Simon Jessop and Ross Kerber. Karin Strohecker

LONDON, (Reuters) – For those funds that are not deterred by China’s treatment Uyghurs or the murder of Jamal Khashoggi in Saudi Arabia, Russia’s invasion into Ukraine has been a wake up call.

One of the fastest growing trends in fund management, investing on the basis ESG (environmental, social, and governance) criteria is attracted investments of more than $35 Trillion by 2020.

Money managers in London and Boston have tended to be more focused on the companies than their country investments. Governance risk is often overlooked by money managers.

China denies allegations that Uyghurs were abused in southern Xinjiang. Saudi Arabia claims that Khashoggi was killed by a terrorist group.

As western companies and banks review their exposure to Russia in the hundreds of billions of dollar range, over half a dozen managers of fund management interviewed by Reuters stated that they were being forced to rethink how countries are assigned risk.

“We need to admit that our industry committed a very large blunder, by not taking the invasion (of Crimea in 2014) for what was and acting accordingly,” stated Sasja Beslik of PFA, Danish $87 Billion pension investor.

“Is this something we’d like to repeat?” Beslik spoke out about investors left with Russian assets that are often in distress since the invasion of Ukraine. Moscow calls it a “special operation” for disarming Ukraine.

A fund can make its own evaluation of the government quality and structure in a country, but this is one aspect of investment decision making.

An estimated 71% (or $35 trillion) of all the investments made with ESG-focused focus are analyzed. The analysis considers the investment’s risk, not a country’s human rights record, or any other governance factors.

If an ESG fund manager believes that the risk of losing money on an asset such as a sovereign debt is low enough given its price it can be more difficult to disregard human rights. This is because, for instance, the country’s government is in control.

Nicholas Lardy is a senior fellow with the Peterson Institute for International Economics. He stated that for China investment decisions, western investors tend to be more concerned about shareholder value than human rights.

But, the next frontier for investors is engagement on sovereign risks, according to Martina Macpherson (president of Network for Sustainable Financial Markets), a non-profit organization that is managed by academic and finance experts.

Macpherson stated that systemic ESG risks like climate, biodiversity, and poor state governance, are particularly relevant.

As long as there are no disruptions to economic activity, it is possible for government crackdowns to be followed up by additional investment. For example, China’s two-year-old clampdown in Hong Kong brought an end to pro-democracy protests.

In 2021, foreign direct investment in China increased by 14.9%

Beijing doesn’t often talk about democracy. But, in the past Beijing has referred to China’s governance arrangements under “whole process people’s democracy”.

RISK REWARD

These market movements have been risky.

For example, international investors were hurt last year because they held bonds from Belarus issued by President Alexander Lukashenko, who intensified his crackdown against protestors.

Investors in Chinese technology and property companies suffered significant losses last year as Beijing launched a crackdown.

Although some funds rejected investments in certain countries due to moral, reputational, and financial concerns, others have chosen to do so for the sake of avoiding losses. These funds tend to be smaller or to focus on a long term outcome.

Many have decided to stay, partly because it is more difficult to exit a larger market.

BlackRock (NYSE) iShares ESGAware MSCI EM ETF funds, for instance has about 3% invested in Russia but 28% is in China, according to Refinitiv Data.

Lardy spoke of China investor holdings, saying that they are “too big to ignore” and “too profitable”.

Ross Gerber from Gerber Kawasaki Wealth and Investment Management shares this sentiment. Gerber said China’s vast economic reach makes it very difficult to invest in.

Gerber stated, “There’s no other way than China,” and holds shares in Tesla (NASDAQ):, for example, which has a huge factory in Shanghai.

People criticize me for investing in China, not Russia. But it is very nuanced. The people criticising me are using a Chinese-made iPhone to type and Chinese-made clothes to wear.

However, there are still some who move money from China.

Norway’s sovereign wealth fund of $1.3 trillion stated that it has excluded China’s LiNing because there was an “unacceptable danger” the Chinese sportswear manufacturer might be contributing to human rights violations in Xinjiang.

Li Ning didn’t immediately reply to my request for comment Tuesday following the announcement by Norges Bank.

SOVEREIGN RISK

ESG calculations are incomplete without the market pricing for sovereign debt. Diliana Detcheva is head of Emerging Market Debt, Candriam’s asset manager Candriam’s SRI Bond EM Fund. This fund has excluded debt from Russia, China, Belarus, and the Gulf States.

Russia has nearly $80billion of foreign debt. This includes sovereign bonds in dollars, euros, and roubles. Investors outside Russia owned 86% the stock market’s free float as of the 2021 end.

Added to that, Western companies such as BP (NYSE 🙂 or Societe Generale, (OTC 🙂 are included. Citigroup Apple (NASDAQ:) and Microsoft (NYSE:) developed ties to Russia. Many people have stopped or cut off these connections after the invasion. Some believe that ESG values seeped into money management and corporate decision-making.

Sonia Kowal (president of Zevin Asset Management in the U.S.), stated that there are not any rules to protect investors from certain countries. Kowal stated that she does not invest in Russia or in Chinese state-controlled firms.

Jeffrey Gitterman in New Jersey is an ESG-focused wealth manger.

“Everything that we know so far about the impact of EM on portfolios will be re-evaluated,” he said.

($1 = 6.8803 Danish crowns)