Commentary: Geopolitics and markets – systematic perspective

Geopolitical risk is a challenging subject for investors, owing to its nebulous, complex and episodic nature. With little in the way of rigorous research, investment management can end up being informed by little more than instinct or anecdote. This is of heightened relevance today in a climate of intensifying geopolitical risk. All over the world, in developed and emerging markets alike, it feels like there is nowhere to hide.

One perennial investing question associated with geopolitics is how to respond to shocks, the proverbial "bolts from the blue." My firm has conducted empirical analysis of local market reactions to surprise events such as coups, assassinations, civil disruptions and natural disasters. Even for high-impact events that initially trigger material losses, we see neither evidence of continued declines over the two weeks after the occurrence nor compelling evidence of substantial reversion. In other words, the results don't suggest cutting losses or doubling down on positions following such shocks, absent an informed view on the specific circumstances.

Without compelling evidence to support a reflexive response to geopolitical events, we advocate resisting the temptation to intervene. In the heat of the moment, such decisions are likely to be based on partial and inconsistent information. Pressured decisions in the immediate aftermath of an event risk perceptual and judgmental errors, especially given the emotional charge implicit in the term "shock."

But this doesn't mean do nothing; it means be proactive. Implement a sound, systematic process as ex-ante preparation. Take a "high breadth" approach to active international investing, to contain the impact from idiosyncratic geopolitical events, and prudently size country, sector and stock-level positions. After-the-fact responses to sudden shifts in conditions may disrupt alpha capture, create churn and costs, and render portfolio behavior difficult to understand.

However, in specific contexts, intervention might be justified — if, for example, an investor has access to material event-specific information. Other valid motivations might include circumstances in which the total risk associated with a foreseeable event exceeds tolerance levels, or where there is potential confusion between alpha and an appropriate market response to a specific stimulus. Even then, however, the intervention should reflect a measured and deliberate trade-off between risk reduction vs. alpha and costs. This underscores the value of a quantitative approach to portfolio construction and implementation.

In addition to the evergreen topic of shocks, a growing geopolitical concern for today's markets is escalating systemic uncertainty. This has manifested in a series of unsettling circumstances, including Brexit, tumultuous elections in the U.S. and elsewhere, and international disputes over territory and trade. More nebulous but no less significant, the potential for competitive nationalistic behavior, rhetorical threats to economic policymaking institutions, and the deterioration of longstanding international relationships are calling into question the stability of a geopolitical environment long taken for granted by generations of investment professionals.

Despite the geopolitical uncertainty, many global equity markets have remained calm. During 2017, for example, U.S. equities were notably subdued, generating some of the lowest levels of volatility observed over the past 100 years. While that response, or lack thereof, is understandable given the relatively benign economic conditions, macroeconomic stability might be blinding us to other forms of uncertainty. This phenomenon is known as risk neglect.

There is good reason to question whether investors are equipped to accurately factor in the full range of potential outcomes associated with complex and abstract aspects of the current geopolitical climate. Behavioral science suggests we are likely to overextrapolate past favorable economic fundamentals into the future, and underweight the risk of negative geopolitical developments outside the scope of our personal experience. This is exacerbated by the pressure on institutional investors to meet high absolute-return targets, while disclosure requirements encourage a backward-looking gravitation toward strategies that have been successful in the past. But if economic conditions soften or markedly deteriorate, uncertainty over geopolitics, policy and macroeconomics might reinforce each other.

Against this backdrop, investors would be prudent to inspect their portfolios for hidden vulnerabilities that infiltrate when economic risk does not fully express itself. In the context of the past few years, one example would be concentration. While investors ought to be embracing diversification in location, markets and returns drivers, there has been temptation to abandon diversification by chasing trendy outperformers (e.g., large-cap tech) and shunning underperformers (e.g., emerging markets).

A second concern would be inadvertent overallocation to downside risk via private markets, where discretionary accounting practices reduce reported return volatility and drawdowns, masking the economic characteristics of these investments. Finally, in a climate hallmarked by intense pressure to reduce fees, investors ought to be wary of active implementations that sacrifice risk management sophistication. The vulnerabilities of so-called smart beta approaches, for example, may not clearly manifest themselves in quiet markets. Oversimplification tends to have hidden costs and risks that may well manifest if conditions change.

While geopolitical risk and systematic uncertainty poses many challenges, the growth of alternative data is allowing for progress. Text processing, for example, is fostering the development of event databases that permit meaningful statistical analysis and measurement of nebulous concepts like "uncertainty." The alignment of need and new tools makes the management of geopolitical risk fertile ground for progress and highlights an exciting current frontier of quantitative investing.

Seth Weingram is senior vice president and director at Acadian Asset Management LLC, Boston. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.