Ukraine/Russia: how to deal with Black Swan events
9th March, 2022
Black Swan events are highly unlikely, highly unpredictable and result in significant and widespread negative consequences. The term was coined by Nassim Taleb in his 2001 book Fooled by Randomness, where he discussed how these “once in a lifetime” or “one in twenty year” market events are actually more prevalent than we anticipate. Since the turn of the Century, we’ve seen the Dot.com crash, the Global Financial Crisis and subsequent Eurozone Crisis, the 2010 Flash Crash, Covid Crash and, most recently, market turmoil in the wake of Russia’s invasion of Ukraine. “Black Swan” events are indeed very prevalent.
When faced with a regular occurrence of unpredictable events, we believe a decision-making framework can help trustees in thinking about extreme world, and market, events.
A good place to start is by considering the legal standpoint. Legally, trustees must make decisions in the best interests of the members they represent. Often, this is taken to mean that decisions on scheme investments should ensure the best returns possible to improve the probability of meeting member benefits in full. As such, an event which is clearly of a financial nature should, unquestionably, be of serious interest to trustees.
Events where there are non-financial considerations are much more of a grey area. The Law Commission has taken the view that trustees may take into account non-financial factors, but only if two tests are met; very broadly:
- Test 1—trustees should have good reason to think that scheme members would share the concern in question, and
- Test 2—the decision should not involve a risk of significant financial detriment to the scheme.
As we watch the catastrophic, deeply upsetting events in Ukraine unfold, there are strong grounds, based on the above criteria, for trustees to consider Russian investment restrictions and disinvestments. Furthermore, on Friday 4 March, The Pensions Regulator provided guidance that trustees should indeed be considering how their scheme and its sponsoring employer is impacted by events in Ukraine.
Investment Decision Making Framework
We’ve compiled an investment decision making framework for dealing with unexpected events and risks. Alongside this we’ve mapped what trustees should think about with respect to Russian Investments:
Identify if an unexpected event creates a risk that is significant enough for further consideration.
Here you can have Financial and Non-Financial considerations (subject to meeting legal requirements noted above).
If trustees are not sure about the right thing to do, UK public outcry points clearly to a strong probability your membership will share concerns about Russian investments. And, The Pensions Regulator has provided guidance that you should be looking at your exposure to Russia.
Identify Level of Exposure to Risk
Once a risk has been identified you should ask your appointed investment consultant to quantify the level of exposure.
This task should be thought about carefully to ensure you understand what you’re looking for. This can be difficult in an interconnected global economy.
Contact investment consultants to understand what exposure you have to Russian financial securities.
This can be complicated because equities, for example, can be listed and headquartered in different locations. Moreover, companies can have Russian subsidiaries, investments in the country and/or significant revenues from there, despite not being Russian companies. That is before you consider second order effects such as changing energy markets.
Understand what asset managers are doing?
Alongside quantifying your exposure, you will need to understand how the asset managers are reacting to any rapidly emerging risk.
We have seen a collapse of the rouble, the rapid fall of valuations of Russian assets and a dry up of liquidity in Russian securities. We anticipate many managers will advise that exposure is limited, and they have an intention to sell, but only once liquidity has returned to the market.
Raising the question of Russia investments with consultants and managers will aid in showing asset manager the general concern of the asset owners.
Consider any changes you’d like to make in your investments
Once you understand your exposure to the risk and the reaction of your managers, you can consider if the actions are aligned with your expectations.
If the outcome of the data gathering causes a concern, consider alternative actions. This can be engagement with the managers or disinvestment from them. If you are invested passively, there may be alternative indices you can consider.
If a manager is not planning any action on Russia exposed securities, then:
1. For investors with direct investments you can provide your investment managers with specific directions regarding Russian securities.
2. For fund investors, you must decide if the managers’ actions are aligned with your beliefs. If not, you can engage further or move to a different fund/manager.
Consider Member Communications
What, and how, should trustees communicate with members who may be concerned about scheme investments?
Members may want to know if their pension has links to Russian investments. However, listed Russian investments are likely to be a small part of a scheme’s investment portfolio.
We believe a proportionate response is to use the next regular member communication to include a reference to Russian investments and the response of the trustees.
Update Statement of Investment Principles
Does your Statement of Investment Principles (SIP) need revisiting? Does it accurately reflect your “Non-Financial” considerations?
As a result of events in Ukraine it may be a helpful time to revisit your SIP. In having discussions about Russia, you can broaden your conversations to understand how the trustees thinks about other non-financial risks, and broader ESG issues. This should then be reflected in your SIP and used when making future investment decisions.
When faced with a Black Swan event, we believe the above framework may be a helpful guide for trustees in considering their scheme’s investments. However, it is important that trustees understand the full impact of events on their scheme. So, discussions should also extend to the likely impact on liabilities, e.g. through higher inflation, and sponsor covenant.