Russia sanctions put ETFs on sidelines during crisis

Over their three-decade lifespan, exchange-traded funds have repeatedly demonstrated their resilience in the face of crises. With the Russian invasion of Ukraine in late February, however, ETFs highlighted how their construction also leaves them open to multiple points of failure.

A common assertion among ETF enthusiasts is that the product can lead pricing when an underlying market is locked or disrupted. Indeed, that is what many expected for Russian and Russian-linked securities following the closure of the Moscow stock exchange on Feb. 25, with ETF institutional memory referring back to the closure of the Egyptian and Greek stock markets in 2011 and 2015, respectively. In those cases, U.S.-listed single-country ETFs continued trading and essentially guided underlying home market prices upon reopening.

Those instances, however, are not comparable to what is going on in Ukraine.

"This is truly unprecedented," said Dave Nadig, financial futurist at ETF Database.

The level of economic sanctions imposed upon Russian industrial and financial firms, the partial reopening of the Moscow stock exchange, and the halt of Russia-linked equities in the U.S. and U.K., have left ETF holders and issuers on the sidelines of war.

"Cuba and Iran are the only examples of similar sanctions in the last 100 years, and in neither case did we have even a tiny fraction of the interconnectedness or cross-border investment we do right now," Mr. Nadig said.

Even as the invasion commenced, trading in U.S.-listed Russia ETFs and ETF options escalated as traders looked to profit on volatility and conflict. Such activity has likely rewarded few as shorts are now unable to close their positions and in-the-money options are sunk because underlying ETF shares are undeliverable.

In what order the dominoes fell is somewhat inconsequential at this point, but the actors involved in maintaining the pricing accuracy, index composition, custody, trading and asset management of an ETF all had to face their purpose with astounding speed.

Index firms were compelled to review the liquidity and investibility of Russian equities, removing them from global, emerging market and sector indexes. With markets closed or trading limited, custodians were unable to access or transfer securities. ETF issuers subsequently suspended creations of new shares. Finally, as net asset values went stale, trading continued for three Russia ETFs listed on NYSE Arca through March 3 and another two on Cboe BZX through March 4.

Over that week, the VanEck Russia ETF saw nearly $600 million of inflows, according to Bloomberg Intelligence data. Such money was either purely speculating on the upside of a quick resolution or broker "create-to-lend" activity in which underlying shares are delivered in return for new shares of the ETF to be loaned out to short sellers, said Eric Balchunas, senior ETF analyst for Blooming Intelligence.

VanEck declined to comment.

Of the five products that were halted, only one —the Direxion Daily Russia Bull 2X Shares — has since liquidated. The others have waived management fees and sit holding cash and securities marked to zero. (At year end, the five Russia-focused ETFs in the U.S. held $2 billion in assets. Collectively, they took in $741 million through Feb. 28 and now sit at $34 million in total assets under management, according to Bloomberg.)

While trading could feasibly continue, listing exchanges have discretion in ordering and maintaining trading halts over regulatory concerns. Similarly, index providers maintain independence from product issuers in publishing index constituents and weightings.

"The sanctity of the index is paramount," said Rahul Sen Sharma, New York-based managing partner for Indxx, which provides custom indexes for $22 billion in ETF assets. "This is not an ad hoc decision for the index committee. Liquidity is part of the index methodology and when liquidity no longer exists, those securities are removed at a price of zero," he said.

Though smaller in scale, Mr. Sen Sharma said that the index and ETF community had a "dry run" of sanction-based index and product adjustment linked to a November 2020 executive order from the Trump administration that prohibited U.S. persons from engaging in transactions in publicly traded securities of Chinese Communist military companies. That executive order saw several index providers remove a handful of Chinese companies from their global indexes in early 2021.

On the fixed-income side, active ETF managers swiftly reduced and/or marked down their Russian government and corporate holdings, while index managers moved to reduce exposure as fixed-income index publishers such as J.P. Morgan Chase & Co. and Bloomberg announced plans to remove Russian debt from their indexes.

In the current market, single-country political risk looms large over emerging markets ETFs, so much so that the $145 million Freedom 100 Emerging Market ETF, which holds stocks based on third-party assessments of personal and economic freedoms in their home countries, has gathered $56 million in net flows since the beginning of the year, according to FactSet. The fund, managed by Alpha Architect tracking an index from Life and Liberty Indexes, has no exposure to Russia or China and is down just 4.2% over the last year, compared to a 17% loss for the Vanguard FTSE Emerging Markets ETF through March 16.

What becomes of the halted Russia ETFs? They are likely stuck in limbo until the underlying securities are either nationalized or continually inaccessible (in Russia) or delisted in the U.K. or U.S., according to Mr. Nadig at ETF Database.