Russia’s invasion of Ukraine has brought into focus the meaning of governance, triggering a debate about whether asset and wealth managers have an ethical or moral duty to divest from Russia or other countries ruled by autocratic regimes. This is particularly relevant for sustainable or ESG (environment, social and governance) labelled firms and funds.
“When it comes to fund management, the primary question is around exclusion versus stewardship, and whether the war has created a set of legally or morally bad actors that investors need to consider removing from a portfolio, because they are not upholding minimum standards required in an ESG investment solution,” explains Adam Rein, co-founder at CapShift, a US-based impact-focused advisory firm.
The Kremlin’s aggression has been met with an unprecedented wave of sanctions against the world’s 11th-largest economy. Asset managers are trying to “navigate” the new world “in real time”, particularly because corporations themselves are making decisions in real time, adds Mr Rein.
“It is likely going to take some more months to really have a consensus around potential bad actor corporations that ESG funds might exclude from a portfolio, potentially increasing the volatility around the benchmark.”
Ultimately, it is the underlying thesis of each asset manager and fund that is going to drive behaviour. If asset managers’ core tenet is to mirror a benchmark having a large exposure to Russian or Chinese companies, it is going to be “nearly impossible” for them to exclude wide swaths of a country’s economy.
But is excluding companies or whole countries under authoritarian regimes always positive for financial returns, or is it only about ethics and reputation?
“Certain government risk factors are very material to financial returns, and it’s very common to see funds staying away from certain countries that have high levels of macroeconomic risk,” says Mr Rein. “But it becomes more challenging when authoritarian regimes or bad actors are in the largest global economies, because there’s no obvious evidence that authoritarian regimes generate lower financial returns, systemically. Historically, many people might even argue the opposite.”
The crisis though has opened a can of worms for investors, as many countries in the world do not embrace Western values of democracy. The conflict will lead shareholders to scrutinise their investments even more, and lead them to invest in more politically stable regimes, believes Edmund Shing, global CIO, BNP Paribas Wealth Management.
“It will be interesting to see whether the war has changed Western companies’ cost-benefit analysis of doing business in Russia and high-risk political regimes,” he says.
A key finding from the second annual leadership survey carried out by PWM and Global Leader Group in March, which gathered views from 50 leaders at financial institutions globally, is that protecting freedom, governance and democracy is a key part of financial services firms’ responsibility, (or G in ESG), according to 40 per cent. Thirty-four per cent believe financial firms are only supporting these ESG values when it does not hurt their bottom line (see Fig 1). More than two thirds believe that the war in Ukraine is driving increased investors’ scrutiny on the impact of their investments (See Fig 2).
“The war is certainly causing a set of questions to be asked linked to the focus on ESG in a way that hasn’t been front of mind for the industry in previous crises,” says Stephanie Butcher, CIO Henley Investment Centre at Invesco.
All the finding and statistics from PWM's Global Leadership Survey are available here:
However, while governance has always been important, the definition of freedom and democracy can differ by region and client, she adds. “This creates new challenges for financial businesses in defining their stance on specific regimes and entities. It must be done, but it will need to be thoughtfully done.”
“Before the war in Ukraine, Russia wasn’t at the top of investors’ minds,” reports Cara Williams, global ESG strategy lead at Mercer. People were comfortable with Russia, provided there was transparency on investments. Russia’s illegal annexation of the Crimea peninsula in 2014 went “quite quietly and certainly was not discussed in investment circles”, she says. “Today, things have changed dramatically. And companies are literally just cutting their losses and severing any ties.”
While political risk has been discussed in the industry for a long time, Russia’s aggression towards Ukraine is bringing it to the fore.
All asset managers, not just sustainable ones, are assessing the risk of instability within certain governments and trying to take that in, as part of their risk assessment. “Many asset managers are starting to question investments in China too, today mainly from the supply chain impact, whether it makes sense to be invested in a market where they may not be as comfortable with the regime,” says Ms Williams.
The whole point of active ownership and proxy voting is that investors “have a say at the table”. But if investors believe they have no influence, on state-owned firms for instance, in regimes they are not comfortable working with, then there is no value in being invested, if they are trying to drive change.
Most asset managers are today doing the right thing, which is not selling positions in Russian companies or companies that have Russian interests, in this sort of downward spiral, as they’ve got a fiduciary responsibility, she says, while some Russian companies are not tradeable in any case.
Meaningful engagement
Historically, sustainable investors have excluded companies to avoid exposure to certain areas, for ethical or value reasons. But this approach can only have a meaningful impact if the whole world stays away.
This is what sanctions against Russia are aiming to achieve, argues Daniel Wild, chief sustainability officer at Bank J. Safra Sarasin. Investors may have better chances of generating impact if they stay invested and engage. But the engagement must be meaningful, aimed at addressing a specific governance or environmental issue, while at the same time improving risk management in their portfolio.
It is also important to establish a clear objective and define key performance indicators to measure progress towards that goal, outlining timelines for improvement and possible exit strategies.
Collaborative engagement platforms, such as Climate Action 100+, are often successful because they allow investors to join forces, enabling them to drive change at very large firms too.
Governance is a broad topic, including transparency of processes, independence of the board and ownership, as well as diversity and inclusion. Within the ESG space, it is often believed to be first into equals. If a company is well governed, it also analyses the environmental and social impact on its business and society. But it is important to assess companies within the context they operate. The governance level of firms in developing countries, for instance, is often lower than in the Western world, and is therefore crucial to invest in those deemed most trustworthy within those geographies, explains Mr Wild.
