INVESTMENTS

Is the greatest threat to economic prosperity the ill-conceived action of a politician ? Perhaps , but an intimate relationship between politics and economics has endured throughout history . The effects of political activity on economic performance can be seen as far back as ancient Rome . 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 , is there a silver lining ? Modern economies are just as beholden to political uncertainty as the ancient ones were , as we have seen recently with the war in Ukraine . Other near-term examples include the slide in Turkish lira last year due to the rise of domestic populism , or the fall in Greek assets during the 2015 bailout negotiations . The question investors must ask is how they can protect themselves from the ire in financial markets when politics is at play . Protecting portfolios from political fallout is difficult because politics is very unpredictable . These are , by definition , idiosyncratic risks and attempting to anticipate them is almost 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 managers who claim to invest globally often tilt their portfolio towards their domestic market , often motivated by a perceived advantage of familiarity . 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 , trade wars or gulf wars , 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 was a perfect example . The question is , how should this knowledge be reflected in portfolios ? One option is to identify political events . In the case of elections , investors could guess the outcome and speculate accordingly . However , this relies on the consistent , accurate prophecy of political outcomes - something easier said than done . More sophisticated investors may adopt a different approach . They focus on identifying opportunities which entail asymmetric risk i . e . trades with large upsides but limited downside . For example , before the Brexit vote in the UK , there were two possible outcomes : the UK would vote to stay in the EU and sterling would remain flat , or the UK would vote to leave , in which case the value of sterling would ( and did ) enter freefall . This is a perfect example of asymmetric risk . The potential downside of implementing a currency hedge was almost zero , while the upside was very attractive . It is through identifying and implementing strategies such as these that active currency management can really add value . Political events causing market turbulence are an interminable fact of life . Fortunately , investors have two powerful tools to add resilience to their portfolios : diversification and currency hedging . 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 positive returns . By combining these techniques portfolio managers are able to insulate investors from the vast majority of political crises .

Important Information

For Professional Clients only and should not be distributed to or relied upon by Retail Clients .

The material contained herein is for marketing purposes and is for your information only . This document is not contractually binding nor are we required to provide this to you by any legislative provision . It does not constitute legal , tax or investment advice or a recommendation to any reader of this material to buy or sell investments . You must not , therefore , rely on the content of this document when making any investment decisions . The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested .

Approved for issue in the UK by HSBC Global Asset Management ( UK ) Limited , who are authorised and regulated by the Financial Conduct Authority .

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The Adviser Issue 5 | Page 39