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Portfolio Theory – Topic Analysis

Master in Wealth Management, Luxembourg School of Finance, 2016-2017

Topic :

Portfolio Management under Political Risk with Case Study of Brexit

Student Name：Li-Kuan FANG

Abstract： Why political risk matters?

We talk about volatility in economics and in markets, but we should expect the same in politics. In the past few years, the Greek crisis, the Ukraine conflict, the migration crisis, the rise of terrorism as examples of significant economic events which were arguably largely driven by political factors.

In the case of the Greek crisis, it had an economic background, but what changed in 2015 was a political development：the election of a radical, alternative government which led to six months of drama surrounding the country.

In 2016, UK referendum (Brexit) and US election were also big surprises and still deeply influence the global financial market over each asset class to nowadays. News reports them all the time and markets up and down along with it. Obviously, political risk matters.

Academically, we built a world under normal distribution, but the reality is fat tail risks happens more often than what we expected. The most frequent fat tail risk could be the political events. I want to figure out a sort of principles to handle with political risk.

In this report, first, I want to use the theories and models that I have learnt in the Portfolio Theory lecture to identify what is the role of political risk. Additionally, I will try to build up quick steps to deal with political risk. Then, I will analyze a case from the perspectives of the steps I built as I am a portfolio manager facing it. Here, let me define political risk as a collective noun of political risk itself, country risk and geopolitical risk.

The Way Political Risk Fails Models Single-Index Model Fails Political risk might zoom up the residuals of the basic Single Index Model equation, which could make Single Index Model to be inefficient.

Formula：Expected Return Obtained by Single Index Model

,

＝ ＋ × ＋

ℎ ℎ ℎ .

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Following the above equation and taking political risk into account, the residual term could be statistically significant, which makes this model fail to calculate the expected return of security i. Eventually, the Multi-Index Model must be applied, which increase the complexity of the estimation of expected return. Facing political risk, if one insists using Single Index Model, what can be expected is losing accuracy of expectation.

Efficient Frontier No More Efficient Political risks also increase volatilities of securities but not necessarily increase the expected returns, which means the distribution of portfolios could be potentially right skewed. Furthermore, we use historical data to calculate volatilities of securities, and find out the efficient frontier by putting the volatilities and expected returns together in a scatter chart, like the chart1 below. But, surprising political events increase the volatilities, which move efficient frontier toward the right side (toward Efficient Frontier 2). Simply, for obtaining one unit of expected return, a portfolio would have to bare more risk than the past. The slope of Capital Market Line (CML), therefore, goes flatter (toward CML2), which means the Sharpe ratio of the portfolio that a financial advisor suggested to a client could be potentially wrong.

Chart：Political Risk Damages Efficient Frontier and Capital Market Line

(Explanation：Efficient frontier shifts from efficient frontier 1 toward the right to efficient frontier 2, and the capital market line flattens from CML 1 to CML 2 by taking potential political risk into account.)

Correlation Increases Meanwhile, political risk might increase the correlation among stock markets, e.g. before and after 2016 US presidency election result revealed, global stock markets moves by the same direction. Despite of this phenomenon didn’t last long, it still might hurt investor’s confidence of diversification strategy and, eventually, investors will go to conservative strategy which could drain the capital market and increasing transaction cost.

1 This chart is borrowed from http://toolsformoney.com/portfolio_optimization.htm, the figures in this chart are irrelevant with this topic.

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Chart：FTSE 100, CAC 40, DAX and S&P 500 Moved by the Same Direction around 2016 US Presidency Election (11/01/2016~11/09/2016)

Source: Bloomberg (Explanation：pink line is S&P500, golden line is CAC 40, green line is DAX and white line is FTSE 100. Y axis represents accumulated rate of return during the period. The rates, from top to the bottom, of each line are 2.44%, 1.64%, 1.14 and -0.08%. X axis is the period which is 11/01/2016-11/09/2016.)

