ETF Investors are Caught in a Russian Bear Trap

Ouch! That hurts!

Morningstar reports 14 percent of “sustainable” fund assets were in Russian assets, just prior to the Ukraine invasion and resulting sanctions.

That means yet another direct hit to the wealth of investors who own ESG-focused ETFs, many motivated by the desire to make the world a better place by putting their capital to work with companies supposedly doing good things.

If you’re asking why anyone had considered Russian investments “sustainable,” welcome to the always opaque and often borderline arbitrary world of Wall Street industry classifications—where companies are frequently lumped together despite common sense dictating otherwise.

For those of us who buy individual stocks, sector misclassification is at worst an occasional annoyance. And it can bring opportunities for investors, for example if a great company with a safe and sustainably growing dividend gets sold off with companies operating completely different businesses.

I see this a lot with conventional oil and gas companies. And over the past year, it’s happened repeatedly with renewable energy stocks—with wholesale unloading of ETFs frequently dragging down highly profitable power producers with earnings-less technology companies.

For the almost always unsuspecting “sustainable” ETF investors, however, the bad and ugly always drag down the good.

And if there’s enough selling and net asset value shrinks enough, the ETF’s sponsor will close up shop, cashing you out at what’s likely to be a low point. True, you’ll have a tax loss to write off (hopefully) against other gains.

When your check clears, you’ll have the opportunity to reinvest the funds. And if you’re lucky on the timing, you may be able to invest the trend you want to again—but all are challenges you would of course avoid by picking your own stocks rather than buying ETFs.

So what about those so-called “sustainable” ETFs that are now heavy into Russian stocks?

As a Morningstar analyst rightly pointed out, in the current industry nomenclature “sustainable” isn’t considered to be the same thing as “ethical.” That means those ETFs were entirely within their rights to own Russian stocks—if for example the companies were considered to rate highly on other environmental, social and governance criteria.

I sincerely doubt that the average investor would see things that way. And it certainly won’t soften the blow of lost value—if indeed sanctions against Russia for invading Ukraine really do wind up making those stocks “uninvestible” and therefore unsalable and basically a write off.

And neither will there be any recourse for investors, whether they knew their ETFs held uninvestible Russian stocks or not—as there is when individual companies are found to have committed fraud.

But that’s just one of the risks of giving up control of what you own—by investing with ETFs rather than taking the time to pick your own stocks.

That’s not to say you wouldn’t be losing money right now if you own individual Russian stocks—or even companies perceived to have heavy Russian exposure. A good example now would be French super oil TotalEnergies (NYSE: TTE).

The price of the company’s NYSE listed ADRs has dropped to the high 40s from nearly $60 as investors have fretted about risk to its investment in non government controlled Russian natural gas, even as the price of Brent crude oil has pushed toward $110 and other producers’ stocks have soared.

The difference is, as owners of TTE ADRs— rather than a “sustainable” ETF that’s heavy in Russian stocks—we can make our own decision about risk, and weigh it against the reward of owning shares of a company that’s also a rapidly growing global leader in offshore wind energy—and is currently making an estimated $70 in free cash flow after dividends for every barrel of oil equivalent it does sell.

That’s not a choice an ETF will give you.

And it’s yet another example of the heavy price you pay by giving up control of your investments, to the giant faceless marketing machines like Blackrock and Vanguard that increasingly dominate the range of ETF choices you have.

Buyer beware.