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Strategy

Geopolitical risk:  Predicting the unpredictable

Geopolitical risk: Predicting the unpredictable

Charlotte Moore
Tuesday 17th October 2017

With many asset managers having a poor track record of correctly predicting political outcomes, Charlotte Moore asks if they should just give up and stick to picking stocks.

"For a fund manager to be successful, they need to have a particular view of the world and the conviction to stick to this opinion."

Daniel Banks, P-Solve

For a group of individuals whose success relies on their ability to assess risk and make predictions about the future; most fund managers are surprisingly bad at analysing and predicting political events. Evidence of this shortfall is somewhat nebulous – it cannot be assessed as objectively as the performance of a particular fund. But there are various clues. The financial markets’ conviction that Remain would win despite the tightness of the polls is one such hint.

Not only do asset managers struggle to predict the outcomes of referendums and elections but they find it difficult to correctly interpret political events. For example, many managers’ were convinced that a Trump presidency would be productive rather than chaotic, even though he has no political acumen.

While much of the evidence is anecdotal, there is also some concrete evidence. P-Solve recently looked at emerging market equity managers’ ability to select stock, sectors and countries.

P-Solve director Daniel Banks says: “We found that while managers were pretty good at selecting both stocks and sectors, their ability to predict which country would outperform was usually very poor. This is of particular importance in emerging markets, as country selection drives almost all returns.

Banks says: “The irony is that most were focusing on bottom-up stock selection yet the most important decision – the country selection – was happening by accident rather than design.”

It’s easy to explain why emerging market fund managers focus solely on individual companies and sectors: if predicting geopolitical outcomes is hard and it’s very easy to get it wrong, then the simpler option is to not bother.

Tapan Datta, head of asset allocation at Aon Hewitt, says: “The instinct to not even try to get a handle on, for example, the risks associated with Brexit are understandable.” When the outlook is that uncertain, it’s basic human behaviour to choose not to think about it and instead to pretend it’s not a factor.

But this the wrong approach to the problem. Datta says: “When issues are truly uncertain and it’s impossible to predict the probability of it occurring with any great accuracy, they should command more, not less, of a manager’s attention.”

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