butmost hedge funds have stayed away from usingthem due to low liquidity and high costs.Many prime brokers also offer options andswaps OTC. Synthetic swaps are used regularlyby most hedge funds and are available for mostsingle stocks. Options are relatively new andmore expensive than other instruments, so theyare less used at present.During the three periods of high volatilitythat Eastern European equity markets haveexperienced in recent times – March/April 2005,October 2005 and May/June 2006 – most equitylong/short hedge funds were able to protect thedownside very effectively.The availability of both OTC and exchangetradedproducts have been key for managers toavoid large drawdowns during stress periods.downside protectionIt has not been unusual to see managers be flatto down less than 1% when their core marketsare down by double digits.This has, in most cases, been achieved by acombination of picking the right single stocksto short and quickly reduce overall marketexposure though index products.A further important aspect of downsideprotection in this market has been the size ofthe fund. Most managers are actively managingtheir total assets to reflect the underlyingliquidity of the market. Consequently, onaverage, hedge funds in the region tend to besmaller than hedge funds in other regions.The development of stock borrow in EasternEurope is still in its early stages compared toother markets, but I am encouraged to see themassive improvements both in local markets,ADR/GDR listings and OTC products.Over the next few years, I expect that hedgefunds, prime brokers, institutional investorsand local investors will become morenumerous and more active, thereby deepeningand broadening the market and leading to furtherdevelopment and improvements in termsof liquidity, pricing and availability of stockborrow and derivatives.author: daniel axmerDaniel Axmer, CFA, is a seniorresearch analyst at AssetAlliance International (London).He is active in hedge fundmanager selection, as well as indue diligence, quantitativeresearch and portfolioconstruction of funds of hedgefunds. Asset Alliance is aninvestment management firm that specialises inalternative investments, which includes hedge fundsand funds of hedge funds (FoHFs).Asset Alliance offers strategic opportunities forhedge fund managers, and provides advisoryservices and manages investment products for highnet-worthindividuals (HNWIs) and also forinstitutional investors.

exchangesExchange of informationOleg Safanov, president of Russia’s largest exchange RTS, tells David Walker why the country’s mainstock and derivatives exchange remains a vibrant place for investors, speculators, public companiesand hedge funds alike...The Russian Trading System (RTS)can be truly considered to be in asweet spot.In the last nine months of 2006,the Russian GDP grew at 37.7%and, notwithstanding emergingmarkets jitters in the last week ofFebruary, and in March’s first week,which saw an 11% decline in thebenchmark RTS Index, the 12-yearold Russian stock market Safonovoversees continues to see a pipelineof public offerings satisfying investors’hunger for listings.One can see why – in the twoyears to 7 March 2007, the RTSindex, calculated on the basisof shares of the 50 most liquidcompanies, appreciated by149%, according to figures fromBloomberg, in an economy displaying6.4% GDP growth in 2005.Similarly, the capitalisation of theRussian stock market has grownfrom 43.0 at the end of 2000 to 837.0by mid-October 2006.Russia’s main exchange has fivesub-sections to its structure – theClassic Market, the T+0 market,RTS Board with a system of‘indicative quotation’, RTS START(similar to London’s Aim market),and FORTS for exchange-tradedderivatives. In total, RTS has morethan 1700 securities quoted.classic record“The Classic Market is the oldeststock market in Russia. Its pricesare given in US dollars and settlementoptions include both deliveryversus payment and free of payment.We are the only Russian stockdifferent systems on offerexchange where the trades are settledin foreign currency and Russianroubles,” Safonov explains.According to RTS’s website(www.rts.ru), the Classic Market has400 securities from 283 issuers.trading modelsThere are two trading models inthe RTS Classic Market. One isanonymous order-driven tradingwith the eight most liquid shares onthe market – namely RAO UES OfRussia, Gazprom, Norilsk Nickel,Lukoil, MTS, Rosneft, Rostelecomand Surgutneftegaz.In the order-driven trading settlementis conducted only on a DVPbasis in dollars and secured by theRTS Guarantee Fund.The second model is quote-driventrading based on the non-anonymousquotes.“The main advantage of thequote-driven trading model is theability to ‘improve the price’ bycalling the party that submitted aquote and agreeing to execute thetrade within the the spread,” theRTS notes.“Such an ability is important fortrading in less-liquid securities thatmight have large bid/ask spreads.Knowing the counterparty to thetrade is also important to managerisks associated with tradingwithout pre-funding of cash andsecurities. Plus, it helps parties tocome to an agreement involvingnon-standard settlement schemes.”flexible settlement“Settlement of trades executed onthe quote-driven market can be performedon the following conditions:“Delivery versus payment” or “prepaymentof pre-delivery,” RTS sayson its website.“The parties have anability to agree on the place, price,“We can see serious interest ofWestern participants in theRussian economy.”sergey nazarov, renaissance investment managementdate of the delivery and the settlementcurrency although more than90% of trades are settled DVP.”With RTS Board, there is asystem of indicative quotation that,in Safonov’s words, “makes it possiblefor companies whose sharesare not admitted to be traded onthe exchange to have an indicativeprice, so they can make an analysisand know what level of prices is setbe the OTC market.“After that, they may decide totrade their shares on-exchange andget them listed.”The fastest growing segmentof the Russian stock market is theTrading platform Order-driven Quote drivenInception 2005 1995Model Order-driven Quote-drivenTraded securities 8 blue chips All other stocks and bondsCurrency USD USDSettlement cycle T+4 From T+0 to T+30Clearing centre RTS Stock Exchange N/ARegistration of traded securities Depositary and Clearing Company Any depositary or registrarDelivery versus payment Mandatory OptionsSettlement firm JP Morgan Chase or RTS Settlement Chamber Any bankSettlement currency USD USD or RURsmall and mid-sized sector, a sectionthe RTS Board is very successfulat bringing into the stock market,Safonov adds.The T+0 market, Safonovexplains, “is targeted for individualinvestors and characterised by prefundingof cash and securities. Asan investment exchange, we arenow trying to promote the liquidityof the tier-two and three shares.”For hedge funds, on the equitiesside there are already 11 firmsoffering prime brokerage servicesacross Russian stocks.They are Alfa Bank, Alton LLC,UBS Securities, Citibank, MDMBank, Metropol, URALSIB, ProspectInvestment, Renaissance,Troika Dialog and UFG (acquiredby Deutsche Bank).“A number of Russian companiesis already coming into the stockexchange, or planning to, and therefore,we find that with the very goodindicators of economic growth andcontinuing appearance of companiesin the stock market, we can seeserious interest of Western participantsin the Russian economy as awhole,” Safonov says.macro healthRussia enjoys political stability, hesays, government budget surplusand a rapid paying-down of foreigndebt at the same time oil at $59 abarrel builds its foreign currencyreserves.Standard & Poor’s, Moody’s andFitch all rate Russia as a country ofinvestment grade.The attractions for both domesticand foreign investors of Russia sawtrading volume on Russian TradingSystem Group markets grow by215%, period on period, in the finalnine months of 2006.In the third quarter of 2006,RTS was also looking outwards, atopportunities for tenders in Turkeyand the possibility of creating atrading floor using IT systems inthe Ukraine. Looking further afield,RTS also signed an agreementwith Standard & Poor’s in 2006 topromote its indices globally, and toco-operate with S&P on calculationmethodology for five new sectorindices – based around oil and gas,telecoms, metals and mining, industrialsand consumer/retail.

