By Dimensional Fund Advisors
Geopolitical events like military or economic conflicts can affect stock markets in many ways. These events are normally widely followed by investors. We believe current market prices quickly incorporate expectations about the effects of these events on economies and companies. Our investment approach centers on using information in current market prices rather than trying to outguess them. If markets stay open and continue to function normally, we generally continue investing our portfolios according to our usual process. We believe that the most effective way to mitigate the risk of unexpected events is through broad diversification and a flexible investment process. This philosophy applies to other crises, like natural disasters, social unrest, and pandemics.
However, geopolitical events sometimes lead to restrictions on investors’ ability to trade in specific stocks or on certain exchanges. One way is through government sanctions. In recent days, the US and other western governments have issued sweeping new sanctions directed at Russia.
The international funds we most often recommend to investors are currently underweight in Russian securities and have been dating back to at least 2014, following Russia’s annexation of Crimea. Additionally, those funds halted further purchases of Russian stocks in January 2022. Furthermore, Russian investments in those funds are denominated in US dollars, not Russian rubles. As of February 28, 2022, Russian equities represented between 0.07% to 0.42% of the international equity mutual funds and ETFs we recommend, compared to 1.59% in the MSCI Emerging Markets Index.[1]
In another recent example of government sanctions, the US issued executive orders in 2020 and 2021 that prohibited US persons from investing in certain Chinese companies. The weeks and months after the original order took effect in November 2020 were a period marked by uncertainty, as fund managers sought clarity on the scope of the restrictions and the exact list of sanctioned stocks.
In some cases, geopolitical events have led to temporary market closures, impacting all stocks in a certain market for a period of time. For example, on June 27, 2015, Greece closed its stock market after defaulting on its government debt. The Athens Stock Exchange stayed closed until August 3 of that year. During the Egyptian revolution of 2011, the Egyptian Stock Exchange closed after January 27 and remained closed for over a month. Unplanned market closures are not limited to emerging markets. In 2019, the Tokyo Stock Exchange closed for 10 days after Japanese Emperor Akihito abdicated the Chrysanthemum Throne. And lest we forget, in 2001 the New York Stock Exchange closed until September 17 after the September 11 attacks on the World Trade Center.
These types of market disruptions are not new, and the form that they take can vary. We’ve seen other examples over the decades, including currency repatriation restrictions in Malaysia in 1997, the introduction of capital controls in Argentina in 1999, and a successful coup d’état in Thailand that led to a market closure in 2006.
As is typical in any other instance of fear and uncertainty, many investors react to such events with panic, selling assets as soon as they are able, usually after a precipitous price drop. We’ve seen it before and have yet to see a situation where panic selling has proven to be the right move for long-term investment success.
The Value of Flexibility
Flexibility is valuable in managing portfolios through these events. No two events are the same, but common themes are uncertainty and rapid change. The diversified nature of our portfolios is important in allowing us this flexibility. If we are shut out for a period of time in a market or in certain stocks, we have many other investments that are still trading across multiple other eligible countries and securities.
Unlike traditional index funds, the investments we recommend are not constrained to follow the actions of a benchmark during these times. Deletions from benchmarks in the wake of geopolitical events typically follow a similar pattern as other index rebalances. The index provider announces the deletion date in advance, and funds seeking to mirror the holdings of that index must sell the deleted securities at the market close on that date. Seeking to track the index limits a manager’s options regarding what actions to take and over what time frame. It may also result in demanding liquidity in specific stocks at the same time as other managers who are also seeking to track the same index fund.
For example, on January 7, 2021, MSCI announced it would drop China Mobile, China Telecom, and China Unicom from certain benchmarks effective at market closing prices the following day as part of a larger set of moves by major index providers to remove sanctioned Chinese stocks from their indices. Together these stocks represented more than 0.5% of the MSCI Emerging Markets Index. Funds tracking that index would need to sell their entire positions in those stocks at the market close on January 8 if they wanted to minimize their tracking error vs. the index. In fact, on that date, all three stocks traded at their lowest closing price for the week and closed higher every day in the week that followed.
While the managers of the funds we use also divested those three stocks, they did so the following week and over several days to take advantage of the price rebound that occurred after buying and selling returned to equilibrium.
Planning for the Unexpected
Investors in global equity portfolios inevitably face periods of geopolitical tensions. Sometimes these events lead to restrictions, sanctions, and other types of market disruptions. We cannot predict when these events will occur or exactly what form they will take. However, we can plan for them by investing in diversified portfolios that build flexibility into their investment process.
FOOTNOTES
1. Numbers are preliminary and subject to change.
SOURCE
Navigating Geopolitical Events by Karen Umland, Dimensional Fund Advisors, March 1, 2022.