The western world has implemented stringent sanctions on Russia after the unprovoked invasion of Ukraine last week. Simply put, the present strategy of the western allies is to avoid a physical conflict and instead to cripple the Russian economy so that its government cannot finance the war machine for long. It is uncertain how effective this strategy will be, as Russia’s exports of energy continue as a source of hard currencies.
In the meantime, the uncertainty surrounding Russia has caused a dramatic drop in its financial markets even before additional sanctions were implemented on February 26th and trading was suspended (see chart). Meanwhile, the Russian central bank has doubled interest rates to 20% while its Ruble currency has been devalued to less than a penny for a dollar.
For some perspective, the Russian stock market is considered an emerging market like China, Taiwan, India, South Korea, Brazil, etc. However, the Russian market makes up only 3% of the overall MSCI emerging markets stock index while the aforementioned countries comprise more than 75% of it. Further, considering that our typical equity portfolio has only a 10% allocation to emerging markets (and 90% to developed markets), the net allocation to Russian securities in global portfolios is typically only 0.3%. Should this number be 0.0% instead? Should we be investing at all in an evil empire?
Many funds have been proactive in reducing Russia exposure ever since the annexation of Crimea in 2014. For example, our Dimensional Fund Advisors Emerging Markets Core Equity Portfolio has had a reduced weight of less than 1% to Russian companies for some time compared to 3% for the indexes. Further, no direct Russian stocks are in this portfolio – any investments are indirect via local securities that meet the same listing standards as for US companies. This approach – to strongly underweight Russia – was made well in advance of the current crisis and is being actively monitored. Further, on March 1, 2022, Dimensional’s investment committee decided to remove Russia from its list of approved markets for investment.
A further important development this week has been the decision on March 2, 2022 to remove all Russian stocks from emerging market indexes. Rather than a moral judgement about the military invasion, the rationale is that the Russian market has become “uninvestable” because of the economic sanctions. This means that Russian securities are currently very difficult, or near impossible, to trade. According to MSCI’s head of index research, it makes no sense to include Russian securities in indexes if those securities cannot be transacted in the market (click here). Further, this step was immediately followed by FTSE Russell, another provider of widely followed equity indexes (click here for article). The impact of removing Russia from indexes could be very dramatic. Almost all investing worldwide is based around indexes, and removal of Russian stocks from key indexes will force many investors to sell any and all Russian stocks. Soon, the only remaining buyer of Russian equites will be the Russian government itself.
In the meantime, Russian debt has been demoted several levels to “junk” by the rating agencies, making it even more difficult for Russia to raise capital (click here for article). We are planning for the removal of all Russian sovereign debt investments, though very minor, from our portfolios.
News about the war in Ukraine has been a shocking reminder of the evil ambitions of unchecked dictators. Fortunately, the financial system is responsive to these threats and able to punish the bad actors economically until they reform. This is little relief for the physical suffering of the Ukrainian people, or the future suffering of ordinary Russians for that matter. In the meantime, we are committed to removing all exposure to Russia in your portfolio.
As always, please contact your advisor if you have questions or wish to have a deeper conversation.
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