exchangesExchange of informationthe markets on offer at rtsMarket RTS Classic Market RTS Board T+0 market FORTSAnonymousNon-anonymousInstruments Eight blue chips Stocks, bonds, mutual funds Stocks, bonds,mutual fundsMarket organizer RTS Stock Exchange, JSC NA RTS StockExchange, JSCGazprom sharesSaint PetersburgSEDerivativesRTS SE, JSCTrading model Order-driven Quote-driven Order-driven Order-drivenDeposits Margin 25% Not used 100% deposit of cash and securitiesbefore order submittedInitial margin3%-20%from the openpositionSettlement DVP T+4 DVP or FOP from T+3 to T+30 DVP T+3 DVP for settledcontractsPrice currency USD RUR RURSettlementcurrencyUSDClearing centre RTS SE, NP Not used RTS SE, NP RTS ClearingCentreCash settlementSettlementdepositoryJP Morgan Chase and RTSSettlement ChamberUSD orRURAny bank (for DVP: JP Morgan ChaseBank and RTS Settlement Chamber)RURRTS Settlement ChamberRURRTS SettlementChamberDCC Any depository or registrar DCC RDC RDC or DDCConnectivity via API Yes Planned Yes Yes

exchangesFrom the land of the bear, a bull emergesThe Russian stock exchange’s options and futures market, known as FORTS, has seen healthygrowth in trading volumes and a diversity of users of new and existing products – each healthy forhedge funds – as its head Roman Goryunov tells David Walker...The portion of Russia’s mainexchange possibly of most interestto hedge funds – and its most rapidlygrowing – is the ‘Futures andOptions on RTS’ portion, alsoknown as FORTS.“Our system of futures andoptions is the leading derivativesmarket in Russia and is among theleading 20 futures markets in theworld,” explains Oleg Safonov, RTSpresident (pictured, right).“The futures and options markethas been developing very effectivelyfor five years,” Safonov said in late2006, “and, in 2006, the commoditiessection began to operate and westarted futures in gold.”Add to this equity and indexfutures and options, bond futures,short-term futures and currencyderivatives (RUR/USD futures andoptions on futures) and the range ofinstruments FORTS offers is broad.Weather derivatives are plannedto be launched, but no sooner thanSeptember 2007 (to be constructedin conjunction by RTS and weatherforecaster RosHydromet). Morethan 13,000 participants served byaround 180 professional marketparticipants have taken advantageof the various instruments offeredon FORTS.“The commodities section will bea large and important part becausewe consider commodity futures tobe a major development of futuresmarkets in Russia. We are planningto issue a large number of futuresand other assets.” Urals oil, dieseloil and gold futures are amonginnovations, as are derivativesbased on petroleum and avgas. Thefutures contracts on Urals oil arecash-settled with settlement basedon pricing from Platts. Diesel oilfutures are physically delivered.“For the Russian market, the priceof petroleum products is not highlycorrelated to the world prices foroil,” says Roman Goryunov, vicepresidentand head of FORTS, “sousing the futures in Urals oil tohedge petroleum products is notyet effective, so we may create aninstrument on petroleum products,not oil, to increase the effectivenessof being able to hedge risks in themovement of prices.”Goryunov adds the derivativesdivision of the RTS stock exchangeenjoyed daily trading volume ofover 500 contracts per day in late2006, equivalent to $500m-$600m.Its bread and butter by volume inthe third quarter of 2006 was futuresand options on securities (64.14%),followed by futures and options onthe RTS Index (31.91%) and thencommodities futures (2.12%), futuresand options on bonds and interestrates (1.26%) and FX futures andoptions (0.57%).“RTS is among the leading 20derivatives exchanges in the worldfor futures and we are the leader forfutures on shares,” he adds.FORTS offers more than 27types of contracts, representingdifferent segments of the market,from equity derivatives futures andoptions, to index instruments – bothfutures and options – instrumentsbased on bonds and instruments ofthe money market.“We also have those based onthe rouble/dollar exchangerate and futures on interestrates and on commodities,”Goryunov notes.“We can all see howactively and seriously theRussian market has grownfrom the point of view ofprices and from the pointof view of volumes andmore and more peopleand companies are thinkingabout hedging their positionswhen investing inRussia,” he says.“The demand for FORTS we haveseen recently shows hedging interestis very serious. At the moment, thederivatives market gives one theopportunity to hedge positions inrouble assets, so if you are investingin assets which are situated inthe rouble zone in Russia you canhedge the position rouble/dollar tohave a guaranteed yield from the“RTS is among the leading 20derivatives exchanges in the worldfor futures and we are the leader forfutures on shares.”sergey nazarov, renaissance investment managementpoint of view of currency, and havethe opportunity of considerablyincreasing your investment possibilitiesby using futures and options.”Goryunov has already seen arbitrageopportunities between markets,and trades connected to trading infutures in euros against instrumentstraded on international markets.“We are also seeing considerableinterest in the arbitrage between theoptions market for equityand discrepancy inmarkets when theprices for Russianassets are higherin the internationalmarketthan in the localmarket,” headds.RTS indexoptions andfutures were introducedAugust 2006,and the volume ofopen interest was$1.4bn. Now, itis them o s tliquid contract in the Russianmarket place.In the past 18 months, FORTShas introduced futures on 30-yearRussian Eurobonds and futures on10-year bond loans of the city ofMoscow, diesel oil futures, futureson RTSc and RTSo.From around mid-2006, there hasbeen trading in futures on shorttermrouble interest rates, instrumentsin high demand due to thedynamics of Russia’s fixed incomemarket, as Goryunov explainedlast October.“Over the past few years inRussia, there has been a situationin which short-term rates were on alow level. Overnight rates were 1%-2% as a connected contract to theextremely high bank liquidity andoil prices.“Recently, we have seen the interestingtrend where the overnightand other short-term rates arerising and participants with a greatvolume of short money financingare finding that the jolly times theyhad in the past would not continueand they have to find instrumentsto hedge their positions,” he says.“It is also an interesting move tohave futures in agricultural productslike grain and sugar becausethere are quite large volumes ofboth of those goods produced inRussia. The domestic market isclosely correlated to the worldcommodities market and arbitrageopportunities could be possiblebetween such contracts, whichcould be highly interesting to globalparticipants in financial markets.”Goryunov adds industry playersas well as financial markets professionalsare becoming “more andmore active because there are moreand more interesting instrumentslike index contracts. We are alsoseeing a serious increase by internationalinvestors.“The increase in the qualityand size of the investor base givesgrounds for the future increase inthe liquidity in the market. Now,the Russian market in derivativescannot be regarded as somethingexotic or completely new. It’s anestablished and liquid and reliablemarket.”The central party inall transactions made inthe FORTS is the RTSClearing Centre.

