Q&A: Van Eck Global on Going Abroad with Small-Cap Funds

Investing in small-cap stocks is a classic way to try to profit from the early stages of an economic recovery. The reasoning is simple: Small-caps tend to be more geared to domestic economies and less vulnerable to global economic trends than larger companies more reliant on exports. Investors are already making a big play on U.S. small-caps—the Russell 2000 Index hit a new all-time high on Apr. 6, though it has slipped slightly since. Now investors are increasingly being pitched on opportunities to invest in small-cap funds focused on foreign markets. One of the most recent entrants: the Market Vectors Russia Small-Cap Exchange-Traded Fund (RSXJ) unveiled on Apr. 13.

The ETF is the fifth country-specific or region-specific small-cap fund that Van Eck Global has launched in the past two years. Russia's rebound from the 2008 financial crisis has been slower than that of most emerging economies, but Van Eck sees encouraging signs for investors: ongoing credit expansion, the start of real wage growth, and a sunnier business climate amid government promises to relax restrictions on foreign investment. Other pluses include the need for increased infrastructure spending before Russia hosts the 2018 World Cup and General Electric's (GE) entry into joint ventures with state-controlled companies to produce equipment for Russian energy and health-care systems. Bloomberg Businessweek spoke with Van Eck portfolio manager David Semple and Adam Phillips, managing director of ETFs, about the rollout and the general appeal of small-cap funds. What follows is an edited transcript of their comments.

BBW: This is the second small-cap ETF that Van Eck has launched this month [The Market Vectors Germany Small-Cap ETF became available Apr. 4]. That could be seen as contrarian at a time when most strategists favor large-caps for their greater exposure to the global economic recovery.

Adam Phillips: For a long time, Van Eck has believed one of the best ways to capture exposure to a country's economy is through small-cap stocks. That's been highlighted as different countries come out of the financial crisis at different speeds and for different reasons. Investors may or may not be looking for global mega-cap names tied to the global economy. They're looking to their international equity allocations to capture compelling themes and stories in emerging economies. And certain of the BRIC [Brazil, Russia, India, China] countries come to mind. Some investors who want to be a little more tactical are more inclined to consider a small-cap ETF that can give them more efficient access to a particular market.

What convinced you the time had come for a Russian small-cap ETF?

David Semple: It was very simple to see where investor demand was strongest. If you want exposure to the large increase in fiscal spending that taxes on higher profits for Russian energy companies have made possible, but don't want the risks associated with large oil and gas companies, a small-cap ETF is a good alternative. And since company-specific risk can be higher in Russia, a portfolio approach seems to suit an awful lot of passive investors. UBS estimated last September that Russia's fiscal stimulus is now 7 percent to 8 percent of its gross domestic product. If you calculate GDP using an average price of oil at $75 per barrel, that stimulus comes to $100 billion per year. That's all being put into the economy and is being reflected in lower interest rates, rising pensions, and more public-sector workers. Russia earned $1.5 trillion from oil and natural gas exports from 2000 to 2010 and collected taxes worth a fair portion of that.

Big energy and natural resource producers are higher profile. Many were once state-owned, may still be state-controlled, and are more susceptible to government persuasion. Smaller companies tend to fly a little bit under the radar and have risks less dictated by the government and more related to practices that can be unfair to minority shareholders. But there's also a lot of government interference in domestically oriented industries, such as health care. It's a very popular political move to depress drug prices. Utilities' prices are regulated, and the mechanism for increasing prices isn't always transparent.

Valuations are cheaper in Russian stocks generally than in other emerging markets. That's due to the composition of the index [the Micex, Russia's broad, cap-weighted index]. When you have more cyclical stocks, such as oil and gas companies, they tend to have lower multiples. There's also concern about the political environment and the fact that companies aren't as transparent as we would like them to be. (The Moscow stock market now trades at about 7.1 times projected 2011 earnings, compared with 8.4 times earnings at the end of 2009, according to Van Eck's website.)

With oil and other commodity prices much higher lately, wouldn't investors prefer to own large energy and basic materials stocks that they get more exposure to through Van Eck's original Market Vectors Russia ETF (RSX)?

Semple: By owning energy stocks, you might not benefit as much as you think from high crude prices, since the government takes a big portion in taxes. If what you really want is to play the trickle-down effect of high oil prices into the domestic economy, that's not as easy to access. The clear beneficiary of higher oil prices will be Russia's domestic economy as a whole. Government spending has ramped up significantly, because they can afford it, and that's paying for more public-service workers, public health care and education. That will result in people going to the supermarket more often or buying more pharmaceuticals. But stocks like Gazprom (SIBN:RM) are not really going to move much in the shorter term. With the government collecting more in taxes from higher oil prices, it doesn't need to borrow as much, and that means interest rates will be lower. That stimulates the economy as well.

It's similar to why the Brazil Small-Cap ETF (BRF) has been successful. If you bought a Brazil ETF, half your exposure would be Petrobras (PETR3:BZ) and Vale (VALE), both global cyclical plays, and the other half would be smaller, consumer-oriented names. Russia is a bit like that. If you buy Van Eck's Market Vectors Russia ETF, you're playing energy and basic materials, which account for 68 percent of the portfolio weight. The small-cap ETF has a combined 35.6 percent weight in energy and materials, leaving more room for allocations to utilities, industrials, health care, and other consumer-tilted sectors.

Any other small-cap ETFs in the works?

Phillips: We've filed for China A-Share sector funds and China A-Share small-cap funds, which would be available only to local mainland nationals. But no other country-specific small-caps for the time being.