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. Last Updated: 07/27/2016

Fund Pioneer Looking Under the Mattresses

Pioneer-First Voucher CEO Tim Frost is spending a gray wintry afternoon in Moscow entertaining a guest in his third-floor suite at the back of a small courtyard on Gazetny Pereulok. For nearly 45 minutes, the Pennsylvania-born Wharton MBA has been a model of charm and bonhomie. Suddenly, he leans forward and slaps his hand on the table.


"There has to be money out there," he says. "There just has to be! Look at all of the exchange booths!"


Frost is not only betting that there is money out there; he is betting that there is a lot of it. In his 22 months as the head of Pioneer-First Voucher, Frost, 40, has pushed hard to put the company at the front of the effort to set up one of Russia's first mutual funds.


This seemingly simple format, in which small investors pool their savings into large cash hoards that professional managers can then thrust into the stock market, has taken off in the United States. If it ever catches on in Russia, the potential could be enormous. Russians hoard dollars because of ruble inflation and a widespread distrust of banks. How much they hold in cash in hard currency is difficult to assess. But economists Pavel Teplukhin and Liam Halligan, working on the basis of money spent within the economy, money saved and money invested, have come up with figures of between $14 and $30 billion. Whoever can coax that money out of the mattresses and put it to work supporting Russian industry or propping up Russia's anemic stock market will not only make a profit. They could change the country.


In the recent downturn, Russian stocks have fallen so low that the total value of all the companies quoted on the stock market is now only slightly more than the net worth of Microsoft CEO Bill Gates. (The capitalization is now around $16 billion compared to Gates' estimated $14 billion fortune.) A process that brought small savers into the system and gave them a stake in seeing the country's wealth increase would give average citizens an even larger stake in preserving the reform process.


Setting up a mutual fund in Russia is not easy. The legal framework is largely still in the works. In order to avoid a repeat of the financial scandals of 1994, President Boris Yeltsin has chosen to err on the side of caution and decreed that legislation must be fully in place before the funds can begin operating. To date, 14 separate regulations have appeared, governing among other matters the capital requirements at depository banks and the process for determining the values of the shares at any given moment. The most important of these regulations is Decree 765, which appeared July 26 last year. It authorized the Russian Securities Commission to begin drawing up legislation for the as yet nonexistent industry, and to start formally licensing companies to manage the funds.


There remains the touchy matter of MMM. Russian investors are still shell-shocked over the collapse of the investment house which lured more than 10 million investors with promises of 3,000 percent annual returns before disintegrating into a mound of accusations and broken pledges. Says Christopher Smart, the head of research for Pioneer Investments: "The initial challenge will be to differentiate mutual funds from the various pyramid schemes. That's why it's important that the [legal] standards be high." Adds Frost: "The potential [for mutual funds] is extraordinary, but it all depends on whether Russian domestic and retail brokers can have confidence in this market."


Pioneer is not the only company to come up with this idea. Given the potentially huge profits, a lot of Russian and foreign banks, as well as fund managers, are seeking to find a way to issue mutual funds in Russia. Inkombank, Russia's fifth-largest bank, is reported to be eager to put its massive branch network to work distributing a home grown mutual fund. Similarly, the investment banking offshoot of the Austrian banking behemoth Creditanstalt says it would like to add a mutual fund in Russia to the five other similar funds it already has in Eastern Europe. Creditanstalt's total assets under management in mutual fund type vehicles in Eastern Europe currently amount to more than $130 million. Meanwhile super-investor Mark Mobius, director of Templeton Emerging Markets and a bullish figure on the investment potential in Russia, is pushing his Franklin-Templeton group, with $131 billion under management, to open a mutual fund in the near future with a Russian partner.


Pioneer has a lot of experience with this kind of product in emerging markets in general, with two mutual funds in India, and $13.3 billion under management. Moreover, the company has a proven track record close by, in Poland. There, within one year, the Pioneer First Polish Trust Fund attracted 500,000 shareholders and more than $1 billion in assets. At one point, Pioneer First Polish Trust's portfolio had grown so big that it controlled an estimated 10 percent of the total Polish government debt -- not an inconsequential amount to be in the hands of one holder. The fund's rapid growth has been tempered by its exposure to Poland's volatile stock market, and the basic portfolio has dropped in value to somewhat more than $600 million.


