Alongside the lack of price discovery, the inability to trade these assets creates further downside pressure as liquidity tends to be highly valued among investors, with illiquid securities typically trading at a discount. The combined impact of this can be seen clearly in the price of ADRs/GDRs that track the price of individual Russian securities, with Gazprom – Russia’s largest company by revenue – down more than 96 per cent at the time of writing, despite continuing to supply gas and oil that is priced in US dollars.
Although it is impossible to set a clear fair value on Russian securities at the current time, the downward pressure from illiquidity is likely to result in prices falling below a pessimistic estimate of fair value. Therefore, investors now selling emerging market funds in order to remove Russian exposure are likely to receive poor value for the risk they are removing from their portfolio, as, following the fall in the price of Russian securities, these assets now account for a very small portion of the broader emerging markets.
The question therefore becomes: should investors increase their exposure to Russia?
Leaving aside the moral question, logically, the belief that the current price to exit a holding is too low must be accompanied by the belief that excess returns can be gained by buying Russian securities.
However, given the lack of a direct access point being open to investors at present, expressing a positive view on Russian assets would probably require investing in a broad emerging markets fund that currently carries little Russian exposure. Acquiring a meaningful holding in Russia could therefore unbalance a portfolio by increasing the emerging markets position too far for the risk tolerance of the client.
It is therefore likely to be better for most investors to seek exposure in other equity and bond markets that are now attractively valued due to the recent falls in price, but are not likely to be highly correlated with Russia over the long term.
This provides us with a great reminder that the robustness of your portfolio construction is as important as the expected returns of your underlying holdings.
Dan Kemp is global chief investment officer at Morningstar
