How the Ukrainian Crisis Is Affecting Russian Markets

Political turmoil is hammering Ukraine's economy. Three months ago, former president Viktor Yanukovych abruptly turned his back on a free trade pact with the European Union to seek closer ties with Russia. This decision triggered a series of massive protests that led to several deaths and his presumed flight from the country and removal from power. The situation is still unstable.

How will this affect the Russian markets?
Russia has strong historical, cultural, and commercial ties with the country, as a big portion of the population claims Russian origins. Now Russia is deploying forces in Crimea, by the Black Sea, which could escalate a local political crisis into an international military conflict. No one knows what will happen next, and the international tension and uncertainty are weighing on the markets today.

Many investors are talking about a "contagion" that would most likely start with a sharp decline in the Russian rouble, leading to concerns about Russian banks and then, subsequently, other sectors. This may have already started to happen: The rouble has fallen to five-year lows, and bank shares are taking a hit.

Three funds
There are three major country-specialized funds that can give you an idea of what is to have exposure to Russian assets: ING Russia Fund Class A (NASDAQMUTFUND: LETRX  ) , Market Vectors Russia (NYSEMKT: RSX  ) , and iShares MSCI Russia (NYSEMKT: ERUS  ) .

The Market Vectors Russia ETF is down 12.5% this year alone. Energy and materials account for 42.2% and 15.9% of the fund's portfolio, respectively, and the commodity market is experiencing a mild correction this year. Further, this fund does not hedge its foreign currency exposure, so a falling rouble is harmful to the ETF's performance.

Then there's the iShares MSCI Russia Capped Index, which, compared to Market Vectors Russia, has more of a large-cap tilt, is more concentrated, and has greater exposure to energy and less exposure to materials. In fact, this fund has a 20% stake in energy giant Gazprom, which accounts for less than 9% of Market Vectors Russia's portfolio. Despite these differences, the correlation between the two funds is still high: The iShares MSCI Russia Capped Index is down 13% year to date. Similarly, ING Russia Fund Class A is down about 12% down this year. Note the tight correlation in these investments' performances in this chart.

The outlook
One thing is clear: The instability in Ukraine will only spread from here. The country's new government still needs to be fully formed and be able to get money from the IMF, the European Union, and/or the U.S. One of the many problems is that Ukraine's interim leaders affirm that the country needs $35 billion in aid to avert a default -- quite a bit of money. In the case of a sovereign-debt default, Russia would be in a stronger position to demand its own terms, forcing Ukraine to take distance from Europe.

The Russian stock market is one of the most volatile in the world, and its extreme volatility owes to the fact that the Russian economy is heavily dependent on oil and gas exports and is therefore sensitive to fluctuating energy prices. Plus, foreign investors hold a significant portion of Russian equities' free float, and they are very likely to move their money elsewhere, given the current situation. A depreciation of the rouble is beneficial in the near term for energy exporters, but in this case, fear is stronger than the potential extra profits these companies could make. Thus these stocks are not responding.

Given the volatility of the Russian equity market and the current scenario, these funds could be suitable as a tactical tool for only the most risk-tolerant investors. If you start a position, you will have to follow the prices of energy commodities closely, as variations have a strong impact on the funds' returns.

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