FX Risk Increases, Hedging Cost Increases “Brexit” made pound depreciated tremendously, US 2016 presidency election made us dollar appreciate hugely, and Russia invaded Ukraine caused financial sanction made its currency depreciated like water fall. It seems political risk comes with FX risk. So, for avoiding political risk, FX hedging should be a must. But, from the perspective of long term investment, constant FX hedging activity could terribly increase transaction cost which probably is not a good thing.

How to Estimate Political Risk Top-Down Approach Macro-political risk is increasing as a result of structural shifts in the international balance of political and economic power. It is a circumstance on top of all asset categories. Therefore, a top-down approach, incorporating systematic measurement (if any) of political risk, should be able to potentially deliver better results than traditional bottom up processes.

Constantly Re-assessing Process Nowadays, the populism is getting wild spread, which would potentially make political environment more volatile, or more irrational. This development is heralding a heightened state of geopolitical tension and risk, which affects the determined value of portfolios. Nevertheless, investors or portfolio managers have to constantly re-assess the political risks they face.

Political Risk Rankings Country-Wise We can rank nations by expected returns based on the outlook for political stability over a certain period (e.g. six months). The ranking indicates the relative level of fat tail risk and potential volatility shift. A portfolio manager or advisor, therefore, can fit her/his suggestion in clients’ risk aversion and loss aversion by the indication.

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Some experts provide political risk and country risk assessment service by scoring or ranking it. For example, the PRS Group publishes the Political Risk Index (PRI) Table2 produced semi-annually of the selected countries and ranked from low to high risk within each region listed.

Table：The Political Risk Index Table by PRS Group (Higher number, lower politic risk.)

Source：The PRS Group web site, 22/12/2016

Identifying the Noise Identifying noise and what really matters could be the hardest part of assessing political risk. Regardless what matters, the frequency of political events is significantly and obviously higher than financial crisis or natural disasters. But just like earthquakes, not each one gives strong impact. If portfolio managers and clients don’t want to live in nervous, identifying the significance of a political event should be one of the important step. Focusing on analyzing long term impact could help.

FX Risk V.S. Stock Market Risk A Stock market is supported by fundamental factors, and, therefore, short term political event could be absorbed easier by stock markets. But FX market is driven by events. On the other hand, political risk influences FX market deeper than it does on stock market. Dealing with political risk should pay more attention on FX market.

How to manage political risk ---- Case Study：Brexit It was 23rd June 2016, the decision made by the British people to leave the European Union in the referendum has caused shock in the U.K., Europe and around the world, adding huge uncertainty to the financial markets and the business community. How could a portfolio

2The PRI is the overall measure of risk for a given country, calculated by using all 17 risk components from the PRS

Methodology including turmoil, financial transfer, direct investment, and export markets. The Index provides a basic, convenient way to compare countries directly, as well as demonstrating changes over the past five years. For more details, https://www.prsgroup.com/category/risk-index

Year 2015 2014 2013 2012 2011

Country/AreaN. & Cent. America Avg. 75 74 73 73 72

Canada 93 93 94 93 94

United States 84 83 80 80 79

Trinidad & Tobago 83 83 80 82 83

Mexico 80 80 79 75 74

Panama 78 77 77 77 76

Costa Rica 77 77 76 77 74

Jamaica 76 76 71 70 68

Nicaragua 74 74 71 70 72

El Salvador 71 70 73 72 73

Guatemala 71 69 69 70 71

Dominican Republic 70 70 68 68 66

Honduras 69 69 68 69 70

Haiti 65 65 63 62 62

Cuba 56 52 49 50 49

Index

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manager do it right when facing such a huge political risk is the reason why I want to study this case.

Market Reactions: FTSE 100 Index and GBP Almost one month before the referendum day, 23rd June 2016, the representative index of UK, FTSE 100, started to reflect investors’ emotions of this political risk. During the whole month of June 2016, the index started to go up and down crazily following the public opinion survey.