exchangesOn your marks...Russia has launched a small- to mid-cap segment to help fledglings get aleg-up as Anja Kuznetsova from START tells David WalkerQuestions of small- and mid-sizedcompanies entering the stockmarket had not been seriously considereduntil recently in Russia.Possibilities suggested by the specialistswere aimed towards largeand, less often, mid-sized firms.The requirements of listing inRussia, imposed by stock exchangeson firms in accordance with Russia’slegislation, remained too high.As a result, companies and evenindustries lost the opportunity toattract investment via the mechanismsof the organised stockmarket. However, in 2006 thischanged. The Federal FinancialMarkets Service (FFMS) set aboutdeveloping the mid/small cap sectorsof the stock market, payingspecial attention to creating afavourable environment for small,fast-growing companies.Russia’s regulator prepared andimplemented measures aimed atstimulating small- and mid-sizedfirms to attract financing throughRussia’s stock market. In 2007, RTSSTART will be created, a segmentof T+0 RTS market which willallow companies in various sectorsto come to market.According to OJSC RTS chiefexecutive officer Anna Kuznetsova,who is in charge of the RTS STARTproject: “RTS START, like Aim, iscreated to offer the opportunity tosmall fast-growing companies toenter the organised stock market toattract investment.”RTS START, she says, allowssmall and mid-sized companies:n to successfully make a start tosecurities trading;n to attract investments from thestock market via an IPO; andn to organise a secondary stockmarket.The success of the investmentstrategies chosen by the companieson RTS START is providedby Authorized Finance Consultants(AFC), and by market-makers.Unlike Aim, START is not aseparate trading ground, rather itis a segment of the “unified tradingground of RTS,” she adds.Work on ‘project RTS START’began in Spring 2006 and STARTwas launched on 29 January. Companiescan be included on RTSSTART if their capitalisation doesnot exceed RUR3bn (about $100m).Russian legislation allowstrading in foreign currency as well.Investors in Russian IPOs havebroadened in nature, Kuznetsovaadds, to include foreign and Russianspecialised funds, portfolioinvestors and natural persons andinternational funds investing insmall-cap companies.In 2007, there are between fourand 10 listings expected on RTSSTART with a value of between$5m-$50m, for the total considerationof $250m.Kuznetsova adds in this regardthat, while foreign listings havebeen a successful option for smallcapRussian firms for the last fiveyears, the trend worldwide is forfirms to list first on their localexchange, typically where investorswill know them – and hopefullyalso value them – better, a trendthat also exists in Russia.Besides, the cost of ‘IPOing’ on thelocal markets is considerably lower.Companies which look for theirsecurities to be admitted to tradingon RTS START are supposed tomeet the requirements in the Rulesof Admittance to RTS trading,which are based on Federal lawsand by-laws of FFMS of Russia.Thus, only the securities thatmeet the following requirementscan be included into RTS START:n the prospectus has undergonestate registration;n results of the securities issue(additional issue) have been officiallyregistered, or a notificationabout the issue of the securities(additional issue) has been made tothe FFMS of Russia;n The company-issuer follows allthe regulations of the legislationon the securities, “normativeacts” of the FFMSof Russia, including theone about informationdisclosure on the stockmarket;n The company iscompliant with theexchange’s requirements,which areobligatory for RTSSTART inclusion.It is also expected:n That the applicanthas sent an application,signed by the companyissuerand AFC aboutthe securities’ inclusion inRTS START addressed tothe exchange’s CEO;n While included in RTSSTART the capitalisation ofthe above-mentionedsecurities shouldnot exce edRUR3000m.n When corporatebonds areincluded intoRTS START,the volumeof the issuedsecurities that are included intoRTS START should not exceedRUR500m.n AFC has presented to theexchange a report containinginformation on the financial stateof the issuer and risk factors, abrief description of the industrythe company functions in, anassessment of the fair price forthe securities included on START,and also additional informationrequired by AFC.n A issuer has presented a copyof the contract with the AFC forthe period its securities are on RTSSTART (with one exception);n A contract has been concludedon performing the market-maker’sobligations for not less than sixmonths from the first trading day.comparison between russia’s START market and london’s aim marketCharacteristics Aim London RTS STARTRole of state bodies and exchange No part in process, decision on admission taken by authorised consultant Play an active rolePreliminary scrutiny of documents for admission to trading byexecutive office (UKLA for UK, FCSM for Russia)Not required if not specified beforehandNot requiredPreliminary scrutiny of documents for admission to trading by SE Not required RequiredMinimum free float Requirements not fixed From ‘no limitations’ to 10%Minimum capitalisation Requirements not fixed From ‘no limitations’ to 1.5bnMinimum life of company Requirements not fixed From ‘no limitation’ to 3 yearsPreparation of admission documents (eg prospectus) State registration not required State registration requiredInternational financial reporting Less than three years according to GB, or company-issued standards No limitationsDisclosure of material information No legal requirement for list, form and terms of disclosure Legally-fixed list of signatory information and factsPriorities when disclosing info Equal access of all to information disclosed Obliged to disclose info first on exchange, then as newsControl over companies’ info NOMAD Authorised Finance Consultant (AFC)Source: RTS

market overviewForeigners eye up corporate RussiaRussia is in rude health. Very rude health indeed. And with an undervalued stock market and macrogoodness, that can only mean one thing – or two, actually: M&A. David Walker speaks with GlobalTrader and Standard & Poor’s to gauge their opinion on Russia’s market...While Russian resources firms arebulging at the seams with oil andcommodity profits, Fleur Gremmen,head of Global Trader, notes foreigncompanies are eyeing up Russiancompanies as potential mergerand acquisition targets.oily profitsGremmen notes Russia’s story hasbeen a Crude one, however, themethod the government uses to calculatehow much tax it takes fromoil producers means their outlookcan change as tax is taken then theoil price or demand shifts.“Right now, there’s a definite holdin oil and gas, so there is a hold onoil. The Scandinavian energy companiesare looking to buy diversifiedassets in Russia, for example,and the main sector is utilities,”she says. “These companies do notpay taxes based on the oil price,but they do get margins based onoil coming through their system,”Gremmen notes.However, Russia’s economy andcorporate landscape extends wellbeyond oil and gas, other commodityextractors and utilities, she notes.