Lessons from the Ukraine War: Autocrats as an Investment Risk

Russia’s invasion of Ukraine was a wake-up call for fund managers with exposure to autocratic countries. ESG funds, for which environmental, social and corporate governance criteria play an important role, are particularly alarmed.

Major index providers have removed Russia from their emerging market benchmarks; many wealth managers have stopped buying Russian assets. Currently, these decisions are still being determined by market conditions. The Moscow stock exchange was closed for a good four weeks, and many Russian companies listed abroad have also suspended trading after being almost completely bankrupted. Basically, the Russian market is no longer attractive.

moral exclusion

But once the market reopens and stock prices begin to recover, investors need to ask themselves a crucial question: Is it time to get back in business and hunt for bargains? Or should one ban Russia from one’s portfolio for moral reasons?

The financial sector has traditionally been rather reluctant to invest in markets that are under autocratic regimes. But it also often takes a pragmatic approach, focusing on safeguarding assets rather than assessing the moral implications of a country’s actions.

Thanks to Russia, that could now change. Many American companies, including McDonalds and Coca-Cola, have already ceased operations in Russia. And many pension and sovereign wealth funds are freezing or selling their Russian holdings.

“It’s pretty amazing how many[companies and institutions]are taking action like this without much encouragement from governments or consumers,” said Jon Hale, US director of sustainability research at Sustainalytics.

Russia’s comeback doubtful

But moral and ethical considerations are perhaps not the only reasons for distancing yourself from Russia. Many asset managers are now sitting on almost worthless holdings. “The current situation should serve as a warning that these autocratic regimes are not without risks,” said Hale.

He doubts that Russia will ever return to pre-invasion levels in terms of investment and doing business abroad. “I don’t think that investors and companies will return to Russia again,” he says. “Companies are now more responsible and investors are much more aware of the impact their money is having on the system as a whole.”

However, most ESG funds already have very little exposure to Russian assets as they generally avoid fossil fuel companies. After all, these make up half of the Russian market. Russian companies also tend to have poorer corporate governance, poorer privacy policies, and poorer human rights records.

Nevertheless, according to Morningstar data, almost 13 percent of the 370 sustainable funds contained Russian stocks at the end of last year. While most had low exposures of less than 2%, some funds have invested more heavily in the Russian market.

The $88 million Artisan Sustainable Emerging Markets Fund, for example, had 8% exposure to Russian companies including gold producer Polyus, energy giant Lukoil and the country’s largest bank, Sberbank. The $11 million Ashmore Emerging Markets Equity ESG Fund had a five percent stake in Russian companies like discount chain Fix Price and online recruiter HeadHunter.

It is not known whether the two funds sold their Russian holdings prior to the fall. Both funds are down 20 percent year-to-date, underperforming 95 percent of their peers. The funds did not respond to requests for comment.

Good performance without autocrats

However, a commitment in Russia does not necessarily mean the ruin of an otherwise stable fund. The $25 million VanEck Green Metals ETF, which invests in companies that produce and process “green metals” for renewable energy, had a 5 percent stake in Norilsk Nickel Mining & Metallurgical before invading Ukraine. While the London-listed metals giant’s shares have fallen 94 percent over the past month, the ETF has outperformed half of its peers.

Most ESG assessments are now carried out individually for companies. A blanket ban in certain countries is rather unusual. The $120 million Freedom 100 Emerging Markets ETF is an exception: the fund explicitly avoids investing in autocratic countries like Russia, China or Saudi Arabia.

The fund is based on an index developed by Life + Liberty Indexes. Using data from independent think tanks based on 79 different social and economic variables, this index ranks countries according to their degree of freedom. The better the rating, the more heavily a country is weighted in the portfolio. For example, India was expelled in 2021 because of the repressive Kashmir government, meddling with the media and blocking the internet.

An autocratic regime and lack of freedom usually lead to unpredictable events such as Russia’s invasion of Ukraine and China’s intervention in the private sector, as well as sharp market volatility, according to Perth Tolle, founder of Life + Liberty Indexes.

The fund has weathered the turmoil in both countries’ markets and has outperformed 94% year-to-date and 88% over the past 12 months of its peers in emerging markets.

Problem case China

It should be easy for many investors to remove Russia from their portfolios, as the country neither has a large share of the world market nor is it particularly attractive for investments. Moving away from China would be much more difficult: the country alone accounts for 30 percent of emerging market indices and is seen by many as a promising investment opportunity. But precisely this focus involves risks.

“In the future, China will be the greatest burden for the emerging countries,” says Tolle. “His growth success will not last forever.”

Not all ESG managers seem to share this opinion: at the end of last year, sustainable emerging market funds had an average exposure to Chinese equities of 20%, just below the average for all emerging market funds, which was 24%.

Translation: Stefanie Konrad

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