Emerging markets ETFs are in ‘uncharted waters’ with Russian stock trading on pause, Morningstar says

Emerging markets-focused exchange-traded funds are in “uncharted waters” as global exchanges and index providers pause Russian stock trading, Morningstar’s Ben Johnson says.

“What comes next is anybody’s guess” with the Russian stock market closed and entities including the New York Stock Exchange halting trading in ETFs and securities tied to Russia, Johnson, the firm’s global head of ETF research, told CNBC’s “ETF Edge” on Monday.

“We’re going to be making some things up as we go and we’re really in uncharted waters here right now,” he said.

As of now, that largely consists of index providers and asset managers playing by predetermined rules for such scenarios: limiting or altogether removing exposure to closed markets, Johnson said.

Trading has been halted in all five Russia ETFs listed in the United States for what is being called “regulatory concern.”

This development could have broader implications for markets such as China, Johnson added. China has stood by Russia amid the wave of economic sanctions from other countries, saying that negotiations should be tried to solve the conflict in Ukraine.

“This is a moment that’s going to give many investors pause,” Johnson said.

Many index and ETF providers already offer emerging markets funds that exclude Chinese stocks, he said.

He pointed to the Freedom 100 Emerging Markets ETF (FRDM), which selects its holdings based on a scoring system for human and economic freedoms, and WisdomTree’s Emerging Markets ex-State-Owned Enterprises Fund (XSOE).

“There’s no sort of limit to the creativity, the dynamism, the options that index manufacturers and fund sponsors have to try to navigate some of these issues,” Johnson said.

However, even if the Russian stock market reopens and restrictions are lifted, “in all likelihood Russian stocks will be in the penalty box for the foreseeable future, off on their own until the index providers can get comfortable mainlining them again, if that ever happens,” he said.

Right now, it’s key for investors and advisors to take inventory of their portfolios, Direxion’s David Mazza said in the same interview.

Mazza’s firm runs the Direxion Daily Russia Bull 2X Shares ETF (RUSL). The NYSE halted trading in RUSL on Friday.

“This particular action, I think it’s a wake-up call for investors,” Mazza said.

After years of diverting focus from domestic mega-growth stocks to cheaper, more out-of-favor emerging markets names, it may be time for U.S. investors to recalculate, he said.

“Just as we’ve seen globalization be rolled back over the last few years and in particular the last few months with this particular aggression by Russia, if we see this in other places that maybe have larger weightings in global equity benchmarks, then investors do need to be aware that their portfolios may need to be positioned differently,” Mazza said.

To that end, if anything similar happens with China, it’s likely that index providers will move quickly, he said.

“I think we know that index providers aren’t going to wait around anymore to necessarily be told what to do and they might be moving faster than asset managers,” Mazza said.