“There has been an influx ofmoney into Russia and that usedto be from oil and gas, but now itis a more diversified picture withthe consumer sector, supermarketchains, consumer goods and power,”she says.Gremmen notes, for those fundmanagers who may be eyeing upthe event-driven opportunities, therecan be a lag in investing because ofhaving to pay on Day One yet onlygetting delivery on Day Three,although ADRs and GDRs are availablein the gas and oil sectors.derivative accessGlobal Trader can offer derivativesbasedaccess to Russia’s marketswith OTC instruments on the RTSindex among the products it offersto international investors.She notes for those looking totrade into the Russian story onleverage, “Russia is a very expensiveplace to execute because creditrarely exists, and where it does, itis very expensive. If you want toborrow funds to trade then you’relooking at 12%-18%.”Margin requirements will bebased on liquidity and volatility ofthe stock you’re targeting and comesout “realistically at not lower than20%, and not higher than 40%,”Gremmen says. As Global Traderextends far beyond Russia in itsinstrument offerings, Gremmennotes a portfolio using their servicescan easily be involved in arbitragetrades, for example, betweenRussia and China or South Africa,for example.Gremmen adds, in contrast toprime brokers who may insist a fundhave $100m assets before they willdeal with them, Global Trader canoffer services to high-net-worth individuals,with $100,000 for example.natural reticenceNaturally, fund investors may be alittle reticent immediately to commitif they believe the emerging markets’slide is not yet over. On 9 March, theMoscow Times descibed as a “hæmorrhage”the Russian stock market’slosing 10% in just three days.Yet, while the flows from investmentfunds may have slowed in thelast month as jitters in Shanghai cutinvestors’ risk appetite quickly, it isnot clear this reticence should detercorporate buyers looking at underlyingfundamentals – and possiblyalso seeing balance sheets as evenmore alluring given cheaper stockmarket capitalisations after riskcapital has run for the safe havensof fixed income, or at least developedmarkets.thumbs up!Standard & Poor’s is one agencythat has given a generally thumbsupsignal to Russia, at least on themacro and sovereign side, recently.The macro factors weighing inRussia’s favour are not hard to identify.In Standard & Poor’s reporton The Russian Federation on 11January, the ratings agency notes:“The external liquidity of Russiacontinues to improve rapidly as commodityprices remain high.”The agency writes, furthermore,that the foreign exchange reservesheld by the Russia Central Bank,including the government’s (ca$90bn) Stabilisation Fund havereached $300bn in 2006.”What will this buy exactly?Almost 10 months of Russia’scurrent account payments and anamount equivalent to 4.5 times Russia’sshort-term debt. “At the sametime (as amassing this amount),astute fiscal management hasimpressed the government’s balancesheet. General governmentdebt will be below 10% of GDP in2007, “less than one third the ‘BBB’median ratio,” the report adds.When assets are taken intoaccount, Russia became a net creditorin 2006. On the current-accountfront, Standard & Poor’s notes,Russia has posted surpluses equal toabout 10% of GDP since 2003. “TheRussian authorities have managedthese inflows responsibly throughthe establishment of the StabilisationFund with a view to containingreal exchange-rate appreciation andtherefore any associated detrimentaleffects on competitiveness,” Standard& Poor’s says.corporate rude healthSo if the picture is so rosy for thegovernment sector, what of the corporates?“The business environmentis poor compared with those of Russia’speers,” says Standard & Poor’s.“Unpredictably, policy enforcementand regulatory actions depressdomestic and foreign direct investment,”Standard & Poor’s says.“Progress in restructuring naturalmonopolies is slow, the administrativeburden and perceived corruptionare high.” However, those companiesinvolved in domestic sales could realisticallyexpect a healthy outlook asRussia’s GDP per capita will surpassthe ‘BBB’ median in 2008, up frombeing less than two thirds the mediain 2004. The average Russian is nowwealthier than the average SouthAfrican, Malaysian and Mexican.With such good news, what arethe clouds on Russia’s horizon?It has, in Standard & Poor’s says,“political, legal and economic institutionsthat remain weak…risingcontingent liabilities associatedwith increasing financial intermediationand the rising debt ofState-controlled companies…(and)an economy that is vulnerable toshocks given its heavy dependenceon the natural resources sector,where large capital investmentsneed to be undertaken to boost productionvolumes.”S&P warns: “The more distantfuture may be characterised by lessbuoyant conditions. Russia’s nationalinvestment ratio is among the lowestin its peer group, trailing the medianby more than 5% of GDP, “a gapthat keeps widening,” Standard& Poor’s cautions. “This may wellundermine capacity in the future,all the more so as a disproportionateshare of investment is dedicated tothe booming real estate market.”Emerging markets hedge funds (source: eurekahedge)Emerging markets Open/Closed HQ 3m 12m Rk 36m* Max Hi water Vol Pos(%) (%) d’down mark MthsRussian Opportunities Fund Ltd O Russia 56.94 102 1 72.17 -87.68 0.00 38.46 8Quorum Fund O Bahamas 27.84 59.38 2 54.55 -27.27 0.00 19.40 9Firebird Republics Fund C US 20.19 59.01 3 55.01 -73.20 0.00 17.45 10Diamond Age Russia Fund Limited O Russia 16.85 36.95 4 - -6.56 0.00 13.59 10Russian Prosperity Fund - Cls A O Sweden 19.56 36.52 5 54.06 -90.26 -0.97 26.29 8Firebird Avrora Fund Ltd O US 18.61 36.05 6 43.55 -9.05 0.00 16.75 9Russian Prosperity Fund - Cls B C Sweden 16.99 34.10 7 49.27 -89.55 -0.84 22.39 8Russian Prosperity Fund - Cls C O Sweden 16.85 33.16 8 52.65 -27.02 -0.88 22.48 8Ashmore Russian Equity Fund O UK 9.89 32.85 9 37.59 -26.59 -2.11 19.09 9Firebird New Russia Fund C US 11.52 32.34 10 46.47 -81.79 -0.22 17.29 9UFG Russia Select O Russia 13.60 31.15 11 43.57 -18.39 -1.08 15.65 9UFG Russia Select LP O Russia 13.57 29.93 12 42.30 -18.20 -1.17 15.76 9Spectrum Russian Growth Fund O Russia 14.36 26.92 13 - -9.04 -1.16 17.96 8RAB Emerging Mkts Opps Fd – Cls A E O UK 11.63 26.62 14 - -0.52 0.00 7.26 9Horizon Growth Fund NV O Argentina 9.92 26.30 15 7.62 -49.81 0.00 10.23 9Pharos Gas Investment Fund Ltd O Russia -0.61 24.75 16 - -30.41 -14.03 43.37 7Credit Suisse Absolute Fund Ltd O Brazil 9.38 23.62 17 - -7.17 0.00 9.39 9Spectrum Russia Absolute Return Fd Ltd O Russia 9.24 23.50 18 22.53 -9.06 -0.47 9.31 9Morley Central European L/S Eqty Fd - $ O UK 7.21 23.42 19 - -1.70 0.00 8.11 9Strategic East European Fund O Monaco 14.83 21.00 20 14.87 -17.90 0.00 15.21 8Polunin Capital Ptnrs Em Mkts Active Fd O UK 13.27 19.17 21 20.91 -25.46 0.00 17.24 8Pharos Russia Fund O Russia 16.19 18.61 22 41.20 -85.01 -1.17 23.87 8Denholm Hall Russia Arb Fd - Cls B O UK 3.37 17.42 23 20.39 0.00 0.00 2.19 12Tiedemann Global Em Mkts LP/Ltd C US 11.01 16.65 24 10.71 -36.40 0.00 6.97 8Denholm Hall Russia Arb Fd - Cls A O UK 5.07 16.47 25 18.62 0.00 0.00 3.32 12Sector Average 8.61 13.81 113♠ 23.07 -18.25 -1.16 10.83 8.12*12 months to 31 Jan, data to 23 Feb 2007. For full rider, see page 55, March 2007 edition of Hedge Funds Review.

political focusParadise lost in a post-Putin world?Expect the Russian bear to bare its teeth well after Vladimir Putin retires, as itsresource wealth becomes increasingly important, experts tell David Walker. Oh,and if you have a spare fiver, maybe place it on Putin making a come-back...While eyes may be set on 2008,when presidential elections installVladimir Putin’s successor, expertsnote whoever follows him will keepusing the country’s vast commoditieswealth to Russia’s global politicaladvantage.Stephen Capon, head of countryand credit risk management withinthe risk and credit division of ACEInsurance Company of NorthAmerica, says: “We believe therewill be a smooth transition, andif you look at the Budget put up(recently), it’s quite clear that withthe implementation of that Putinwill leave quite a legacy behindhim and will have tied the handsof his predecessor (by) movingtowards a three-year budgetaryprocess rather than an annual one.”Few would argue Putin has notleft Russia in a stronger economicposition than when he gainedpower in 2000.With the global influence thatstems from ownership of commodityprices, Putin and the Statehave sought international influenceusing gas and oil, and usingcompanies such as Rosneft (oil)and Gazprom (gas) as projectionsof this power, Capon says.Sberbank, the State-owned bankthat has 60% of Russia’s retailbusiness, or Gazprombank, couldbe used similarly in the bankingsector, Capon notes. The State ownershipwould clearly obviate anyneed to go after oligarchs such asMikhail Khodorkovsky of Yukosfame, to bring corporate Russiainto the government’s fold.Capon understands the risksof renationalisation in Russia,working for ACE Insurance Companyof North America, which providespolicy cover for events suchas renationalisation and expropriation,among other event risks, ofprivate companies.He numbers hedge funds amonghis clients seeking protection cover,and consulting advice.While the renationalisation ofgas and oil concerns is proceeding,Capon also notes Putin’s moves tocreate a “centralised holding companyfor the nuclear sector