Russian invasion of Ukraine has European investors on alert

Russia's invasion of Ukraine is making institutional investors in Europe nervous, with some pension funds reducing their Russian holdings, and others watching closely.

The political situation that has been brewing since late 2021 escalated dramatically Feb. 24, when Russian troops invaded Ukraine. That prompted other countries, including the U.S. and the U.K., to impose increasingly strict sanctions against Russia, and the prospect of more from Canada, Japan and Australia.

European Commission President Ursula von der Leyen promised swift approval of "massive and targeted sanctions" against Russia to weaken its economy, freeze Russian assets in the European Union and block Russian banks from European financial markets.

The conflict heated up Feb. 22 when Russian President Vladimir Putin recognized two Russian-backed separatist territories in the Donbas region of eastern Ukraine.

That move alone prompted Danish pension fund AkademikerPension, Gentofte, to temporarily "quarantine" investments in Russian government bonds and shares in state-controlled companies.

When Russia invaded Ukraine, the 128 billion kroner ($19.5 billion) pension fund saw "no alternative" but to exclude Russia from its investment universe. "The invasion is a clear and unequivocal violation of international law and of our policy on responsible investment. Therefore, there is no other option than to exclude Russia," CEO Jens Munch Holst said.

AkademikerPension will divest Russian government bonds and investments in Russian companies in which the state owns more than 50%, which together amounts to $46.3 million, or 0.2% of pension assets. After running the numbers, "we are confident that we can still maintain adequate risk diversification after this exclusion," Mr. Holst said.

In Canada, new sanctions banning the purchase of Russian sovereign debt and other financial dealings related to Ukraine prompted Caisse de Depot et Placement du Quebec, Montreal, to sell its Russian holdings.

The C$420 billion ($329.7 billion) pension fund manager will now work to avoid future exposure, CDPQ spokeswoman Kate Monfette said in an emailed statement. "We have no interest in direct investments in Russia," she said.

Earlier in February, PensionDanmark, Copenhagen, started reducing its exposure to Russian government bonds and to companies in which Russia had "deciding influence," said spokeswoman Ulrikke Ekelund. The pension fund, with 304 billion Danish kroner in assets, sold 400 million kroner in Russian government bonds and will disclose moves in other asset classes shortly, she said.

For other European-based asset owners with exposure to Russia, it is a waiting game.

"We are closely monitoring the situation," said Line Aaltvedt, spokeswoman for Norges Bank Investment Management, manager of the 12.02 trillion Norwegian kroner ($1.35 trillion) Government Pension Fund Global, Oslo. NBIM had 27 billion kroner invested in Russian equities at the end of 2021.

NBIM recognizes that "geopolitical tensions could obviously influence the financial markets. We are, however, a long-term investor and can sit through potential short/medium-term volatility," Ms. Aaltvedt said.

The deepening crisis is less of a concern for pension funds like Pensioenfonds Zorg en Welzijn, Zeist, Netherlands, with €278 billion ($315 billion) in assets managed by PGGM. PFZW has most of its liquid assets linked to indexes, and illiquid assets are concentrated in North America and Europe, said PGGM spokeswoman Ellen Habermehl.

As government officials in the U.S., U.K. and Europe continued imposing sanctions last week and promised more to come, index providers are also preparing for change after Russia invaded Ukraine.

For sanctions that reduce international investors' options, MSCI Inc. said it would consider taking steps, including freezing Russian-specific indexes, limiting the number of Russian company shares in indexes, or even taking specific Russian companies out of equity indexes. Further deterioration in access to the Russian equity market may lead to reclassification, MSCI said.

In response to the latest U.S. sanctions and feedback from market participants about investing in and replicating the Russia indexes, MSCI said that starting with its February quarterly index review, it will apply a "special treatment" for Russian securities by not making any changes that would normally be considered.

MSCI indexes include the $255.4 billion MSCI Russia index for mid- and large-cap companies, and the $251.9 billion MSCI Russia 25/50 index.

MSCI also will not make any changes, including constraint factors, related to any security classified in Russia in non-market capitalization weighted indexes and custom indexes such as the MSCI factor, ESG, thematic and capped indexes, it said.

For now, the immediate impact is global market volatility in bonds and equities, and rising energy prices following Germany's decision to halt approval of the Nord Stream 2 gas pipeline from Russia to Germany.

A Feb. 24 investment note from Amundi group CIO Vincent Mortier, deputy group CIO Matteo Germano, and Amundi Institute head Monica Defend warned that global markets that had not priced in a war scenario "are now adjusting given the magnitude of this military move," and it will take time to price it in. "This is not a time to try to buy the dip, as the market does not yet fully understand the impact of this geopolitical shock," the note said.

"Overall, we believe it is time to keep hedges in place and stay cautious, but not overreact to excesses that we will likely see in the coming days," it said, predicting that equities will be the first target of risk reduction, followed by credit. Without a quick resolution, there is "a rising probability of further repricing across global risk premia." Paris-based Amundi manages €2.06 trillion in assets.

To the BlackRock Investment Institute, there are several aspects to the "protracted and unpredictable" Russia-U.S. tensions resulting from the invasion. The key macro impact is inflation from higher energy prices, which will complicate central banks' efforts to contain it.

For investors, equity markets have sold off but with bonds showing diminished diversification properties, "we still favor stocks over bonds," BlackRock said. "We were prepared to take advantage of market dislocation, but are holding off on making changes to our tactical views until the interplay dynamics become clearer. For now, we keep favoring equities over bonds at lower risk levels than last year."

Tim Ash, senior emerging market sovereign strategist at BlueBay Asset Management in London, with $128 billion under management, said warnings from Western governments in November prompted the firm to reduce exposure to Russia across all its funds.

"We still see the situation as incredibly worrying and uncertain," with continued sanctions on Russia weighing on asset performance, increasing borrowing costs and subduing investment, he said. A potential Russian regime in Ukraine that would also face crippling sanctions "will make its assets almost uninvestable," said Mr. Ash, who also worries about contagion risk in emerging Europe and Turkey.

The Ukraine conflict's impact on energy, and companies reliant on it, is an equally pressing concern, sources said.

"Ukraine has always been an issue; this is the latest and probably the most serious," said Richard Lum, managing partner and co-CIO of global energy infrastructure manager Victory Hill Capital Group in London, with £330 million ($447 million) in assets under management. The result could be more emphasis on energy supply and "would direct people's attention to the midmarket energy sources," Mr. Lum said.

The steps taken by the Danish pension funds and possibly others are to be expected, said Dominic Bokor-Ingram, senior portfolio manager of emerging markets for Fiera Capital Corp., London, with $150 billion under management. "There will be a lot of pressure. For any small country in Europe, what's going on in Ukraine is pretty scary," he said.

The military escalation in Ukraine presents "material downside risks," said Marcelo Assalin, partner, portfolio manager and head of emerging markets debt for William Blair Investment Management in London, with $79.6 billion in assets under management.

The new sanctions "will certainly weigh on investor sentiment and we do expect bond prices to go further down in the near term," he said. If those bond prices fall well below fundamental value, "we may consider buying benchmark-eligible (and not subject to sanctions) Russian sovereign debt," he said. With Russia less than 3% of the firm's benchmark, the J.P. Morgan EMBI Global Diversified, "excluding Russia would not materially impact the long-term risk-adjusted return characteristic of the asset class," Mr. Assalin said

Still, with both Russia and Ukraine important emerging markets, "the headline risks definitely hurt sentiment at the margin for emerging market assets more broadly," Mr. Assalin said.