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Has passive investing failed during Russia's invasion of Ukraine?

If an index allocates to Russia, then the index investor is exposed to Russia.

john HeadshotsTRY sq John Berry 3 minute read

Investing can mirror real life – not only are the ups and downs of our world reflected in the ups and downs of markets, but life lessons can also apply to investing.

For example, “price can be inverse to quality” can be true in investing as it is in life.

Russia’s invasion of Ukraine has created a desperate humanitarian disaster, and throws a spotlight onto finance, investing and corporate activities.

Many companies have actively suspended or exited their Russian operations, including Apple, Nike, car manufacturers, accounting firms and even big oil.

With investing, active managers may have acted before the invasion by choosing not to have any Russian stocks or Russian government bonds.

Meanwhile, index investors have less flexibility because they can’t exclude those parts of an index they don’t like.

If an index allocates to Russia, then the index investor is exposed to Russia. They cannot actively decide to do differently.

Blackrock, the world’s largest asset manager, has its iShares funds stock exchange listed around the world.

They’ve very publicly moved into sustainable investing using environmental, social and governance metrics (called ‘ESG’ investing) although as we will see this proves hard with a pure passive index strategy.

You’d expect a listed index fund labelled ‘ESG Aware’ to invest with a heightened environmental, social and governance focus.

Yet, at the end of last year iShares’ US listed emerging markets ‘ESG Aware’ fund held just over NZ$100 million in three Russian companies: Rosneft, Gazprom and Sberbank (and it still holds them although their value has plummeted).

Weirdly, iShares ‘ESG Aware’ listed US shares fund holds a number of stocks that are very questionable from an ESG or ethical perspective, like ExxonMobil (oil), Ceasars (gambling) and Raytheon (weapons).

We also saw last week the ‘Ethically Conscious’ Global Index Bond Fund from another provider, Vanguard, is invested in Russian government bonds.

Maybe I shouldn’t be surprised, over time ESG indexes and passive sustainability strategies have delivered some unexpected results.

For example, cigarette manufacturers Philip Morris and British American Tobacco have both featured in Dow Jones’ Sustainability Indexes.

So, what’s going on? May be ESG index rules aren’t always well constructed. May be there’s an intent to invest with an environmental and social focus, but it is just too tempting to be an index hugger.

A kinder interpretation may be that the index provider thinks it’s better to stay invested in egregious holdings and vote as a shareholder for change.

Or more likely you really do need active oversight rather than blind acceptance of passive raw data when it comes to ESG and ethical investing.

Passive funds are indeed cheaper than active funds, often much cheaper, but let’s apply our life lesson about how ‘price’ equates with ‘quality’.

Let’s look through the lens of an ethical investor with a social and environmental focus – in which case I’d say "cheap” likely delivers the inverse of “quality”.

This commentary is general information only, it is always a good idea to seek professional financial advice for your personal circumstances. Pathfinder is an active fund manager.

-John Berry is co-founder and chief executive of ethical fund manager and KiwiSaver provider Pathfinder Asset Management.

Originally published in Stuff 17/3/2022

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