Russia has seen huge economic sanctions across the world. For the asset management industry to follow suit and steer clear of Russian exposure as an ethical consideration, it must overcome complex challenges in a world now more globally connected than our forebears could have imagined.

Shifting ethics and exposure

One challenge is fully understanding the exact exposure of a fund’s holdings, particularly regarding ESG. If complete visibility of a fund’s holdings is unattainable, or there is only a partial view, it can be difficult to react to a rapidly changing and evolving situation like the one in Ukraine – where one asset or market is suddenly regarded as toxic.

Despite the challenge above, some major players in the investment industry responded quickly to the suspension of financial trading in Russia or have taken an unequivocally strong position. Liontrust suspended its Russia fund; Jupiter suspended its Emerging European fund, while abrdn and DWS have said they will not make any investments in Russia “for the foreseeable future.” However, the speed at which different asset classes can respond to the sudden escalation of conflict varies, as many will be taken by surprise and forced to act quickly to adhere to their ESG commitments. For example, many companies announced their intention to withdraw from Russia such as BP, Shell, Apple, and Adidas. 

But it is easier for an equity-based fund to divest itself from ‘unethical’ investments than it is for a property fund. Surges in redemption requests can have serious implications for every fund, but it is felt particularly sharply among property funds at times of stress, as the gating of M&G’s property portfolio showed toward the end of 2019. For every day  the conflict goes on, liquidity across every fund facing redemptions will dwindle until the conflict resolves or the fund must gate.

The conflict also shows how fluid the definition of ESG may be. Armaments and munitions, for instance, have long been considered an unethical investment. Yet the argument that armaments now constitute a “good” investment, in light of the changing security situation in Europe, holds some significance. Might the same apply to nuclear power if gas supplies are stretched (the director-general of the French Treasury said the war in Ukraine supports the inclusion of nuclear power in the EU’s sustainable taxonomy) or to genetically modified foods if Ukraine’s leading position as a wheat producer comes under strain?

This conflict, therefore, solidifies the opinion that investing in a ”pure” ESG fund with no exposure to controversial industries, is practically impossible. ”It depends…“ seems to be one of the few narratives that is consistent when it comes to ESG investing: armaments were once unethical, tobacco companies are promoting their “next-generation” products, and fossil fuel companies are transitioning to sustainable energy providers. Is alcohol still an unethical investment?

Investing in transparency

Another consistent principle that regulators strive toward is transparency. In a modern, global economy, where industries and services are interlinked, it can be very difficult for an investor to avoid every potentially “harmful” or “controversial” industry in their portfolios. Even the greenest of industries will have some exposure to fossil fuels in the supply chain. Wind power for instance requires turbines, which in turn require steel made by burning coal.

It is important, therefore, for investors to be fully aware of what their portfolios contain at the underlying holdings level. If they have a strong aversion to nuclear energy, gambling, or tobacco, they need to understand where their funds are investing. Greater transparency from investee companies, along with regulations such as the SFDR in the ESG space, are welcome regulations that enable ESG funds to react more quickly and exert their influence effectively in times of global crisis such as in Ukraine.

If, in times of conflict, ESG definitions are more fluid, then that will surely affect their long-term performance in relation to ”traditional” funds. Throughout the pandemic, market conditions supported ESG funds’ ability to generate superior returns, but that was in an economy where technology stocks bolstered most ESG funds. Now as the “age of complacency” is potentially over, oil prices have soared past 2014 levels, and as no ESG fund is likely to have holdings in a major oil company, the ability to generate positive returns in this new global economy, excluding Russia, may prove challenging. Furthermore, if the “age of complacency” really is over, the difficult question must be asked: Can ESG as we know it perform as desired if a ”new normal” befalls Europe and the zeitgeist reverts from prosperity and growth to defense and survival.