Navigating Geopolitical Events
In February, we learned that Russia launched an attack and invaded Ukraine.
These recent actions remind us of the underlying uncertainty and
geopolitical risk involved when investing in global markets. What will be
the long-term impact? Navigating geopolitical events requires expertise and
flexibility. Dimensional's systematic active approach adjusts to new
information in real-time, including details about geopolitical events and
their potential repercussions for markets.
Global Developments and Their Impact
Geopolitical events like military or economic conflicts can affect stock
markets in many ways. These events are generally 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 may 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 stated they would impose new sanctions on Russia.
The exact nature of these sanctions and extent to which they would impact
listed securities are uncertain. If imposed, they would add to sanctions on
Russia that have been in place for a number of years.
In another recent example, the US issued executive orders in 2020 and 2021
that prohibited US persons from investing in certain Chinese companies. Like
the ongoing situation in Russia and Ukraine, this period was marked by
uncertainty. For weeks and months after the original order took effect in
November 2020, 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 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. 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 events are not new, and the form that they take can
vary. We've seen other examples over the decades during which we have
managed portfolios, 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.
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 halt investing in a market or in certain stocks, we can
continue trading across multiple other eligible countries and securities.
Dimensional equity portfolios typically invest across thousands of stocks.
If we divest from certain stocks or markets, we consider the costs and
portfolio impact in our trading strategy.
Unlike traditional index funds, we 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. We divested from these stocks within
portfolios for US investors for the same regulatory concerns that caused
MSCI to drop them. However, because we have flexibility, we didn't need to
isolate our trading to a short period of a single trading day. Instead, we
traded over several days during the week of MSCI's announcement and the
following week.
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 managing diversified portfolios and building flexibility
into our process.
If you'd like to discuss how this could impact your financial plan, please
contact me at bkrabbe@prosperityca.com <mailto:bkrabbe@prosperityca.com> or
call me at 641-456-4644.
Glossary
Tracking error: A measure used to quantify how closely a portfolio follows
an index or benchmark, often defined as the standard deviation of the
difference between the portfolio and index returns.
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Risks include loss of principal and fluctuating value. Investment value will
fluctuate, and shares, when redeemed, may be worth more or less than
original cost. International and emerging markets investing involves special
risks such as currency fluctuation and political instability. Investing in
emerging markets may accentuate these risks.
Diversification neither assures a profit nor guarantees against loss in a
declining market.