Impact of Russia’s Invasion of Ukraine on Long-Term Expected Returns

Impact of Russia’s Invasion of
Ukraine on Long-Term Expected Returns


In March 2022, we removed Russia from Asset Allocation Interactive (AAI). As a result of the Russian invasion of Ukraine, Russian equities were essentially rendered uninvestable. In the immediate aftermath of the invasion, the Russian exchange closed for nearly a month. The MOEX reopened on March 24, however, sanctions on Russia and significant controls placed by the exchange on foreign investment have continued to prohibit investment. When a full capital market, trade, and economic reopening will occur would be purely speculation, but the fact that all major index providers have removed Russian equities from their indices suggests it may be some time away. With Russian equities as a backdrop, we would like to revisit how we determine our expected returns and to remind AAI users what our models include and exclude.

We model long-term expected returns using a standard building-block approach: valuation change + growth + yield. Higher expected returns are often associated with the countries that have the highest expected risk and uncertainty. Prior to the Russian invasion, Russia had the highest real expected return of any country at 15.1% with expected volatility of 33.7%. Russia was followed by Turkey, with a real expected return of 12.5% and Brazil at 11.8%. Aside from Malaysia and Poland, no other country has an expected real return above 8.0%. The return forecast for Russia was almost entirely driven by the building blocks of yield and expected change in valuation. Prior to the Russian invasion in late February, the yield on Russian equities was 7.0% and the estimated change in valuation over the next 10 years contributed 5.4%.

Attempting to determine the expected return of Russian equities at the end of March would have been an impractical exercise. At that time, the quoted price of the MSCI Russian Index had fallen to 0.002. Using this price would have resulted in a yield of 2,944,500%! Even though the Russian equity market has since reopened, MSCI is still quoting the same miniscule price due to the inaccessibility of the Russian equity market. Given the attractive yields for Russia, does this mean that investors should indiscriminately pile into Russian equities at the expense of diversification? How about the relatively less risky equities of Turkey and Brazil? As recent events have shown that could be a recipe for disaster. Recall that the total future realized return is the sum of expected return and unexpected return. Expected return is well-grounded in finance theory, whereas unexpected return (positive or negative) captures the return that cannot be modeled, but must not be forgotten.

Our return forecasts have no Putin or Erdogan component. While geopolitical risk, corruption, and other uncertainties are often priced in, resulting in high yields and low valuations, our high long-term real return expectations do not take into account, for example, Putin’s serial willingness to expend blood and capital in foreign adventures, Erdogan’s erratic economic policy choices, or rampant corruption in Brazil. As such, near or total loss of investments in these countries is possible, as is currently the case with Russia.