Geopolitical risk: Investing for the new geopolitical reality

by

15 Oct 2013

The risk landscape for investors has changed. Europe appears to be on the mend and markets are less sensitive to political developments as confidence returns in the value of the euro. The world has now shifted to a Fed-led paradigm dominated by uncertainty about when the taper will start and how soon interest rates will rise. Meanwhile, the Arab Spring continues to throw up significant global risk and inflate the oil price, creating a drag on global growth. In this new environment, volatility will prevail and likely increase across currencies, bonds and equities, which could hurt those ill prepared for its consequences.

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The risk landscape for investors has changed. Europe appears to be on the mend and markets are less sensitive to political developments as confidence returns in the value of the euro. The world has now shifted to a Fed-led paradigm dominated by uncertainty about when the taper will start and how soon interest rates will rise. Meanwhile, the Arab Spring continues to throw up significant global risk and inflate the oil price, creating a drag on global growth. In this new environment, volatility will prevail and likely increase across currencies, bonds and equities, which could hurt those ill prepared for its consequences.

Navigating the choppy times ahead is not just about protecting from volatility. Taking advantage of opportunities as they arise is also key to generating positive returns.

The need for greater adoption of more dynamic investment management is perhaps best demonstrated by the sideways movement for the FTSE 100 for the last 13 years. The index finally broke through its previous high set in early 2000 for the first time on 22 May, before heading south again. A long-term investor who bought into the FTSE 100 on 29 December 1999 and held it until 20 September 2013 would have suffered a 3.5% fall. While long-term investors can absorb some short-term volatility, it is much harder to do so over the medium term.

“It is necessary to be dynamic in portfolios,” Clarke says. “Europe fading as a concern is a case in point. In Q2 investors’ main response to the fiscal and debt situation was to shy away from risk. Now things are more relaxed and markets have appreciated. If you stayed on the side-lines, you’ve missed all the excess returns. Investors can’t respond to instability merely by never taking risk.”

Between Draghi’s pivotal speech on 26 July 2012 and 20 September, the FTSE Eurofirst 300 rose just over 21%.

More institutions are looking at ways to increase their dynamic abilities, whether through delegating to a fiduciary where decisions can be made more quickly, or through implementing new processes at the fund level.

The Merseyside Pension Fund, for example, is currently reviewing the possibility of appointing a transition manager to implement a derivatives-based tactical overlay to the strategic asset allocation. In the past the fund has struggled in its target to produce outperformance through tactical or medium- term asset allocation from its strategic benchmark. The poor performance in this regard has been attributed to the fund not being able to quickly move back to benchmark weightings given the difficulties of moving assets between managers to implement asset allocation changes, which it says is almost impossible for illiquid assets. The solution proposed at the Wirral Council’s June pensions committee meeting was to appoint an overlay manager to use derivatives to enable the fund to either return more quickly to its strategic benchmarks or to implement a deliberate medium-term active position.

Volatility will be a significant factor in most asset classes over the medium to long term. Even long-term investors need to consider a more dynamic approach to portfolio management across the whole range of asset classes. Once tapering is announced the road will get more bumpy and the Arab Spring will add to the hurdles investors must grapple with.

As the geopolitical sands continue to shift and change, protecting portfolios from losses and taking advantage of short-term opportunities will be increasingly essential to long-term success.

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