However, the war and the sanctions against Russia have led investors to question existing standards. “One question we are currently discussing is how we will deal in the future with companies that are now on the sanctions list,” reports Mr Wild. These include state-backed companies or those which are profiting from the crisis or even funding the war through their activities.
“The hope was that through investment, and by integrating these firms in the international community, we could all have a positive influence, leading to democratisation and increased standards for the companies and the government, over time,” he says.
“But the lesson from this crisis is that globalisation, which worked, at least partly, on the economic level, has not always led to the establishment of values, democratic systems and control frameworks we would have hoped for.”
One area of discussion since the start of the war has been around weapons, or the defence sector in general, generally seen as a ‘sin’ sector.
Dutch Bank ABN Amro excludes all weapons from its sustainable strategies, but allocates to countries with nuclear weapons, and firms producing them, in its ‘ESG improver portfolios’, as long as they only supply weapons to Nato countries that have signed the non-proliferation of nuclear weapons treaty. “This strategy resonates very well with some of our customers,” says Vincent Triesschijn, global head ESG and sustainable Investing at ABN Amro.
Generally, the bank’s preference is to engage rather than divest, unless it is dealing with companies that violate international standards, such as the UN Global Impact sustainable principles. When engaging with firms, the focus is on avoiding situations of “everlasting engagement”.
“Engagement is a way to create impact. But you should also be very cautious that you don’t engage forever, because then you end up in a situation where you don’t change anything, and you just go on like you’ve always done. We expect clear milestones and a clear timeline from asset managers.”
The bank has recently added to its exclusion list both Russian and Belarussian government bonds, Kremlin-backed firms and those companies where engagement is deemed no longer possible.
Red flag
Firms can apply stringent ESG criteria in their sustainable fund range.
“The war has really pushed us to look into the governance aspect much more in-depth. Yet, Russia, from an ESG perspective, has always been a red flag,” says Rupini Deepa Rajagopalan, head of ESG office at Berenberg Wealth and Asset Management. None of the bank’s sustainable funds invest in Russia and Russian companies.
Within the sovereign debt segment, the German asset manager applies strict exclusion criteria, avoiding countries that do not follow, for example, the Paris Climate agreement, or have a low Freedom Index rating. Nations where the death penalty is legal, or where corruption is high, according to the Corruption Perceptions index, exposed to high risk political instability, are also excluded.
Similarly, a market is also left out if it generates more than a third of energy production from nuclear, or if it possesses nuclear weapons. This leads Berenberg to exclude even US treasuries from its sustainable portfolios. “Nuclear weapons are something we don’t want to support, so we don’t invest in US treasuries.”
But when it comes to corporate bonds and stocks, while firms with “extreme controversy risk” are avoided, Berenberg believes in engaging with “orange flag” companies, with some success achieved with corporates operating in arguably authoritarian regimes such as China.
No excuse
Some leaders are harsh in condemning the asset management industry and its role in supporting the atrocities in Ukraine.
Industry researchers at Morningstar estimate that 14 per cent of sustainable funds globally, which has today morphed into a $40tn industry, held Russian assets before the war.
“Russia’s invasion of Ukraine is laying bare unexpected exposure in much of the ESG universe,” says Matthew Zimmer, director of governance research at US-based Newday Impact Investing.
Funds labelled ‘ESG’ own shares of Russia’s state-backed energy behemoths Gazprom and Rosneft, as well as its biggest lender Sberbank. Funds also hold Russian government bonds, providing money that “ultimately helped pad the coffers of president Vladimir Putin’s autocracy,” explains Mr Zimmer, who lived and married in Ukraine and has in-laws there.
“Companies are scamming the system, or greenwashing, to satisfy the growing demands to comply with ESG standards,” he states.
His firm screens countries based on their governance practices, made public by the World Bank, and ranks the top 50 markets accordingly. China and Russia rank at the bottom of the list, and Mr Zimmer is sceptical that any investment tied to either of these countries can be categorised as ESG.
Ukrainian-American Sonia Kowal, president at Zevin Asset Management, a US-based boutique investment manager focused on socially responsible investing, is “angered by the role of the investment community in enabling the current catastrophe in Ukraine, brought on by Russia.”
“When Putin invaded Ukraine on February 24, his third invasion in 12 years, investors had no excuse for being invested in businesses with ties to the Russian state,” she says, sharing that her cousin’s baby was born in a basement bomb shelter of a Kyiv hospital in March.
Putin’s invasions of Georgia in 2008 and Crimea in 2014 should have been early warning signs for asset owners and managers, yet they chose to stay invested, prioritising “profit over values”.
Today, investors are responsible for helping create an environment in which “an overthrow of the current Russian regime by the Russian military and/or populace is the only viable option,” she says. “By evaluating Russian supply chains and isolating companies that contribute to Putin’s war machine, investors can help weaken Russia’s economy and financial system.”
As a former Russian equity analyst, she saw up close the potential for “making gobs of money by investing in Russian-owned businesses”. Yet, her firm has “long resisted any temptation to invest in Russian public companies, or global businesses with significant sales or operations in Russia”.
This is because of “excessive” political risks surrounding the current regime and the country’s economic instability, which do not warrant any capital allocation in a portfolio that tries to “prudently balance both risk and reward over the long term”.
“The horrific impact of Russia’s invasion of Ukraine should be a wake-up call for anyone invested in countries with authoritarian regimes and a reminder that investors can become targets just as easily as dissidents,” concludes Ms Kowal.
