Investment Manager: Citadele Asset Management

Portfolio Manager: Elchin Jafarov

(August 2011)

How has the Fund performed recently compared to its peers and are there any particular stocks or areas where the Fund is performing well?

The Fund is quite unique in its nature as it invests into a mix of predominantly Russian, Central Asian and Ukrainian names, while giving significant weights to all of these countries. This unique characteristic makes the peer group comparison broadly unrepresentative. During a one year period the Fund has delivered a positive 15.7% return, although the year to date figure looks less attractive, standing at -2.8%, as of the end of July 2011. Annualized 3 and 5 year returns were -7.8% and 2.4%, because of the recent financial crisis. Overall the Fund has performed well in its Russian segment, which mostly contributed to the return figure in absolute terms. As far as the Ukrainian and Central Asian markets are concerned, we have performed relatively well, but in absolute terms the numbers are negative, due to recent heavy sell-offs we have seen in those markets.

It is important to mention that the Fund is now of an absolute return nature. That means generating high returns during upward market movements and low to modestly negative returns during heavy market downturns. We are continuing to strengthen those results by implementing derivatives tied to the assets of the region. For Fund investors this means benefiting from the significant return potential offered by the region, while being to a considerably large extent saved from heavy losses which are peculiar to the highly volatile markets under the Fund’s coverage. This is offered alongside the expertise in individual security selection and knowledge of the region that the Fund’s management team delivers.

Many people outside the region assume the attractive equities in Russia and the CIS are all in the commodities sector. Is this true or do other sectors offer equally enticing potential returns for investors?

Without any doubt the commodities sector forms the most important part of the Russia and CIS economies. Within this sector, oil, metals and soft commodity sectors are most important. However, the CIS story is not, as many investors believe, only about oil. In the long-term, which is our recommended investment horizon for the region, cash generated by on-going active commodity exports is transferring into sectors oriented towards internal demand and infrastructure. These include retail banking, consumer retail, recreation industry, food production, telecommunications, health care, civil engineering, utilities and others. Considering the sizeable number of active consumers - about 280 million largely well educated people - in the region, these sub-sectors see good demand. Besides, many parts of Russia need huge infrastructure developments to keep industry expanding, especially towards emerging economic giants, such as China. This fact has already been confirmed by the Russian government in terms of, for example, plans for the enhancement of a large part of the Siberian region.

Relevant figures also talk for themselves. In the one-year period ending on July 31, 2011, returns from the Russian oil and gas sector were +27.3%, well behind that of the consumer and retail sector’s 44.3% return. Another example is Russia’s telecoms sector, which was up 45.5% during the same time period. It is interesting to note that at the same time crude oil prices rallied 44.5%.

Historically, some investors have been put off the region by perceived political instability. Has stability improved in Russia and the CIS?

We have seen improvements in the political arena and country governance within the region. Changes of government are not as frequent as previously and politicians stay in power for a predictably longer amount of time. During the MENA crisis we contacted the region’s representatives to be sure that, for example in Central Asian countries, the same scenario would not be played out as selected regional countries’ profiles match those of MENA countries, making them vulnerable to an uprising. But so far this has not happened, reassuring investors about stability.

Nevertheless, we still see considerable risks stemming from political issues, which can arise at random. We have recently seen such situations in the Ukraine, Kazakhstan and Uzbekistan, leading to the immediate downturn of equity markets by hurting investor sentiment towards the region.


The Russian weighting in the Fund is very heavy. Does this mean that all the best investment opportunities in the region are in Russia?

The Russian market is relatively more mature and bigger. But it is still full of high-return opportunities and is fundamentally the cheapest in the entire MSCI emerging market segment. In terms of liquidity we are also able to immediately trade our ideas at a given time and desired price, which is not always true for, say, many Ukrainian names. Daily trading volume numbers amount to several billion USD for Russian names, compared to several tenths of millions for the remaining countries of the region. Thus allocation to Russia provides us with exposure to one of the top emerging economies as well as world class liquidity and constantly improving corporate governance.