andthose companies who buy andexport capabilities around it.”nervous trepidation?Many observers express at leastsome trepidation about post-PutinRussia. Standard & Poor’s, normallysanguine on its pronouncements,says of Putin’s rule: “Asthe Kremlin has extensively centralisedpower during Putin’ssecond term in office, a changeat the helm comes with aboveaverageuncertainties and risks topolicy continuity.”Centralisation has included inS&P’s views, “ending the directelection of regional leaders, tightermedia control, and the introductionof a restrictive law regulatingthe activities of non-governmentalorganisations. A new president willbring risks for prudent economicmanagement.”This will occur, S&P says, if theincoming, who is widely expectedto be a recipient of a Mexican-styleel dedazo (the ‘big finger’ wherethe incoming is designated by theincumbent), cannot wield powerand respect as Putin has, and sohas to “buy” respect and favour,loosening fiscal strings to do so.far from perfectHailing Vladimir Putin’s achievementsis not to say Russia is perfectas it stands.The World Bank’s GovernanceIndicators show in Standard &Poor’s analysis, that “Russia hasthe weakest institutional environment(of its peers), (and) also thatit has actually deteriorated duringVladimir Putin’s second administration.The sub-categories ‘voiceand accountability’ and ‘politicalstability/no violence’ have deterioratedparticularly sharply,” the ratingsagency says.(Stephen Capon says simply ofRussia’s corporate environment, itis “abysmal.”)Indeed, one large Russian hedgefund notes in its monthly fact sheetthat one major listed firm’s newissue was beset by “a series of contradictory,and apparently uncontrolled,announcements by severalof the parties involved in the issue,and the consequent volatility inthe share price suggested attemptsat price manipulation may have“Governmental, legal, andeconomic institutions andaccountability remain veryweak (and) energy assets areincreasingly concentrated in Statehands and used as a political toolin Russia’s foreign policy.”standard & poor’s, the russian federation report, 11 January, 2007been afoot.” Another major foreigninvestor makes little secret that,when he first began investing indomestic stocks back in the 1990s,bodyguards were an importantpart of any activist hedge fund’sbusiness plan for Russia. (He distanceshimself from such daysnow, prefering the rule of law.)Nevertheless, Russia scores particularlypoorly in the period 2002-2005against its peers in the World Bankstudy – South Africa, Malaysia,Kazakhstan, Poland, Saudi Arabia,is russia’s end-game iran?If Iran is bombed in 2008, whatdoes this mean for Russia, whichis believed to supply much of thatcountry’s scientific expertise?Russia could block any UN vote onfurther sanctions against Iran underPresident Mahmoud Ahmadinejad,with China abstaining, leavingAmerica, and possibly allies, toimpose its own penalties on Iran.If it then comes to bombing Iranfor fear of a developed, offensivenuclear programme, Russia couldprove the ultimate beneficiary, nothaving got Tehran offside by votingfor a blockade against it.Oil would spike while Iran’soilfields closed temporarily, butthereafter it is a fair bet AmericaBulgaria, Thailand and Mexico – on‘control of corruption,’ ‘rule of law,’‘regulatory quality’ and ‘governmenteffectiveness.’Standard & Poor’s also noted,not without some concern that“governmental, legal, and economicinstitutions and accountabilityremain very weak (and)energy assets are increasinglyconcentrated in state hands andused as a political tool in Russia’sforeign policy.”So much for Aussenpolitik.On the front of Innenpolitik,Standard & Poor’s adds: “It is alsodoubtful whether Putin’s successorwill be equally able to balance therival factions of technocrats on theone side and the so-called siloviki(politicians from the security or militaryservices) on the other.“These uncertainties increase therisks to the policy outlook.”So, by 2009, Putin will be goneand the world will have to adjust toboth the domestic and foreign policystance taken by his dedazo Kremlinsuccessor. Oh, really?Not so fast: Stephen Capon saysPutin could be headed for a leadershipposition in the Duma, and notone without political influence.the comeback comrade?And after that? Place your bets forPutin Mach II. “There’s always thechance Putin could make a comeback,”Capon says. “If Belarussiais absorbed into Russia in time, youwould need a new Constitution,and that could be a trigger...”would not receive contracts to drill ordevelop Iran’s oilfields. If not the US,then who?Experts say Russia and China.Russia’s regional influence wouldthen be strengthened, and alsocontrol over much of the world’s oilproduction (including, of course, itsown) affirmed.While Vladimir Putin has left Russiain a stronger position than it wasin 2000 – partly due to Crude oil’sand commodities’ prices – and ifthis scenario delineated above playsitself it, his successor could leavethe Kremlin having put Russia in astronger position still.(Just in time, then, for VladimirPutin to enter [again], stage right?)

fund profile: auroraExpanding horizons with AuroraAurora Russia seeks profit by investingin small to mid-sized Russian firms.In doing so it is not alone, but itsmanagers’ combined 24 years’experience in Russia’s markets givesthem an edge, as one of the founders,John McRoberts tells David WalkerWhat was the reason behind settingup Aurora?Aurora Russia was established toacquire interests in small and midsizedprivate growth companies inRussia in the financial, business andconsumer services sectors.Financially, Russia is in a goodposition at the moment. The macroeconomicenvironment has stabilisedand the economy continues toexperience strong growth.Over the past few years, the Governmenthas instituted significantreforms making it easier to operatebusinesses, raise funds and obtainlicenses to invest in certain industriessuch as in the financial servicessector. Russia is finally gettingrecognition by the West as a marketwhere multinational companiesneed to have a presence.We believe now is the ideal timefor private equity companies likeourselves to invest, particularly inthe service sector, which we believetracks the strong economic growththat the country is experiencing.Why the focus on financial, businessand consumer services sectors?We have considerable investment andoperational expertise in these sectors,which puts us in a good positionJohn McRoberts (left), and James Cook (right), Aurora Russia Ltdto identify and invest in high-growthcompanies operating in them.What is the reason for seekingblocking or board representation?As a significant shareholder, we areable to provide hands-on operationalsupport and develop a strong partnershipwith the other shareholders.It is important to us that bothmanagement and other shareholderssee us as partners ratherthan as portfolio investors.What IRR are you targeting frominvestee companies?In our view, the internal rate ofreturn should reflect the perceivedrisk that strategic investorsattribute to Russia. We target superiormarket returns.Do you expect your average holdingperiod to be 2-4 years for each company,and is there an investor lock-in?We do look for viable exit opportunitieswithin two to four years. Theestablishment of a lock-in period isdependent on the nature of the exit.If we were working towards an IPOand the market told us that we hadto agree to a lock-in, we obviouslywould consider it.Our philosophy is to act in a waywhich makes an exit most effectiveand provides the highest return toour shareholders.Do you expect most exits to be viainitial public offering or trade sale?It is difficult to say at this point aswe are still at quite an early stage inthe investment process. It obviouslydepends on valuation and interestfrom strategic investors at the timeof exit and how buoyant the IPOmarket is.The advantage of the IPO processis that it allows you a certain degreeof control over the process.Could you run through the duediligence you look to conduct oninvestee companies, and the investmentprocess?We initially carry out in house duediligence to produce a preliminaryinvestment proposal which takesinto consideration a variety of factorsincluding IRR, the strength ofthe market, competition, financialprojections and the route to exit.

