How the Russia-Ukraine war highlights the importance of ESG considerations in FX markets

Could a heightened focus on ESG (environmental, social and governance) factors have prevented investors from experiencing steep losses in Russia-related investments the past few months?

It’s a good question, with some surprising answers.

Following Russia’s unprovoked Feb. 24 assault on Ukraine, sweeping sanctions placed on Russia’s currency and Russian companies have rippled through all asset classes, affecting portfolios across the globe—including those with an allocation to foreign exchange (FX) markets. In some cases, these impacts have been fairly detrimental, with investors’ hard-earned alpha seemingly evaporating overnight.

But what if ESG factors had been taken more into consideration in the weeks leading up to the invasion? What if the governance risks of an exposure to Russian securities had been fully integrated into a currency strategy? Or if increased attention had been paid to the implications that an attack could have on environmental factors, such as an allocation to oil and gas? Would investors have earned higher returns?

We’ll take a look at all of this in short order—particularly as it relates to foreign exchange markets. But first, let’s back up a step and review the basics of what makes a strategy an ESG strategy. Call it ESG 101.

ESG strategies: A review

ESG strategies aim to incorporate environmental, social and governance factors within the investment-making decision process. These factors are defined in the table below.

Table 1: ESG factors, defined 

Source: CFA Institute

There are a variety of approaches to screening the universe of assets and incorporating ESG factors into such strategies. Let’s take a look at the ESG factors in the context of the ongoing war in Ukraine to help understand the value of such an approach.

The penalties of underexposure to oil and gas: Assessing the environmental factor

Russia is an important provider of energy, being the largest natural gas-exporting country in the world, with a significant supply chain dependency.¹ Most ESG strategies typically move capital allocation toward green energy and away from oil and gas, but in a world that’s still heavily reliant on the latter, such an approach can prove costly. Russia’s invasion of Ukraine demonstrates this all too well. Western sanctions imposed in response to the assault on Ukraine have pushed oil stocks up due to supply worries.² As Russia’s revenue on exports of crude oil rises³, ESG investors with underweights in oil stocks are seeing their portfolio alpha penalized.

Is this something that could have been prevented with a more complete ESG analysis? We would argue so, because when it comes to ESG investing, there’s almost always more than meets the eye. Factoring in ESG considerations into an investment process is often complicated, complex, and—in this case—contradictory. And, as this example shows, when large amounts of money are at stake, the cost of not conducting a comprehensive ESG analysis can be high.

The cost of underweighting defense stocks: Assessing the social factor

The war in Ukraine has also led to a surge in defense stocks, with the S&P500 aerospace and defense industry rallying over 13% during the first quarter of 2022. Not unlike its oil and gas counterpart, defense is a sector that most ESG strategies typically omit exposure to, as companies in this industry make lethal weapons. After the invasion of Ukraine sparked a need for increased security across the globe, however, investors started reviewing their positions.⁴

For return-seeking investors, this is another example of the perils of only conducting a surface-level assessment of ESG risks and opportunities. Once again, the Russia-Ukraine war demonstrates there’s more than meets the eye for ESG investors—and that context matters.

Figure 1. S&P500 Aerospace & Defense Total return in USD from 04/15/2021 to 04/15/2022. Graph from Bloomberg.