In terms of security selection and allocation, we tend not to distinguish between countries, as we look for names or sectors which will provide superior returns in the mid and long-term time horizon. Thus, we can comfortably invest in companies operating in such frontier markets as Turkmenistan, Georgia, Kirgizstan, Mongolia and other countries in the Fund’s portfolio.

The Fund has smaller holdings in Georgia and Turkmenistan. Do you see these countries as growing in importance to the Fund in the coming years?

We do not foresee a substantial increase in the number of issuers for the coming years. If and when they emerge, we will consider them, research them and then decide when and how to invest.


As commodities are so important in the region is the performance of its markets, and subsequently the Fund, especially sensitive to external factors affecting demand for commodities e.g. slowdowns in the US and Chinese economies?

It is true that the behaviour and wellbeing of giant economies affect our target region via commodities and also through elements of monetary policy. It is well known that a restriction of global liquidity causes a flight from risky assets. Also, China, being the leading consumer of commodities, is currently a powerful engine of global economic growth. As well as this, many companies operating within Russia and the broader CIS region derive part of their profit from overseas operations. This is true, for example for oil and gas, and the metals and mining sectors, where a number of companies are either headquartered or operate overseas.

Is money from commodities and specifically oil and gas exports being re-invested to help develop other sectors to diversify the region’s economies as some other oil-rich countries have done?

The infrastructure sector is receiving the main flow of oil revenue re-investment. There are some powerful growth drivers involved: the APEC-2012 summit, the 2014 Winter Olympics, World Cup 2018. For example, planned expenditures on preparation for the 2014 Olympics and development of infrastructure in Sochi are RUB500 billion (USD16 billion). APEC-2012 expenditures will reach nearly RUB270 billion (USD9 billion). World Cup 2018 preliminary expenses are estimated at USD50 billion. The Russian government is also going to establish the Federal Road Fund. The overall size of the Road Fund is estimated to be RUB378 billion, RUB348 billion and RUB408 billion in 2011, 2012 and 2013 respectively. Moscow City is earmarked to receive USD4.6 billion for transport infrastructure development during the next 3 years. All these budget expenditures will be mostly financed from oil and gas revenues.

In the past much of the investment in the region’s markets, especially in Central Asia and the Ukraine, has come from foreign investors. Is this changing?

The problem of hot money is still debatable, because markets are mostly supported by foreign funding. Although in Russia the number of investment vehicles oriented towards local institutional and retail investors, has grown dramatically, this is not the case for the Ukraine or Central Asian countries. Foreign participation is in fact desirable for a wide range of investors, as it provides a huge portion of liquidity. A brief case study is the massive depository receipt programmes that CIS companies have carried out to target foreign investors. Another, but smaller, example is the on-going desire of Ukrainian companies to be listed on the Polish Stock Exchange to gain access to Polish institutional investors.

Have there been any regulatory changes to the region’s market recently that should encourage investment?

The focus is oriented towards privatization, which touches many of the region’s companies. Talking, for example of Russia, there have been some major changes: 1) WTO membership: despite various problems remaining between Russia and the EU over trade access there is a more determined momentum for Russia to join the WTO by later this year or early next. WTO membership is now viewed as an important step in efforts to improve Russia’s investment image and to attract a higher volume of foreign capital inflow. The formal agreement on entry terms is expected this summer, and entry may then be achieved in early 2012. A recent World Bank study estimated that Russia should gain about 3.3% of GDP in the medium term and 11% of GDP in the long term through accession, with gains mainly from increased FDI and services. 2) Privatization: Russia’s privatization agenda is planned so as to ease pressure on the budget. The Russian government expects to raise almost USD60 billion from the sales of stakes in as many as 900 companies and the government has taken steps (on paper at least) towards its goal of reducing the state’s influence in the economy. Assuming the process will be clear and transparent, the net effect is expected to be positive for investor perception of Russia.


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