fund profile: auroraExpanding your investmenthorizons with Aurora RussiaThe proposal is presented to theboard of Aurora Investment Advisorsand subsequently AuroraRussia Limited. If there are anymajor concerns raised by eitherboard, these are addressed at thisstage. Once we have addressed anyconcerns the board members mayhave, we begin our formal duediligenceprocess, hiring advisersfor forensic due diligence, one ofthe Big Four for financial due diligenceand a reputable law firm isinstructed to represent us in legaldue diligence.A final recommendation is madeto the board based on the respectivedue-diligence findings, our ownfindings and the deal that we havenegotiated. The transaction is thenapproved at board level.Could you explain the experience ofyour team?James Cook and I are the foundersand directors of Aurora Russia.James has over 13 years’ experienceadvising, founding and managingcompanies in consumer finance,residential mortgage lending andleasing sectors in Russia.James is a former executivevice-president of Delta Capital andChairman of Delta Financial ServicesGroup.He was also the founder,chairman, and chief executiveofficer of DeltaCredit Bank and theco-founder and chairman of DeltaLeasing.James served as chairman andchief executive officer of DeltaBankand most recently as chairman andchief executive officer of GE ConsumerFinance Russia following thesale of DeltaBank to GE ConsumerFinance in 2004.I have spent the last 11 yearsworking in Russia. Prior to settingup Aurora Russia, I worked as acorporate financier, having advisedapproximately 40 clients in Russia ona variety of transactions includingfundraising for private equity funds,equity private placements andmergers and acquisitions.In 1998, I set up Altium Capital’scorporate finance business inRussia and ran the business until2003, when I accepted the positionto lead the corporate financeadvisory business of Deloitte &Touche in Moscow and build up ateam to advise mid-sized Russiancompanies in raising capital andadvising foreign strategic investorson making acquisitions in Russia.We are supported by two investmentofficers, Oleg Bystranov andAndrey Gurin, and a team of twostaff. Oleg’s experience includesNorthstar Corporate Finance, ABNAmro Corporate Finance and theUS Russia Investment Fund, currentlyknown as Delta Capital.Andrey is the former manager offinance for GE Medical Systems forfirstly Eastern Europe and latterlyMiddle East & Africa.He was later appointed managerof finance for GE Oil & Gasservices operations in the globalheadquarters and, most recently,financial controller and treasurerfor DeltaBank after it was acquiredby GE Consumer Finance Russia.Which companies are you investedin presently?Aurora Russia has committed investmentinto three companies.In July, we invested £5.1m for a40.31% stake in the holding companyof the OSG Records Managementgroup of companies, the marketleader in records-management inRussia, Ukraine and Kazakhstan.We have also provided OSG witha convertible working capital facilityof $5m of which $1.6m has so farbeen drawn down. In September,Aurora committed to invest £12.5mto launch Kreditmart, a mortgageand consumer-finance brokerage.In November, Aurora RussiaLtd signed an agreement to invest£10.4m for a 26% stake in UnistreamBank, one of the leading moneytransfercompanies in Russia.What is the capacity of the fund?Aurora Russia raised £75m onadmission to AIM last March. Sincelisting, we have made three investmentsand committed a total ofapproximately £30.1m.We would like to be fully investedby the end of September 2007.“Financially, Russia is in a goodposition at the moment. Themacroeconomic environmenthas stabilised and the economycontinues to experiencestrong growth.”john mcroberts, aurora russia limitedFUNDAMENTALSCould you discuss the topic of corporategovernance in private companiesin Russia?In my view, corporate governance isa vital ingredient in any early stagegrowth investment, irrespective ofthe market in which the company isoperating.My experience having worked atDeloitte and James at GE, has givenus exposure to and a good understandingof some of the key corporate-governanceissues which faceprivate companies in Russia. I thereforebelieve that we are in a goodposition to help establish corporategovernanceprocesses in our investeecompanies and ultimately increasethe value of these companies.How many companies will you aimto be invested in on at capacity?We now have three investments andintend to invest in three or four morecompanies.Why did you list Aurora on London’sAlternative Investment Market?We came to market last March. Webelieved that there was a strongappetite from listed-company investorsfor Russian companies andbelieved that Aurora would be wellreceived by the market.Could you comment on investmentvaluations, the standards you willuse and who the third-party valuationagent is?Investment valuations are made byan internal valuation committee asopposed to a third-party valuationagent. The committee conductsa comparable company analysis,evaluating the performance ofthe company under considerationalongside a number of other listedcompanies. The committee alsolooks at comparable transactions inthe market and uses the net-presentvaluemethod.Name of manager:Aurora Investment Advisors LimitedFull name of fund:Aurora Russia LimitedAddress of manager:Investec House, La Plaiderie,St. Peter Port, Guernsey GYI 3RPPhone contact for further info: +44 (0) 20 7839 7112Launch date of fund: IPO 24 March 2006Size of portfolio:(Market cap) £67.9mOpen or closed to new investors? Closed-ended fund but available tosecondary marketGeographic focus:RussiaAdministrator:Investec Administration Services LimitedAuditor:Deloitte & ToucheInitial fee:2% carry, 20% carryAnnual fee: 2%Is there a high watermark for the performance fee? NoIs the fund listed:Yes, AimDomicile:GuernseyShare classes/currencies: One chare class – commonMinimum investment:£5.1mEnvisioned capacity before soft and/or hard close: £75m

fund profile: asset alliance eastern european fundAn Eastern European assetAsset Alliance’s Eastern European Fundof Funds is designed to protect on thedownside and capture on the upside asDaniel Axmer (pictured), senior analyston the portfolio at the London group,explains to David Walker...You note five macro features ofimportance in Russia: oil, politicalstability, fiscal strength, WTO negotiationsand market valuations. Couldyou comment on each of these?Of course. Oil: Russia is the world’ssecond-largest oil producer and thehigh oil price in recent years hasbeen a very important underpinningfor the resurgence of the Russianeconomy. The oil wealth has enabledthe development of a domesticeconomy that has led to diversificationand the emergence of newinvestable industries.Political stability: PresidentPutin is very popular among Russiansand has been instrumental inimplementing structural reformsfacilitating growth and stability.That said, with presidential electionsdue this year, we anticipate someincrease in market uncertainty.Fiscal strength: FX reservesand the current account and haveimproved tremendously due to acombination of high energy andcommodity prices, with fiscal prudence.The central bank reservesare roughly $300bn and the currentaccount is 6% of GDP.WTO negotiations: Russia finalisednegotiations with the US at theend of last year, and as Russia wasthe largest economy outside theWTO, entry could give the countrythe same boost as China had when itentered in 2001.Market Valuations: Domesticmacro fundamentals and localmarket liquidity are still lookingstrong. Sectors geared towardsdomestic expansion like financials,telecom, utilities and domestic industrialsare especially attractive.What are the main drivers of reformand economic growth in EasternEurope?The accession to the EU and eventualadoption of the euro by manyEastern European countries hascreated a favourable market environment.Economic convergence in theregion has played a very importantrole. Falling interest rates, lowerinflation and currency stabilisationover the past decade all have createdeconomic stability – leading tohigher consumer and corporate confidence,expansion of credit growthand decreases in the cost of capital.Lower tax rates, high industrialproductivity growth and cheaplabour costs have increased capitalflows into the region tremendouslyduring the past years. Companiesare becoming more transparentand open to investors – and there’sincreasing investor demand, moreIPOs, and greater M&A activity.Why establish a FoHF focusing onhedge funds in Eastern Europe?The markets are still inefficient comparedto developedmarkets so activemanagers have manyopportunities, plus themarket is now matureenough to implementhedge fund strategiesefficiently. Theinherent volatility oflocal markets benefitsabsolute-return strategies.The increasein stock borrowing,IPOs, ADR/GDRs andM&A activity havecreated a whole newdimension in terms of the range oftrades that can be undertaken.Over the past couple of years, thehedge fund market has grown exponentiallyand the diversity of themanagers in terms of quality haswidened, increasing the need forgreater scrutiny.How many funds are in your universe,and how many have you met?The universe has grown considerablyin last two years and nowthere are roughly 100 funds that weconsider investable. The universe isquite young since many of the marketswere only established in thelast decade or so. We have met witharound 90% of the managers.Do you believe Eastern Europeanmanagers should be based there?No, there