It’s also important to know how to read politicians. This should not be too difficult for asset managers – once they have engaged their critical faculties. “They are used to listening to economists telling them how the world should look – politicians are no different,” Bathgate quips. But while managers should improve their ability to assess political risk, they need to be aware that their ability to forecast will always be limited. Banks says: “Even the best forecasters can only show improved ability to forecast over a six to 12 month period. It was nearly impossible to improve the ability to forecast political risk more than a year into the future, however. “Beyond that it is similar to flipping a coin in terms of accuracy,” he adds. While it will always be impossible to make accurate predictions, asset managers can dramatically improve their political augury skills by actively engaging in political debate, talking to a wide group of political commentators and journalists and guarding against their own particular bias.
Experience also plays an important role. Bathgate says: “Assessing political risk is like any other skill – over time you learn how data should be interpreted and how to read certain situations.” It is similar to assessing the behavioural biases of financial markets, he adds.
Banks agrees: “While it might be impossible to tell what will happen, managers need to assess the implications of different outcomes and the impact on their portfolio, being adaptive to markets.” Managers failed to do this at the time of the referendum. “The majority expected Remain to prevail,” he adds.
But assessing possible outcomes means doing more than carrying out stochastic analysis of a portfolio. Banks says: “The problem with this type of risk assessment is that it is usually based on historic data and cannot take account of a geopolitical event overriding all other factors.” While some managers have successfully incorporated this qualitative skill successfully into their investment process, it is a minority pursuit.
There are multiple reasons why an accurate assessment of political risk has been such a low priority for many managers.
The first is a practical one – for many decades political risk has not been an important factor for most developed market managers. A long period of political stability meant that many managers could rely on a fundamental assessment of macroeconomic and company data in order to produce outperformance – there was simply no need to develop this skill.
Recruitment policies among asset managers have also played a role. Bathgate says: “In the past, graduates would work as an apprentice to a fund manager for two to three years.” Graduates in history, law and psychology would be hired even though they had no financial market knowledge because they would learn it on the job.
“But graduate recruitment has now become a management science carried out by professional HR departments,” Bathgate says. Now economists, mathematicians and physicists are more likely to be hired.
“This places a great emphasis on individuals with highly rational and analytical brains while individuals with greater insight into human behaviour are less well represented,” Bathgate says.
It’s likely that the underrepresentation of women in the asset management industry also plays a role. Bathgate says: “One area of the asset management industry where there are many successful women is among fund allocators.”
The job of a fund allocator is to meet with a huge number of different individuals and determine which team will most likely outperform. “In other words, a fund allocator needs to be able to read people well and accurately assess their skills and personality,” Bathgate says.
A greater diversity of personality traits might also be important along with graduate and gender diversity.
“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,” Banks says. Without this character trait, fund managers would not be able to stick to their positions for long enough to be proved correct.
Yet the more successful forecasters are those who have a flexible world view and will change their mind when new data is presented, says Banks. “This is a completely different view of the world to most active managers.”
If an asset manager wants to get better at analysing political risk, they need to attack the problem from multiple angles. Bathgate says: “The first step would be to make this priority and assign sufficient resources both from a budgetary and human resources perspective.”
Many managers may have no choice but to start devoting greater resources to political analysis over both the short to medium term.
The Trump presidency looks increasingly unstable and the outlook for Brexit remains uncertain. Over the longer term, populism in Europe is in remission rather than facing extinction. And emerging market managers would do well to improve their ability at country selection.
