Is the greatest threat to economic prosperity the ill-conceived action of a politician? Perhaps, but an intimate relationship between politics and economics has certainly endured throughout history.
The effects of political policy on economic performance can be seen as far back as ancient Rome: an economic powerhouse destroyed by political hubris and the pursuit of hegemony. The question investors must ask is: how can they protect themselves from the ire in financial markets when politics is at play, and more importantly, can they profit from such events?
Political events causing market turbulence is an interminable fact of life. Fortunately, we believe that investors have two very effective tools to face political risks: geographic diversification and currency management. The problem is, many investors are either unable or unwilling to use them.
A truly geographically diverse portfolio, without a home bias, will limit investor exposure to unpredictable and idiosyncratic political events. On the other hand, active currency management can be used to identify asymmetric risks and generate impressive returns. By combining these techniques portfolio managers are able to insulate investors from the vast majority of political crises.
The unpredictability of politics makes protecting portfolios from political fallout difficult. These are, by definition, idiosyncratic risks and attempting to anticipate them is futile. Fortunately, the academic literature could not be clearer on the appropriate way to deal with idiosyncratic risks: diversify.
In the majority of cases the impact of political events on investment performance is highly localised; only affecting the returns of specific asset classes in specific countries. Political risks are therefore managed most effectively by constructing portfolios that are truly globally diversified rather than having a regional focus.
Even those who claim to invest globally often tilt their portfolio towards their domestic market, typically motivated by a perceived advantage of familiarity. In 2019 the average allocation to UK equity in the IA Mixed Investment 20-60% sector was 17.8%, but the UK represents just 5.8% of the MSCI All Countries World index. This increases portfolio concentration, reduces diversity and ramps up exposure to domestic political risks.
We advocate against having a home bias, and suggest instead creating portfolios with a truly global exposure. Whether it is Brexit or Grexit, commodity crashes or currency crises, global diversification is key to mitigating political risk.
Although most political events can't be anticipated, some have long lead times, allowing investors to prepare for them directly. Britain leaving the European Union is a perfect example; all investors know the outcome of Britain's EU referendum. The question is, how should this knowledge be reflected in their portfolio positioning? Active management of currency exposures can be a powerful tool.