isn’t any evidence thatmanagers based locally outperformmanagers based outside the region.Most of our managers have multicountrymandates and trade acrossthe entire region so there’s no disadvantageto sit in London comparedto Moscow. However, when runninga country-specific fund or a strategythat requires close contact with localmarkets, we would prefer that themanager has people on the ground.You note M&A activity in EasternEurope is a driver of returns. Whatare some of the recent deals?Both global and Western Europeancompanies expand operations intoEastern Europe by buying regionalassets. Recently, Unicredito acquiredHVB, the rationale of which waspartly driven by HVB’s exposure inEastern Europe. Mittal Steel boughtKryvorizhstal in Ukraine after atough bidding war with Arcelor.The government of the CzechRepublic sold its 51% stake inCesky Telecom to Spanish firmTelefónica, Fortis acquired Turkishbank Disbank and in RussiaGazprom bought Sibneft. It is evidentthat mergers and acquisitionsare occurring across multiple sectorsinvolving all types of sellersand buyers.Could you give some flavourof the breakdownof strategies pursued inthe fund of funds?There are currentlyfour broad strategiesthat Eastern Europeanhedge funds follow;credit, equity hedge,event-driven and multistrategy.As the regionmatures and develops,we are confident thatmore strategies willappear.How do you cope with volatility andhow does the region’s volatility compareto that of, say Western Europe?Volatility is part of the attraction ofthe region as it creates opportunitiesfor active managers.Part of the argument for investingin the region via hedge funds is thatthey can preserve capital and generatereturns from the volatility.Compared to Western Europe, wherehistorical equity volatility has beenaround 15%, in Eastern Europe ithas been around 30%.Do you find many of your underlyingmanagers using derivatives?Yes, increasingly so. The fixedincome and currency markets havehad liquid instruments for sometime. The recent developments havemostly been on the equity derivativeside with single-stock options, syntheticsingle-equity swaps, basketproducts, and so on.Most of the derivatives tradingexecuted in the region still takesplace over the counter.How have you performed in limitingdownside in comparison to some ofyour peers?Since the fund’s launch in April 2006,there have been four down monthsin the region, measured by MSCIEmerging Europe. In three of thesemonths, we’ve been either flat orpositive. The start of this year wastough for Eastern European equitymarkets, which on average lost 5%during January and February. Overthat period, our FoFs were up roughly2%. In terms of peer group, it’s hardto find suitable comparisons sincethere is no other dedicated EasternEuropean FoFs that we know of.What diversification and risk-controlprocedures do you employ?On a monthly basis, we have astrategy meeting where we discussEastern European markets to formulatea top-down view. This thentransfers into target strategy allocations.We are fairly active in terms ofre-balancing between strategies asit is a key component in generatingreturns in this region. The individualmangers we’re invested withhave a high level of transparency,so we aggregate exposures on asset,country, sector, and instrumentlevel. We also perform a wide rangeof quantitative analysis like stresstests, liquidity tests, up/down beta,correlations, PCA, cluster analysis,and so on.What liquidity do you have at theunderlying fund level and what doyou offer at the FoF level?The underlying liquidity variesdepending on strategy. Event-drivenmanagers tend to be the least liquid.We have not so far invested in anymanagers with hard lock-ups orliquidity worse than quarterly.We decided early on that wewould have a flexible, liquidproduct, so right now, only two managersof 15 have quarterly liquidity– the rest is monthly or better. Onthe FoFs level, we provide monthlyliquidity with 60 days’ notice.What experience have you in theregion?We have been monitoring the hedgefund development in the regionsince 2001 and made the first investmentin 2002 when we launchedour first fund of funds. Since then,we’ve made numerous allocationsfrom our fund of funds to managersinvesting in the region.What is the biggest threat to yourstrategy’s success?Like any fund of funds, strong directionalityin underlying markets withlow volatility would not benefit thestrategy.

fund profile: troika russia fundDrawing on local expertiseThe Troika Russia Fund displays theinnovation of many of its peers, seekingreturns in an underresearched market.David Walker spoke with Stephen Cohenof Troika Dialog’s London officeWhat is the case for investing in Russia’spublic markets presently?The market capitalisation of Russianequities now exceeds $1trnand the free float probably exceeds$250bn and is growing rapidly.Turnover is now around $4bnper day with reasonable liquidity inat least the top 40-plus stocks andmanageable liquidity in further 50or so issues. Beyond this, there aremaybe a further 100 issues in whichit is possible to invest but whereliquidity is more difficult.In addition, the markets of bothKazakhstan and Ukraine are rapidlybecomingm o reliquid, and in due course, other marketswill open up in the region, suchas Georgia and Azerbaijan.Problems of settlement and ownershipare in the past. Corporate disclosurehas vastly improved. Manycompanies offer IFRS or US GAAPaccounting. Most companies’ managementsare ready to meet withserious investors. Multiple brokersmake competing prices. Domesticinvestors’ participation continues togrow rapidly.The diversity within the marketcontinues to increase with newissue flow of $15bn-$25bn in 2007.Just as the macroeconomic story inRussia is no longer about naturalresources, so the rangeof opportunities inthe stock market ismuch broader thanoil or mining. Corporategovernancestandardscontinue toimprove, albeitslower than onemight wish.Russia is astable capitalisteconomy withsome of the bestmacroeconomicsin the world, thethird-largest foreignexchangereserves and a presidentwith popularityratings of over 75%.What is the main challengeof running EM money inyour view?There are three main challenges.Firstly, liquiditycan be more variableandless reliable as a result of a narrowerinvestor base and because manyforeign investors commit only at themargin to emerging markets and canbe quick to retreat.Secondly, and partly because ofthe liquidity issues, volatility canbe much higher, thereby increasingtiming risk but also increasing theopportunity to add value.Thirdly, more proprietaryresearch and analysis is necessary,given the higher corporate governancerisk lower levels of disclosureas compared with developedmarkets. This is a challenge butgiven adequate in-house researchresources, this creates great opportunitiesfor serious investors.What is currently driving Russia’seconomy and aren’t the benefits ofthis focused in a small number ofsectors/companies?Real GDP in 2007 should grow byover 6%, while CPI should comedown to about 7%. Growth is beingdriven by both private consumptionand capital investment which shouldboth rise by over 10% in real termsin 2007.This growth looks “baked-in”, evenif the oil price comes back to $40,as the government would still be insurplus and both the personal sectorand the corporate sector are veryunderleveraged by Western standardsand even by Eastern Europeanstandards.One of the many beneficiariesof this is the banking sector, whereloan and profits growth has beenover 40% annualised. Other beneficiariesbeyond the obvious consumerretail companies include notonly mobile telecom companies(where ARPU is expected to rise)but also infrastructure companies.This includes not only electricutilities, and it is notable that UEShas been the most heavily tradedstock in 2007 as the stock markethas digested the consequences ofthe massive reorganisation andrestructuring currently under way,but also selected steel companies.Finally, it is now possible toinvest in an ever wider array of realestate companies.The RTS Index has gone up by afair amount in the past 12 months,aren’t Russian stocks overvalued?The Russian market has enjoyedgood returns since the crisis of1998, but is in the middle of therange of global emerging marketson valuation comparisons.The domestic macro environmentis one of the very best in theworld. 5%-6% per annum real GDPgrowth looks very probable for thenext five years.The rouble is also likely to rise byabout 5% per annum for the nextthree years. Inflation is falling andthere is abundant domestic liquiditywith money-supply growth runningat over 40% per annum.Domestic real interest rates areclose to zero and unlikely to risemuch in 2007. Industry restructuringcontinues to spur productivitygrowth and make Russiancompanies globally competitive.Crucially, domestic investor confidenceis strong. The domesticmutual fund industry is nowgrowing rapidly from low levelsand during the recent correctionlocal asset managers enjoyed goodnet inflows. At the same time, foreigninvestors are generally underweightRussia (maybe by around20%) in the global portfolios so thatforeign net selling pressure maybecome less relevant.At Troika, in the fund, how doyou combine top-down views withbottom-up analysis?All of our investment decisions forthe Troika Russia Fund combinetop-down and bottom-up.The top-down macro data, globalcapital markets and commodityprices can have a big impact onboth the total market and individualcompanies’ valuation.Thus, our macro outlook guidesboth our search for alpha and moreimportantly our risk management interms of managing factor risk exposures.Thetop-down analysis willguide our decisions around sectorexposures, portfolio net long, portfoliosensitivities to global growth,commodity prices, and so on.That said, we expect most of ouralpha to come from managing individualstock exposures, based on ourproprietary bottom-up research andanalysis, using both the cash marketand the OTC derivatives markets.We also seek to reconcile thebottom-up analysis results in termsof valuation and relative attractivenesswith our top-down analysis, sothat the portfolio reflects a coherentinvestment outlook.Could you explain the reason also forinvesting in private companies (andare these companies expected to IPOand so join the public markets?The Troika Russia Fund only investsin private companies (or those whichmay be listed but where there hasbeen no effective liquidity) withinstrict exposure limits and on the firm

