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April 19, 2022updated 20 Apr 2022 9:33am

Russia exclusions raise tough questions for passive investing

Most major index providers and passive fund managers have removed Russia from their products following the invasion of Ukraine. Could or should they be doing the same with fossil fuel-related assets, as some campaigners and investors argue?

By Vibeka Mair

Out of bounds: Russia has been dropped by big index providers and passive fund providers. Is that a sign of things to come? (Photo by Vladimir18 via iStock)
  • Campaigners say the exclusion of Russian securities by mainstream passive funds and indices shows that assets can easily be screened out too, despite claims to the contrary.
  • Russia accounts for a smaller section of investment portfolios than, say, high-carbon stocks; excluding the latter would be far more controversial.
  • Some investors are taking the matter into their own hands by simply removing certain assets from their passive portfolios themselves.

As equity index providers and passive investors scrambled to cut exposure to Russia following its invasion of Ukraine, campaign groups were quick to point out that excluding assets from benchmarks and index-based products is therefore entirely feasible, despite claims to the contrary. For years, calls for the blanket divestment of, say, fossil fuels or weapons from passive funds have been met with the responses that the product must be exposed to all companies in a particular index and that mainstream indices must track a whole market, warts and all.

But moves in March to strip Russia from mainstream global indices – such as those of FTSE Russell, MSCI and S&P Dow Jones, the three biggest providers (see chart below) – and related passive funds appear to debunk such arguments.

MSCI, for instance, was able to do so by reclassifying Russia from emerging market to ‘stand-alone’ market status following consultation with international institutional investors, as it has other markets such as Argentina and Zimbabwe. The move appears to have been at least partly driven by clients, not least $10trn fund house BlackRock. MSCI told Capital Monitor the decision to remove Russia from its indices was driven by several factors and not solely based on BlackRock, but as a result of a consultation conducted globally with stakeholders and investors.

BlackRock itself suspended the purchase of Russian securities across both its active and index-tracking funds in late February and has since divested these assets completely, like most major passively managed funds and index providers.

Calls for broader screening

“There is a lot of leverage within index providers to modify the rules or to consult asset managers when they want to change the methodologies,” says Lara Cuvelier, sustainable investments campaigner at Paris-based non-government organisation Reclaim Finance. “I’m not saying it is as simple for their active management [strategies to do this]. But there are a lot of ways that asset managers could do a lot more on their passive management.”

For instance, coal only accounts for around 4% of the MSCI World, and removing a very small number of companies from indices could happen – and without damaging performance if providers tweaked their methodologies.

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Maria Nazarova-Doyle, head of pension investments and responsible investment at British life insurance and pensions company Scottish Widows, takes a similar view. “We’re seeing that shift in how investors approach divestment and have been successful in encouraging BlackRock and SSGA [State Street Global Advisors] to introduce exclusions in various passive funds and continue to work with them on broadening the exclusions list,” Nazarova-Doyle says.

Lara Cuvelier of Reclaim Finance says asset managers should lobby index providers more publicly to identify and exclude climate laggards. (Photo courtesy of Reclaim Finance)

Last month, Scottish Widows announced a new range of bespoke indices screening out tobacco, carbon-intensive assets, controversial weapons and UN Global Compact violators. The indices, covering £20bn of its £188bn in assets, were designed by FTSE Russell and will be managed by BlackRock. 

This type of activity should extend to their normal off-the-shelf funds, Nazarova-Doyle adds. “There are certain things you expect to be excluded by default even from passive funds now.”

Reclaim Finance, for its part, wants asset managers – in line with their net-zero commitments – to come together to get index providers to identify and exclude climate laggards. Lobbying activity has happened in pockets, says Cuvelier, but managers must be more public about it to move the needle, especially as Russia has shown that passive investment exclusions can be implemented quickly given sufficient will.

Of course, Russia accounts for a far smaller proportion of portfolios – 0.1% of Legal & General Investment Management’s $1.8trn, for instance – than fossil fuel-related assets and is therefore far easier to remove from indices or passive funds.

Russia exclusion: a simple choice

Russian assets are now effectively worth nothing and have no liquidity, and that is what caused index providers to react, says Adam Gillett, head of sustainable investment at London-based investment consultancy Willis Towers Watson. He does not think it is as simple to exclude a big swathe of assets as Reclaim Finance suggests.

As an executive from another investment consultancy said to Capital Monitor on condition of anonymity, ultimately it would be controversial to impose a blanket ban on fossil fuels because “not everyone believes in climate change”. Many would push back against such a move for that and for financial performance reasons.

Gillett adds: “An invasion of Ukraine or response to the Russian regime is very different from what we need to do and think about on a net-zero transition or about a just transition or cost of living or social issues elsewhere. It’s appealing to draw those comparisons directly, but I think we need to be very cautious.”

Robert Edwards of Morningstar says morality did not play a role in the company’s decision to remove Russia from its indices. (Photo courtesy of Morningstar)

Certainly, Morningstar removed Russia from all its indices not for moral reasons but because the stocks could not be traded, says Robert Edwards, head of ESG indexing at the fund research and consulting firm. The move was effective 18 March for equity indices and 31 March for fixed income indices.

Before doing so, Morningstar said it undertook “an extensive and far-ranging client consultation when the invasion first happened in order to make the most informed decision we could regarding the removal of securities from our indexes”.

Capital Monitor also approached MSCI, FTSE Russell and S&P Dow Jones Indices for comment, but they declined to be interviewed.

Similarly, BlackRock, Vanguard, SSGA and Legal & General Investment Management – four of the biggest passive fund providers – were also approached for comment for this article. SSGA declined, while the others did not respond.

Passive asset build-up

The huge and growing wall of passive investment – which had exceeded $15trn by May last year – makes it all the more important to address this issue, says Marilyn Waite, managing director at the Climate Finance Fund, a philanthropic platform trying to mobilise capital for climate solutions. They account for over half of public equities in the US and over a third in Europe, she notes.

The current state of passive investing is causing “an economy on autopilot for carbon-intensive industries”, where the default allocation to fossil fuels and other climate-changing industries are artificially raising the value of such stock, adds Waite.

But major changes can happen, she says, pointing out that the Dow Jones Industrial Average kicked out Exxon Mobil in 2020. It was the Dow’s longest-tenured member and a once-dominant stock. 

Nonetheless, despite new innovations such as a growing range of customised ESG indices and benchmarks, mainstream passive investing looks set to continue on its meteoric growth path with potentially major implications for the climate, says Waite.

Some investors have, like Scottish Widows, taken matters into their own hands and taken a step further. Norges Bank Investment Management, which runs Norway’s $1.3trn sovereign wealth fund, simply screens out stocks with unacceptable ESG risks from its equity benchmarks, regularly divesting such assets and reporting when and why it has done so. Sweden’s AP4 state pension fund is investing its equity portfolio using a low-carbon strategy, and a growing number of investors are adopting low-carbon benchmarks.

In the meantime, other big questions will inevitably be posed for sustainability-committed passive investors and index providers, such as: what would be their response if China were to invade Taiwan? That would be a far trickier response to frame than that posed by Russia’s war in Ukraine. 

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