(Bloomberg) — From the pandemic to the Greek debt crisis, exchange-traded funds have traded as usual during the toughest times in the market. But with Russia’s war on Ukraine, the industry is finally facing a phenomenon through which it cannot trade.
The announcement on Wednesday that a short product listed in Tokyo will stop trading next week means every Russia-focused stock ETF in the world is now suspended or will soon be. Events like the Arab Spring and even Covid have never been able to do this kind of shutdown.
Investors turn to these products in times of turmoil, both as a source of liquidity and as a means of price discovery, when assets tracked by the fund are stuck. But the financial fallout from Russia’s invasion of Ukraine is so extreme that this time, fund issuers can no longer make untraceable tradables.
“These are extraordinary circumstances, a situation we’ve never lived through during the ETF era,” said Ben Johnson, Morningstar Inc.’s director of global ETF research. “This is an episode where we learned what boundaries are.”
Sanctions targeting Russia for the invasion and the country’s own response – including domestic market closures and capital controls – mean that Russian stocks held by a slew of ETFs are untraceable. As in previous similar episodes, such as when the Egyptian markets were closed for nearly two months during the Arab Spring, the fund continued to trade on the hope that the stock exchange would eventually reopen. The underlying asset and fund fell in line when it did so.
The issue with Russia is that even if the Moscow market does reopen, sanctions will mean that ETFs still cannot buy or sell Russian assets.
“There are situations out there all the time that I think are unique and unprecedented, and this is one,” said Sylvia Jablonski, CEO of Defense ETF.
Jablonski hopes that these developments will inspire the industry to create new guidelines for any similar scenarios in the future. “I think they’ll become index rules so that investors know, ‘Hey, if there were to be X, Y, Z, and we shut down the stock market or put sanctions against this country, then the index provider would have to go through this security’. Will value to zero, or we will use the final price till the position is over,” he said.
For now, both fund issuers and investors are still at the mercy of geopolitical events. According to data compiled by Bloomberg, The Next Funds Russia RTS Linked ETF (ticker 1324JP) is the last Russia-focused ETF trading in major markets. It will be stopped from March 17, Japan Exchange Group Inc said in a statement.
The move was made by BlackRock Inc. Following the suspension of the products from the issuers of Franklin Templeton. It has already been announced that at least one fund, a leveraged offering from Direxion Shares ETF Trust, is being closed. The fate of all others – which mostly physically hold Russian assets, unlike the options exercised by leveraged funds – remain uncertain.
Eric Balchunas, senior ETF analyst at Bloomberg Intelligence, acknowledged that there are two possible outcomes. First, as the geopolitical situation improves, the halving is lifted and normalcy resumes, the prices of these funds could skyrocket. Second, the crisis will intensify, ETFs will become delisted and liquidated and investors will be wiped out.
“I’ve never seen anything like this,” said Balchunas. “ETFs are the cockroaches of the investing world. They trade through everything, and this has been proven time and time again.”
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Balchunas points out that in some cases mutual funds in Europe withheld redemptions weeks before taking action similar to ETFs. Meanwhile, the decision to halt appears to stem from the stock exchanges hosting the funds, rather than the ETF issuers.
For industry professionals, this is a sign that ETF structuring is still one of the best ways to weather the crisis.
Ross Mayfield, investment strategy analyst at Robert W. Baird & Co., said, “Last week at least for the first few days, you saw the use-case as they were still trading, while the underlying asset was completely frozen in Russia. Had happened.”
It turned back to a selloff in the COVID-triggered 2020 market, when trading activity in the bond market froze. The ETF was hailed for providing an alternative source of liquidity, with the Investment Company Institute saying the ecosystem has “proven its resilience” and the research even noted that the fund has a good exposure to the broader market. Acted as a shock absorber.
“If the limits of an ETF to serve as a price discovery vehicle are armed conflict, so be it,” Johnson said in Morningstar. “I would say it’s a very strong level.”