Drawing on local expertiseexpectation of an IPO in the nearfuture, typically three to six months.Companies raising capital likethis often need funds to restructurein order to make themselvesmore presentable for the IPO. Thediscount to the eventual IPO pricecan be very attractive. The issuinginvestment bank will often make alimited market in the pre-IPO stock.Thus, the positions can be pricedeffectively and we are able to offermonthly liquidity in the fund withoutany material portfolio impact. Itwould be unlikely for these positionsto exceed 5%-7% of the portfoliototal. In fact, in recent months,there have been very few attractivesuch investments. Any exposure inthe Troika Russia Fund to pre-IPOsecurities would be counted insidethe self-imposed limit of a maximumof 20% of the total portfolioto less liquid securities.Could you comment on the degreeand focus of analyst coverage of theRussian market?Many major brokers now providegood cover the top 10 stocks, butbeneath that, coverage becomesthinner and is often confined to Russianspecialists. The strength of themarket and the scope for new issueshas spurred investment banksto increase their Russia coveragein recent years. As with all suchresearch, quality is variable and nosubstitute for in-house research.You note in your written materialthat you must be ready for “rapidchanges in corporate governance.”What do you mean here?Most of these rapid changes are forthe better, for example, more transparency,stock buybacks, increaseddividends, independent directors,better treatment for minorities, andso on, but, occasionally, some arefor the worse.Norilsk Nickel is a company wherechanges over the last 18 months haveall generally been positive, whichhas helped the share price. However,there is a possibility that the Governmentwill decide that the company’smain mining asset, the Taimyrore body, having been designated“strategic”, should now becomemore than 50% owned by the State,possibly by means of requiring amerger with an existing State-ownedmining company.How do you and the fund handlethe risk of liquidity draining fromstocks? You note the portfolio willhold between 40 and 70 stocks. Whatkind of liquidity can you get in themarket this far down (e.g. at the 70thstock level)?We are constantly focused onliquidity at a portfolio and an individualstock level. We are mindfulthat the positive trends of the lasttwo years might reverse. We monitorthe liquidity of the portfolio versusthe liquidity terms of the fund. Welimit the fund to a maximum of20% in less-liquid names and aimto be able trade out of most of these25-30 names within 30 days.Do you find stocks to borrow inRussia for the short side or do youonly use ADRs and GDRs?Every year it is becoming easier andcheaper to borrow Russian stocks.The range of stocks is increasing. Itis more difficult to borrow domesticshares but it is now possible. Wecan also take short positions via therapidly burgeoning, increasinglyliquid but still inefficient derivativesmarkets.What is the experience of themanagers at Troika in long/shortinvesting?Troika has managing equity long/short portfolios since July 2002and achieved net returns of 34.5%per annum through March 2006ahead of the launch of the TroikaRussia Fund.The Troika Russia Fund is managedjointly by Oleg Larichev andVladimir Potapov. Oleg Larichev,the chief investment officer ofTroika Dialog Asset Managementhas been managing these portfoliosfrom inception, for almost five yearsnow. He has been with the companysince 1998 and the Troika groupsince 1996. Vladimir and Oleg haveworked together for four years now.In terms of shorts, do you use theseto protect on the downside or tomake money? And have there beenperiods when the RTS index fell butyou rose?We use shorts primarily in pairtrades to make money and aim toprotect the downside by managingour delta-adjusted net exposure,using both OTC derivatives and thecash market. When we were managingseparate accounts, there wasa 12-month period ending 31 March2005 when the market was down -10.6% and we were up 12.6%. Morerecently, in January 2007, when themarket fell by 4.1%, we were onlydown -0.3%.What risk controls do you have inplace in terms of stop-losses andsector/stock limits?Given the huge individual stock volatilityin Russia, we do not have automaticstop-loss controls but rathercompulsory reviews of positions bythe full team and by the OversightCommittee when they fall betweencertain amounts.How large is your universe of potentialinvestee companies?The universe is growing andchanging constantly, but in theRussia+CIS region, we look at about125 companies and up to a further 50with limited liquidity.What research factors do you considerbefore making long/short pairtrade recommendations?Our research team maintains modelson all the companies in which weinvest and continuously monitorvaluation comparisons intra sector.We use a variety of valuation techniquesbut primarily discountedcashflow. We are also very carefulto consider possible short/mediumterm event risk at individual companiesbefore initiating any long/short position.In January you had 29.9% in oiland gas and 14.9% in metals, eachof which one would assume wouldhave factor exposure to the crude oilprice – do you limit factor exposurein the fund?We actually had very limited exposureto oil per se and have donesince July 2006, preferring gas. Theliberalisation of the domestic gasmarket through 2011 will still leaveRussian gas prices at less than 50%of Western European levels but representa 250% increase on currentlevels. The resultant incrementalprofit flow will not be that sensitiveto the underlying oil price. Ourmetal exposure was concentratedon Norilsk Nickel, where the stockwas cheap on global comparisonsand we expected continued upwardrevisions for the medium/long-termnickel-price market forecasts.Thus, while, there was someshort-term oil factor risk in thesestocks, which we did manage, theinvestment logic was not related tooil-price expectations.You note “investors have a visceralreaction to sell Russia when oil isweak.” Is this a logical reaction on thepart of investors? And do you protectby shorting, or going to cash?The size of both Russia’s currentaccount and fiscal surpluses isrelated to the oil price, which thusimpacts money-supply growth rates.In the short term, this can affectoverall market-valuation levels. Fornow, the investment opportunity isrelated to domestic demand which ispretty independent of the oil price.So far, we have effectively limiteddownside and managed volatilitythrough OTC derivatives. Ifwe became medium/longer-termbearish, we would also reduce thenet long by increasing shorts.You had around 20% in cash in January,this seems quite high, and only6% net in shorts, this seems quitelow, are these positions intentional?These figures were just month-endsnapshots. The stock short has moretypically been around 15% +/-5%.But we also use OTC derivativesto create synthetic shorts and lookto manage our delta-adjusted net.These are often OTC single-stockoptions, so the cash position doesnot reflect the true exposures. Deltaadjustedgross has been up as highas about 130%. Overall, we need tomanage the aggregate risks we aretaking. The OTC options have beenvery profitable, as is evident fromthe excellent returns, but we havebeen wary about piling too muchextra risk on top of this.Your monthly fact sheet on 31 Januaryreads “Sberbank’s new issuehad been much trailed but the pricinghad been unclear. A series of contradictoryand apparently uncontrolledannouncements by several of the partiesinvolved in the issue and the consequentvolatility in the share pricesuggests attempts at price manipulationmay have been afoot.” How doyou guard against getting involved insuch deals, and is this kind of thingprevalent in Russian markets?In any market at any one time, manycommentators are seeking to influenceprices by trying to get their sideof the story heard. In Russia, thereare fewer controls around this.It is thus essential to understandthe motivations of those involvedand to be able to interpret their messagesclearly. This can create opportunitiesas well as pitfalls.What is the main opportunity forRussia in the coming year?The main investment opportunity in2007 is the gradual growing recognitionof the Russian domestic demandstory. There are many ways to getexposure to this. For now, we remainfocused on utilities and financialswith some selected metal stocks. Wethink the story will persist and willcontinue to look for the best valueexposure to this story, which maychange over the course of the year