Should Russia be excluded from ESG ETFs?

Moral qualms are not driving Russian securities out of indices

Jamie Gordon

a screen shot of a computer screen

Index providers are starting to remove Russia from their benchmarks and ETF issuers are halting the creation of new Russia ETF units, however, is it time to blanket ban Russia from the growing environmental, social and governance (ESG) space on moral grounds?

Many of the largest and most outspoken investors think the answer to this question is a resounding yes. Big players such as Norges Bank Investment Management – the nation’s $1.3trn wealth fund – the UK Universities Superannuation Scheme and the New York City Employees’ Retirement System have been disposing of their Russian assets. Meanwhile, other vocal pools of money such as the Church of England Investment Fund and Member of Scottish Parliament pension fund have followed suit.

Between these parties alone, a combined $4bn will be divested from Russian equities and bonds – and this does not cover the growing number of pension funds and wealth managers doing the same.

The timing of these offloads varies between when Russia first invaded Ukraine to when new rounds of sanctions tightened the noose around Russia’s financial infrastructure.

Taking drastic action, the giants of the indexing world have also begun sweeping exclusions of Russian securities from their benchmarks.

Following a policy meeting over the weekend, MSCI said it was considering the total exclusion of Russian securities from its index range as a “potential next step”.

Dimitris Melas, head of research and chair of the index policy committee at MSCI, told ETF Stream: “If the situation persists and the market remains uninvestable for several days, we may have no option but to, subject to consultation with market participants, remove Russian securities from our indexes.”

Even with some prior warning, investors tracking the MSCI Emerging Markets index will still take a hit from this measure, with Russia making up 2.2% of the flagship benchmark, down from 3.6% at the start of the year.

The key drivers for these decisions are not moral ones. Instead, Russia’s stocks and bonds now simply lack the minimum liquidity to satisfy the screening processes of index providers such as MSCI.

MSCI’s Melas said ESG exclusions are carried out using ratings at individual security level and added there was “no automatic downgrade” as a result of military action. Rather, any questions over individual ESG ratings would be longer-term in scope.

Where blanket ESG exclusions would occur, Melas said, would be when the same securities are removed from the equivalent parent indices.

Furthermore, JP Morgan has revealed plans to remove Russia from two emerging market debt ESG indices. It is yet to carry out these exclusions, however, and is consulting with clients over how and when to eject Russia from its emerging market debt benchmarks, Reuters reported.

ESG as risk management

Some make the case that ESG is appealing from a risk reduction point of view – and in this sense, blanket bans on Russian securities in ESG baskets might seem intuitive.

Russia’s capital markets has taken a severe hit in the first few days of sanctions resulting in the central bank closing the Moscow exchange altogether.

Subsequently, BlackRock and DWS have halted the creation of new units of their Russia ETFs while settlement house Euroclear closed its link to settle trades in Russian securities with Clearstream Bank.

For some, these are the events that have tipped the balance on what they might see as acceptable risk tolerance. For others, Russia was already beyond the pale, thanks to its generally poorer corporate governance, environmental stewardship, political structure and human rights records.

Someone in the latter camp is Perth Tolle, founder of Life + Liberty Indexes, who told ETF Stream: “We have always excluded Russia from our indices along with other big autocracies – China and Saudi Arabia.

“Autocracies have no place in emerging market ESG strategies yet they are not allowed to deviate from parent benchmarks so most emerging market ESG funds have the same exposure.

Tolle cautioned that if investors wait for ‘black swan’ events such as Russia invading Ukraine or China’s “excessive” intrusion on private business, it is often too late to divest. This is significant given securities from autocratic nations can often make up 40% of most market cap-weighted emerging market ETFs, she argued.

These warnings seem particularly apt not only in the current Russia situation but also the mounting rhetoric from China on their intention to invade Taiwan.

The thin green line

Such risks do not seem as apparent within economies with more predictable democratic politics, however, from a moral standpoint, is this enough to absolve some transgressions while punishing others that fall outside of certain moral norms?

Put plainly, a country such as India falls within the democratic umbrella but is infamous for still having relatively poor workers’ rights, informal economies and bribery, a political context that encourages aggression towards different cultural groups and security forces carrying out violence against the Kashmiri population. At what point are Indian stocks excluded from emerging market indices on ESG grounds?

Looking west, Germany chose to let its nuclear power capacity run down and has supplemented this deficit with coal and Russian natural gas, neither being more environmentally friendly solutions.

On Monday, the country’s chancellor Olaf Scholz announced an additional $113bn in military spending this year. This has led to conversations with the EU over whether weapons manufacturers should now be considered ESG-friendly, so these companies can benefit from additional financing in the current wartime context.

While the need for extra investment in such industries is understandable, bending an entire system of standards to facilitate this would undermine the validity of ESG as anything more than a Eurocentric norms game, which would be dangerous for the entire movement. Heckler & Koch being labelled a sustainable investment would be hard for most to wrap their heads around.

As for whether it is time for Russia to be excluded from ESG indices – perhaps it is. In many ways it contradicts the western democratic norms from which ESG’s moral basis is drawn. From a risk standpoint, it is unpredictable and quite frankly its market is less investable than other more appealing moral transgressors.

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