With volatility and market uncertainty on a global scale due to the tragic Ukraine crisis, investors are reminded of the importance of effectively positioning their portfolios to confront unforeseen risk. ETF vehicles have long been considered a reliable tool to provide both liquidity and accurate intrinsic valuation estimates during market unrest. They also enable investors to shift allocations toward and away from risk.

Here are 3 key ETF-related observations in light of what we expect will remain a very fluid situation.

Single-Country ETF Risk in the Spotlight
ETFs come in many shapes and sizes. They can be concentrated in a single market theme, sector, or country, allowing investors to weight portfolios according to a specific market hypothesis and risk/reward expectations. However, extraordinary geopolitical circumstances can render single-country ETFs illiquid and deeply discounted, at risk of complete delisting, and even wiping out investors entirely. Event-driven country risk can increase significantly, forcing exchanges to halt trading for extended periods – the 2015 Greek debt crisis and the 2011 Arab Spring are two such examples.

Russia’s invasion of Ukraine, however, is unique in how fast the situation deteriorated and how unified the global response has been to enforce sanctions. Russia is being forced into a pariah state, creating dire consequences for some of its largest multinational companies.

Russian-focused ETFs, tracking Russian-domiciled public companies, have seen valuations cut significantly with wild swings, some even teetering on the brink of inviability. Investors may need to revise their balance of risk and reward when allocating capital to such concentrated ETFs.

Amid Turmoil, ETFs as a Primary Price Discovery Source
The Moscow Exchange (MOEX), the main marketplace for Russian publicly-traded securities, was halted for several weeks starting on February 25, the day after Russia’s invasion and just before western sanctions were enacted. During this time period the underlying security net asset values (NAVs)1 trading on this exchange became extremely difficult to calculate at “fair market value” because there was (and arguably still is) no fair market for Russian securities.

Russian-focused ETFs generally will not hold equity in the MOEX itself, but rather, hold GDRs/ADRs2 that trade on UK and US exchanges. Some of the biggest Russian company GDRs (Gazprom, Lukoil, Sberbank and Rosneft) were trading at pennies on the dollar on the London Stock Exchange prior to the recent halt, with expectations of delisting entirely due to sanctions. This doesn’t necessarily make the companies worthless at a local level as they still hold tangible assets… at least for now.

As such, the discussion of an ETF being priced at a “premium” or “discount” to NAV becomes increasingly irrelevant. Due to these extreme uncertainties – with some Russian-focused ETFs trading at over 500% premiums to reported NAV after the MOEX was halted – the ETFs themselves become an actual point for price discovery in the short term.

ETFs can control arbitrage3 opportunity through the creation and redemption process. However, since many Russian-focused ETF issuers have suspended share creations, this has not been possible. Nonetheless, investors may still trade ETFs on secondary exchanges to create their own estimates of intrinsic market value as events unfold (albeit with assumed risk of disjointed paper valuations).

While almost all Russian-focused ETF trading remains halted, ETFs did serve as one of the last vehicles for US investors to gain or limit their Russian exposure. The resumption of the MOEX does not translate directly into the immediate resumption of these ETFs as economic sanctions and foreign exchange restrictions have posed an unprecedented and unique challenge for the industry. Investors will be monitoring avenues for liquidity closely.

Active Management Navigates Turbulence
Active managers are typically able to navigate turbulence more effectively than passive managers. Via in-depth bottom-up stock selection with robust top-down risk analysis, active managers build portfolios focused on companies that they think possess attractive risk/reward profiles. Active managers engage with company leadership directly and determine how geopolitical risk can be addressed and possibly mitigated.

Contrast this approach against index-following passive ETFs merely following allocations set by an index provider with no discrimination between quality and mediocre investments. Since index provider MSCI reclassified Russia from emerging market status to “stand-alone” status in early March, passive ETFs that track the emerging market index are forced to liquidate Russian securities and reallocate proceeds across other regions. Since these assets have become “uninvestable,” passive ETFs cannot even sell in the near future, and if/when they do, it could be at extremely depressed valuations.

Thus, passive ETFs will need to value most of these Russian securities at zero and still hold them on their books, potentially leading to increased benchmark-relative tracking error4 even at very low weightings.

By definition, active ETF managers do not follow index provider allocations and aren’t mandated to reallocate following any reclassifications. Needless to say, it behooves active managers to take a renewed deep dive into any portfolio security to ensure limited exposure to this, or any, crisis. Active managers benefit from ongoing, intensive due diligence and can maintain a longer-term approach that doesn’t force them to sell companies at distressed prices. An extended time horizon is a formidable ally on an active manager’s side, which can benefit investors down the road.

While the wide range of available investment vehicles offer distinctive advantages, ETFs are uniquely able to harness liquidity and intrinsic valuation discovery through secondary market trading when the primary market is no longer an option. Active ETFs can also provide the expertise of high-conviction portfolio managers aimed at identifying long-term opportunities when they trade at a discount to intrinsic value. With hopes of a quick resolution to the Ukraine crisis, particularly given the humanitarian implications, investors should doubtless prepare for a wide range of outcomes.

1 The net asset value (NAV) of an exchange-traded fund represents the value of each share’s portion of the fund’s underlying assets and cash at the end of the trading day.

2 A depositary receipt is a negotiable certificate issued by a bank representing shares in a foreign company traded on a local stock exchange. The depositary receipt gives investors the opportunity to hold shares in the equity of foreign countries and gives them an alternative to trading on an international market. A Global Depository Receipt (GDR) would entail listings on more than one foreign market. An American depositary receipt (ADR) is essentially a GDR that is issued by a foreign company but only is listed on American exchanges.

3 The term arbitrage refers to the simultaneous purchase and sale of an asset on different markets with the aim of profiting on price differences between those markets.

4 Tracking error measures the standard deviation of the difference between the periodic returns of an investment and its benchmark.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Investors should fully understand the risks associated with any investment prior to investing.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Natixis Investment Managers, or any of its affiliates. The views and opinions are as of March 24, 2022, and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

Exchange-traded funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are not individually redeemable directly with the Fund, and are bought and sold on the secondary market at market price, which may be higher or lower than the ETF's net asset value (NAV). Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns.

Active ETFs, unlike typical exchange-traded funds, do not attempt to track or replicate an index. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. There is no assurance that the investment process will consistently lead to successful investing.

Unlike passive investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of an active investment to achieve its objectives will depend on the effectiveness of the investment manager.

Morgan Stanley Capital International (MSCI) is an investment research firm that provides stock indexes, portfolio risk and performance analytics, and governance tools to institutional investors and hedge funds.

You cannot invest directly in an index.

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