“Brexit,” Hedge Funds and Political Risk
The extent to which almost everyone bet incorrectly that the “Remain” camp would prevail in a referendum vote has underscored the need for disciplined and independent political risk analysis when constructing portfolios and trading in today’s global markets.
To be sure, the victory of the “Leave” camp was hardly overwhelming, and it was reasonable to assume that even a large number of voters who were skeptical on the question of European integration might decide that the risks (many of them unknown) associated with Brexit were just too great to take the chance. But while the expectation of a “Remain” victory was not completely unfounded, many analysts failed to seriously consider what a vote to withdraw from the EU would mean until it had happened, and in the rush to address that omission, there has been a tendency to overstate both the severity and the immediacy of the risks associated with Brexit.
The Brexit vote is clearly a major event. The negotiations to follow will substantively alter the UK’s economic relationship with the EU, and perhaps other trade and investment partners, in significant and lasting ways. In addition, the UK’s decision to leave the EU is already generating popular pressure within other member countries to hold similar votes, which is presumably one of the reasons that several EU ministers have called on the UK to quickly invoke Article 50 of the Lisbon Treaty (the mechanism by which exit negotiations are triggered) and get on with the process.
But is the victory of the “Leave” camp a calamitous event that should be feared by hedge fund managers? Cautiously, no. The decision by the voting majority to leave the EU cannot be compared to a major terrorist attack or a surprise military incursion, which, to most, is sudden, largely unexpected and, most importantly, difficult to harness in the short- to medium-term by various competing interests in the hope of achieving desired outcomes.
Generally, the negotiations that will follow – like almost all trade and customs negotiations – will be slow, somewhat methodical, hopefully transparent, and be cognizant of various political forces shaping the agenda of elected officials and their negotiators. That negotiations will likely not commence in earnest until a new Tory leader is chosen – and given that the next UK election is not until 2020 – will lend some stability to the process.
But this is not to say the risks facing the EU are not important: Tensions among EU members, driven by policy concerns such as refugees and debt, will not ease anytime soon. The potential for additional secessionist movements obviously cannot be ruled out. There is also the possibility of European voters electing new governments with similar EU ‘exit’ stratagems for their country. France and the Netherlands are the most obvious ones at this point.
Interestingly, as it affects the US, some – perhaps not completely unfounded – fear a similar unexpected outcome with a Trump election victory despite most polls showing Clinton ahead of her billionaire rival. The concern here is that, despite so much of Trump’s policy agenda being unclear at this point in time, American voters will nonetheless vote emotionally (thus rejecting the ‘establishment’) and put into office a person untested in politics and potentially prone to extreme policy choices.
As political risk therefore plays an increasingly significant role in a globalized investment world, what should hedge fund managers do?
First and foremost, political risk in its various forms must be accepted as a reality in today’s investment landscape, made more acute by sluggish economic growth, high levels of indebtedness and joblessness, and rising expectations fueled by the power of social media.
Second, correlations must be drawn between the various forms of political risk and asset behavior and tactical positioning in portfolios drawn so the full effects of diversification are realized.
On this latter point, there is a fairly longstanding history in academe and in the research work of some multilaterals (e.g., the IMF), dating to at least the early 1990s, where causal and predictive relationships between the various metrics of political and country risk and asset classes have been drawn, especially emerging markets. It would well serve more hedge fund managers to be aware of this body of work and exploit it accordingly.
Looking ahead, political risk analysis must be less intuitive and “opinionated,” more disciplined and quant-driven, independent (viz., free of bias), and focus on a full range of country risks (viz., political, economic, and financial) since they tend to work in tandem.
Proper country risks should include quasi-Type 2 errors (essentially worst case and best case outcomes over the short- and medium-term), and make clear the probability of different regimes coming to power and the kinds of risks they pose to investors and business, from (discriminatory) taxation, to local content requirements (favoring domestic firms over foreign enterprises), to equity limitations on foreign firms, as well as the probability of new tariffs being put into place and various conditions (e.g., payment delays) imposed.
Political risk rating and forecasting firms, such as The PRS Group, are largely quant-driven in their approach. The firm’s institutional investor clients use the firm’s data to run rather sophisticated econometric models to construct their global portfolios, while PRS’ multinational clients also take advantage of the firm’s approach to political risk to develop correlations between political risk and other important metrics (such as the price of oil and budget deficits), as part of their strategic planning process. Academics and the IMF have long used PRS’ data to shed light on various economic phenomena.
That the impact of political risk on various asset classes has only been exploited fully by a select number of hedge fund managers is unfortunate. Funds with various approaches from global macro to event-driven (to name a few) could all benefit from understanding and exploiting political risk as yet another another factor shaping the pricing of assets in their portfolios.
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