(Bloomberg) — Major index providers are officially cutting Russian assets off their gauges, adding to pressure on the exchange-traded fund industry already facing an extraordinary stress test.
MSCI Inc. and FTSE Russell both said late Wednesday they were removing Russian equities from their widely tracked index, a day after Stoxx Ltd. announced that it would remove Russian companies from its benchmarks and discontinue its country-specific gauges. Firms including the S&P Dow Jones Indices and JPMorgan Chase & Co are still consulting on the matter, with a decision expected soon.
Given the chaos surrounding “uninvestable” Russian securities, this move is not surprising. But they further complicate the outlook for ETFs already suffering after sanctions and Moscow market closures made it nearly impossible to buy or sell their underlying assets.
US-listed funds tracking Russian assets, including the iShares MSCI Russia Capped ETF (ticker ERUS) and VanEck Russia ETF (RSX), were facing several trading halts following the news on Thursday.
“What’s really being tested is the flexibility of the market-place,” said Reggie Brown, co-global head of ETF trading and sales and a principal at GTS. “It’s something unique.”
The structure of ETFs means that they are still trading, even if their assets are stuck. As prices fall and valuations erode, one Russia-focused ETF is already taking off. Most others — including products such as BlackRock Inc. and DWS Investments — are blocking new cash from entering.
Now, many inactive vehicles cannot actually sell to follow index changes, handle investors exiting, or both.
Matthew Brennan, Head of Investment Management, said, “For ETFs such as the broader global ETF or even the broader EM ETF where Russia’s holdings are limited, the ETF will continue to hold Russian assets, tracking a benchmark where these are removed. Has been given.” AJ Bell.
The idea is that Russian securities will continue to be held even if the value is at zero. This can lead to tracking error — when a fund’s actual performance deviates from the benchmark it follows — but also has potential upside if the asset ever recovers.
The positive news for the broader industry is that Russian securities typically make up only a small fraction of major developing-nation gauges. According to Bloomberg Intelligence, emerging market ETFs typically account for about 3% to 4% in the country. For example, the iShares MSCI Emerging Markets ETF (EEM) had a geographic weight of 3.56% for Russia as of December 31. About 2.8% of the $79 billion Vanguard FTSE Emerging Markets ETF (VWO) is in Russia.
“Given Russia’s small weighting on most global funds, the impact will be minimal,” said BI analyst Rebecca Sinn.
Excluding dedicated Russia trackers, there are 33 US ETFs with at least 3% (mostly EM ETFs) in Russia that are worth approximately $6.5 billion and they are all trading at a modest premium to their NAV with the exception of EM debt. who are trading at a discount. see through them here @tpsarofagis pic.twitter.com/icCLMYUWGl
— Eric Balchunas (@EricBalchunas) 2 March 2022
When it comes to purely Russia-focused ETFs like ERUS and RSX — both of which have suspended the creation of new stocks — it’s less straightforward.
Direxion Daily Russia Bull 2X Shares ETF (RUSL), the only leveraged Russia ETF, has announced that it will be closing. Other Russia ETFs often hold securities directly from the nation rather than using options like RUSL — so it can be harder to turn off. Still, according to Todd Rosenbluth, head of ETFs and mutual fund research at CFRA, that could be the endgame.
“If the market is considered non-investable for MSCI, it seems difficult to offer ETFs linked to it”, he said. “It is now increasingly likely that the ERUS/FLRU and perhaps the RSX are closed unless Russia agrees to end its military efforts.”
A BlackRock spokesperson did not immediately respond to a request for comment on the fate of ERUS. The firm said on Thursday that it was pressing index providers to remove Russian securities from broad-based benchmarks, and was working to help ensure that clients “whenever and wherever regulatory and market conditions allow” to exit positions.
A spokesman for Franklin Templeton — which runs the Franklin FTSE Russia ETF (FLRU) — did not immediately comment, citing its earlier press statement. A VanEck spokesperson declined to comment.
The second possibility is that Russia-focused funds continue to trade in the secondary market even if the market they track is closed. This is a scenario the industry has faced before.
Back in 2015, when the Greek stock exchange closed during the country’s government debt crisis, the Global X MSCI Greece ETF (GREK) was still available to investors. Similarly during the Arab Spring in early 2010 when the Egyptian stock market closed, the VanEck Egypt Index ETF (EGPT) continued to trade.
In these past events, a gap emerged between the prices of ETFs and the value of the assets they hold, which did not close until the reopening of stock exchanges. ETFs actually served as a vehicle to help value the underlying securities, whereas they could not trade.
Ben Johnson, director of global ETF research at Morningstar, believes whether history repeats and ETFs keep trading is now up in the air, thanks to the latest actions from index providers.
“We are in uncharted territory here,” he said. “The two major index providers have effectively told Russia that it is on its own and that its stocks are worthless.”
At Bespoke Investment Group, strategists are urging investors who do not have a high risk tolerance to avoid any Russian equities, even through exposure through ETFs, saying they Products are subject to liquidation or wind-down due to restrictions imposed on the country. Last week he said “bottom fishing is still extremely risky.”
“It is unclear whether ETFs have actual securities that can be legally (or operationally) traded, even assuming they have found a buyer,” said a global analyst at the firm. said macro strategist George Perks. Liquidating funds may not be able to sell securities, given the current regulations surrounding restrictions, he said.
RUSL’s liquidation was announced on Monday, before BlackRock suspended construction for ERUS, and the likes of DWS Investments, Franklin Templeton, HSBC and VanEck halted fresh shares in some of their funds.
For now, the fact that ETF shares still trade on the secondary market highlights a major advantage of the structure over mutual funds, said Nate Geraci, president of ETF Store, an advisory firm.
“ETFs offer an exit ramp,” he said. “I think it’s important in an environment like this.”
With the help of Abhishek Vishnoi, Farah Elbahrawi, Jan-Patrick Barnert, Veronica Gulias, Sagarika Jaisinghani and Vildana Hajrik.