In Russia, Pioneer has chosen a different approach. It has teamed up with First Voucher, which was, as its name would imply, the first voucher fund to be registered -- hinting at deeper connections within the Russian government than CEO Mikhail Chebotaryov would like to admit. During the frenetic voucher privatization program of 1993, First Voucher managed to amass 4 million vouchers -- and invested them into a reasonably promising portfolio of Russian businesses. Last year, First Voucher became one of the few voucher companies to actually pay a dividend to its shareholders. True, many investors sniffed that the 5,000 rubles (about $1) per share on offer were hardly worth the effort to go down to the local post office to collect.


Within a year of its founding, First Voucher decided to seek out a strategic investor to help it better restructure the companies it had acquired and to shore up its long-term financial future. By April 1995, Pioneer had agreed to buy a 51 percent interest in First Voucher for $10 million and some stock options. Today, the two companies jointly manage First Voucher's portfolio of 125 firms.


Setting up a mutual fund is as much about logistics as investment savvy. Frost estimates that a Russian mutual fund could have as many as 30,000 redemption or withdrawal requests a day -- a staggering amount of transactions to process. If the mutual fund is going to take off, investors will need to know that they can withdraw their money quickly and on short notice, and this will require a massive computer network to administer the fund. Here Pioneer's Polish experience will be particularly useful.


Frost has seen the inside of a lot of Russian companies. He says he is actively involved in supervising the restructuring plans at more than a dozen, including the modestly successful Seversky tube works, where First Voucher is a major shareholder. But Frost cautions that, for the foreseeable future, Russia's best investment will be in GKO government Treasury bills.


"We would like there to be an equity component [to our fund]," Frost says. "But in Poland, [our fund got so big that] we couldn't get our money invested in equities without distorting the market."


Frost knows all about Treasury bills. Before joining Pioneer, he was part of the team that helped set up Russia's Treasury bill market. Raised a Quaker, he had abandoned a career in public finance at Smith Barney in New York, where he was briefly a partner. In 1991, he chucked it all to found the Financial Services Volunteer Corps, an organization dedicated to providing badly needed financial services to emerging markets. His favorite project to date was creating a centralized stock exchange in Mongolia. "They worship the soil so much that they refuse to till it," he says, adding that a long-time visitor can even come to like the fermented horses' milk still served in the villages.


Like so many things in Russia, mutual funds will take time to set up, and will probably arrive in a messier form than Frost would like. First Voucher's Chebotaryov has a more realistic assessment: "We think the future [of the country] lies in mutual funds," he says. "But [putting Russia's domestic capital to work in Russia] is a task that can't be done in a year. It might take decades." At present the target launch date for the mutual fund is May.


Pioneer-First Voucher has already been pipped at the post. On Dec. 18, a company called Financial and Industrial Partners, backed by Fairchild Corporation and the Moscow-based Business Development Bank, announced that it had set up Russia's first mutual fund and had already signed up 1,000 clients. The news came as a surprise to Pioneer, because the fund, which Financial and Industrial Partners have named "the Bolshoi fund," has not been licensed through the Securities Commission. Instead, the fund received its license from the Finance Ministry.


Despite the problems, the importance of mutual funds cannot be overstated. In the United States, mutual funds have already profoundly changed the financial markets and business climate. Their arrival on the scene en masse in the mid-1980s is one of the many factors that have forced U.S. banks to consolidate so aggressively. Banks are having trouble competing with the relatively low interest rates on traditional savings accounts.


The arrival of the funds has been one of the important factors that has driven the U.S. stock market to record highs. The Dow Jones industrial average has soared from around 3,000 in February 1991 to more than 5,400 in recent weeks -- in no small measure on the back of the increased capital stemming from mutual funds.


Until Russia finds a way to tap its domestic capital market, the country will remain a financial backwater subject to the whims of international capital flows. Victor Huaco, CEO of brokerage house AIOC Capital, has done a study of Russia's highly volatile stock market and come to a surprising conclusion. Huaco found that Russia's capital markets respond less to the often dramatic domestic political developments than to the simple ebb and flow of international venture capital in and out of the country. If Huaco is right, Russia desperately needs capital that will understand and respond to its domestic situation. Otherwise, the country is destined to remain an inward-looking emerging market of enormous, but ultimately untapped, potential.


Says Frost: "At the end of the day, foreign investment can go anywhere. The only money a country can know it has is its domestic capital."