Russian sanctions impact asset fund flows

The imposition of Western sanctions on the Russian economy has been discussed and analyzed in many places. The direct impact on the energy and banking sectors are well known. The indirect impacts, however, are more difficult to evaluate.
We take a look at the asset management industry (AM industry), which has already experienced some noticeable shifts. In this respect, the recent launch of new composite share indices by Morgan Stanley provides a good opportunity to analyze industry features and, more precisely, how a firm grasp of the financial architecture can be useful in understanding how financial decisions might be levered into policy tools.
The objective here, of course, is not to discuss whether sanctions are the best available method to solve the East-West crisis, but to shed light on the indirect way the financial sector is impacted.

Passive versus active management
Let’s review how the AM industry works. To simplify, much of it is split into two broad business models, each following either a passive or active investment style.
Passive investment styles stem from the idea that financial markets are relatively efficient in the sense that all information is available to the public; therefore, an individual investment manager doesn’t have insider information and can’t, on average, over a certain period of time, achieve better investment performance than what is provided by a passive investment in the S&P 500 index, for instance. In other words, an investor can’t beat the market.

The best possible investment strategy, in this view, thus consists of approximating the market of investment securities. This is done through formulating an index that reflects the market. The asset manager then chooses stocks to replicate this index, and would then work to minimize the risk of deviations from it. This index is then considered to be a benchmark for the asset manager and is disclosed, or promoted as the manager’s performance target to the investor.
The second type of manager is the so-called active investment manager. They believe that there exist market deviations from the fundamental share value, financial anomalies that can be exploited by skilled and well-informed investors. Of course, this presumes that one can pin down the fundamental value of an asset, which does not really make sense from a purely economic viewpoint, as valuations by nature are subjective.

Incidentally, this year’s American Finance Association meeting includes an interesting exchange about anomalies and bubbles between last year’s Nobel Laureates Robert Shiller, Lars Hansen and Eugene Fama. The video is available at www.afajof.org. It is interesting viewing, to see how Nobel Laureates might disagree about terms such as the meaning and definition of a bubble.

Back to our active versus passive investment management story. Active managers typically manage alternative investment funds and are often registered in off-shore territories. The recent Alternative Investment Fund Managers Directive (AIFMD) actually aims at attracting some of those funds to Europe by providing better access to the European fund market, provided some risk guidelines are followed.

Most active managers don’t replicate a benchmark; however, some commit themselves to achieving absolute investment return targets. For instance, they promise investors a return of 5 percent, whatever the market situation. Nonetheless, most assets are managed by fund managers who follow a passive investment style.
The Figure 1 indicates the composition of the European asset management industry. Approximately 71 percent are standard UCITS Funds, which means that they are more or less passive investors that replicate indices created by financial service providers.

Removing Russia
The indices that are used as benchmarks by passive investors are created by different service providers such as Morgan Stanley and Standard&Poor’s. The Dow Jones is perhaps the most well-recognized.
Morgan Stanley offers one of the major indices, under the title Morgan Stanley Capital Indices (MSCI). There exist different kinds of indices for different kinds of markets. For instance, MSCI All Countries is a weighted average of different indices in the world, the latter reflecting local stock market valuations.
MSCI All Countries is a natural benchmark for an internationally diversified investor. The emerging market index, however, is a weighted average of stock market valuations in emerging markets. This index would thus be ideal for an investor investing in emerging markets.

As already alluded to, recently MSCI launched new versions of its composite MSCI All Country and emerging markets indices which exclude Russia. This is because sanctions against Russia have changed some investors’ sentiment: there is growing demand among passive investors for indices that exclude Russia, given the potential negative impact of EU and U.S. sanctions on the Russian market.
Sanctions have had an impact on how investors view Russian investment. Performance results show that the MSCI EM Eastern Europe, with the Russian shares excluded, has a better performance than does the index which includes Russian shares.

The impact of the decision to create more ex Russia indices is potentially huge, especially considering that the value of assets under passive management is overwhelming. Before the creation of these new indices excluding Russia, managers that had as a benchmark an index where Russia was included were forced to invest in Russian securities. They now have the freedom to avoid the Russian market.
In addition, as the number of ex Russia indices started increasing in July, this should have been met with a net outflow of cash out of the Russian stock market, putting downward pressure on the Ruble.

The reinforcing impact of ETFs
Currently, other service providers such as Standard and Poor’s have not yet opted for the creation of ex Russia indices. If other market players were to move in that direction that might put huge negative pressure on Russian stock market valuations. Moreover, the structural shifts in terms of costs and business models are worsening the situation for the Russian market.
In fact, if an investor believes that markets are efficient, then why should he invest in a managed fund that charges a fee, sometimes up to 1 percent of assets, even though the theory says it isn’t possible to do better than the market.
It is simpler to directly replicate the market index with so-called tracking algorithms or by buying a fraction of the relevant stock market capitalization.

Given the demand for those products, the financial sector has innovated by creating funds that track stock market indices at a much lower fee, around 25 basis points (0.25 percent) of assets under management. Moreover, the shares of those funds are traded on stock exchanges and the funds are called Exchange Traded Funds (ETF).
This has led to an explosion of the ETF market attracting huge inflows. Blackrock Asset Management, a leader in the market, recently noted that over recent months there has been an increase of investment flows into emerging markets.
The increasing size of these ETF markets has led to greater leverage for change in the index composition.
According to Blackrock, cumulative asset inflows into equity ETFs were $248 billion in 2013 and $171 billion so far in 2014. This gives an idea of the potential market movements the changes in index composition might kick-start.
If the situation in Russia were to worsen, other index providers might join in the creation of ex Russia indexes, which would add pressure on its economy.

Dr. Michel Verlaine is managing director of SLF, specialists in law and finance (www.slf.eu.com).