Where Russian Sanctions Can Affect ETFs

February 25, 2022

Western leaders are rushing to impose severe sanctions on Russia and its largest companies in the aftermath of its late-night invasion of Ukraine, moves that could reverberate among ETFs, including those that don’t specifically follow Russia. 

President Biden released a first set of sanctions earlier this week banning U.S. financial institutions from trading any Russian government debt issued after March 1 in the secondary markets. Institutions have been prohibited from directly lending to Russia since last June. 

He followed up on Thursday with bans on buying debt or equities from state-owned enterprises with maturities longer than two weeks, effectively stopping firms like Gazprom and several banks from accessing any financing beyond commercial paper. 

The reach of the sanctions could affect ETFs targeting a wide swath of strategies, from emerging market bonds to international energy producers, and poses risk to investors and asset managers alike. 

Emerging Markets Bonds 

The shares of ETFs holding these targeted assets aren’t themselves frozen, as shown by the 19% sell-off in the VanEck Russia ETF (RSX) on Thursday. Rather, new issuances of debt and equities from sanctioned companies are what’s forbidden from entering U.S. coffers. 

For example, the WisdomTree Emerging Markets Local Debt Fund (ELD) carries a 9.56% weight to Russian debt at various maturities, while the $17 billion iShares JP Morgan USD Emerging Markets Bond ETF (EMB) has a 3.28% weight to Russian bonds. 

Between the diminished value of the ruble and soaring premiums for credit default swaps on Russian debt, active asset managers that want out of those positions are at a disadvantage. 

That could inflict even more pain for investors who sought out emerging market debt for yields earlier in the year. Mike Mulach, a fixed income research analyst for Morningstar, said emerging market central banks hiked aggressively last year and attracted bond investors unconvinced by calls that inflation would be transitory. 

“A lot of the bid-ask spreads right now on Russian debt is pretty wide,” Mulach said. “It sounded like you could sell out of positions if you'd like to, but you're taking a pretty big hit.” 

ADR Exposure 

The biggest ETF issuers in the world may also find themselves exposed due to their outsize ownership stakes in some of the targeted Russian companies. Vanguard is the largest institutional owner of four of the 13 firms targeted by Thursday’s sanctions, according to FactSet data, and prominent ETF issuers such as BlackRock, J.P. Morgan, VanEck, Schwab and Invesco also appear among those firms’ top 10 holders. 

This shows up in the form of small weights in broad-market ETFs like the SPDR Portfolio Emerging Markets ETF (SPEM) and the Vanguard All-World Ex-US Shares Index ETF (VEU), which have 0.52% and 0.11% in Gazprom ADR weighting among their portfolios. 

It’s not quite clear if the sanctions could force some index-based funds to remove those holdings. 

MSCI’s index methodology eliminates holdings from countries with “significant economic sanctions,” and the index provider said on Friday that it will not make any changes to the MSCI Russia index or other composites including the country. 

In a statement Wednesday, ICE Data Indices said it was monitoring the sanctions situation by the U.S., the United Kingdom and the European Union for potential changes to its indexes. 

Perhaps the closest precedent for the U.S. ETF industry is from June 2021, when several index providers removed from their indices companies deemed by the outgoing Trump administration to be in support of the Chinese military. That led to some confusion in interpreting whether those firms had to stay or go. 

“I point to that example not just because it’s recent, but also just to illustrate that there are countless Rumsfeldian unknown unknowns that we would need to have answers to to understand exactly what the ripple effects would be at the level of individual funds … how they might go about handling it,” said Ben Johnson, Morningstar’s director of global ETF research. 

 

Contact Dan Mika at [email protected], and follow him on Twitter 

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