Once the survey showed positive result, market went up, vis versa. For example, from 6/1 to 6/14, the index dropped 4.33%, but from 6/14 to 6/23, the index went up 7%. After the official result released, from 6/23 to 6/27, the index went down 5.62%, and from 6/27 to 6/30, the index went up hugely again by 8.73%. Despite the result seems bad for UK’s long term economic development, but overall, in June 2016, the index went up 5.05% and kept the uptrend well till now (12/20/2016).

Chart: FTSE 100 Index (5/5/2016~6/30/2016)

Source: Bloomberg

Chart: FTSE 100 Index (5/5/2016~12/20/2016)

Source: Bloomberg

The FX market (pound) reacted much negatively than the stock market did. At the beginning, the pound went up and down along with the momentum of stock market before the referendum, but since 6/24, just one day after the referendum day, pound depreciated dramatically than usual and kept the downtrend since then, which totally opposite against the uptrend of the stock market.

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Chart: GBP/USD (5/5/2016~12/20/2016)

Source: Bloomberg

If I Was the Portfolio Manager…. Following what I have written in previous two segments, if I am a portfolio manager in the future and facing this kind of risk of Brexit, I will create a time horizon based scenario analysis of the change of macro economy power of the country by top-down approach and focus on its long term impact. Then, constantly re-assess the scenarios.

Meanwhile, it is impossible for a portfolio manager to constantly fly far away for observing local circumstances. So, it is necessary to ask for consultancy of political risk ranking service. Focusing on the worst scenarios, I will assess what will happen in different time horizon, and try not to get into the trap of short term momentum for avoiding noises, but it might be appropriate to do some short term country wise hedging.

Talking about hedging, FX hedging could be more important than stock market hedging from the perspective of political risk. Based on what I have learnt from the lecture, I would consider the currency as an asset. If I identified the political risk event will cause significant long term impact, I will re-allocate part of my portfolio to different currency based asset instead of doing long term FX hedging.

By the steps above, I can keep my portfolio in a proper volatility and an efficient allocation. And most important, keep the clients’ interests as my first priority.

What wisdoms else? Country-Specific Strategy Analyzing regional risk is more complex than it is on single country, and, in fact, in some regions, the distribution of economic growth and stock market performance are wildly divergent, which makes a regional risk assessment meaningless. Therefore, considering political risk, portfolio managers could move broad-basket investment into country-specific strategy, like country-specific funds, for effectively reducing exposure of political risk.

Loser loses Market valuations can be misleading. For instance, usually, lower earnings multiples are often buying signals, but, taking political risk into account, lower earnings multiples stay with higher political risk is not a good thing. In a higher political risk circumstance, lower earnings multiples (losers) could be even lower (keep losing). Portfolio manager should tru to dodge away markets that have constantly higher political risk, despite of very cheap valuations.

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Conclusion Political risk matters. It damages the efficiency of our portfolio and annoys investor and portfolio managers. Wrongly and immaturely analyzing political risk or dismissing it could cause incredible cost. In the case of Brexit, the UK’s stock market keeps going up, but its currency keeps depreciating oppositely. If a portfolio manager deal with it wrongly, it would also be a disaster, not just generating cost.

Mark Twin said history does not repeat itself, but it does rhythm. Learning how to live with political risk will be a demanding skill nowadays and in the future.

References Aswath, Damodaran (2015), Country Risk: Determinants, Measures and Implications-The 2015 Edition, New York University-Stern School of Business.

Georgina Hurst (2014), Investors Grapple with Emerging-Markets Political Risk, Institutional Investor.Com, December 09, 2014.

Daniel Franklin (2015), Political risks and market rewards in 2016, Schroders Investment Conference in Budapest, September 2016.

David Turner (2016), Learning to live with heightened political risk, Professional Wealth Management.Com, August 23 2016.