Geopolitical Risk in Portfolio Management

financial investment 2024-01-27 11 Comment

Geopolitical Risk in Portfolio Management

By Lauren Goodwin, CFA Posted In: Drivers of Value, Economics, History & Geopolitics, Performance Measurement & Evaluation, Portfolio Management, Risk Management

Geopolitical risk has always been an important investment concern. The question for asset managers today is not whether these risks are a force for volatility, but whether that force is relevant for portfolio decisions.

In some cases, the answer is an unambiguous yes. Agile, risk-tolerant portfolios can take advantage of shifts — temporary or structural — brought on by geopolitical risk. By monitoring dislocations and applying geopolitical risk analysis, these managers can cushion the blow of adverse events and enhance upside growth potential, generating alpha.

For other investors, however, geopolitical risk discussions drain resources without delivering any tangible benefit.

Geopolitical risk plays an important role in our asset allocation decisions on New York Life’s Multi-Asset Solutions team, and we’ve identified a few helpful methods for integrating it into the investment process.

Set the risk management goal.

Does geopolitical risk matter for your portfolio management team? It sounds like a simple question, yet nearly all teams struggle with the tradeoff between resource allocation and alpha generation. It’s not about the possibility of impact, which is a given, but whether preparing for it is worth your team’s resources. Will your analysis lead to meaningful improvement in results?

For some funds, particularly those with top-down portfolio management approaches, again the answer is yes. Other firms focus on applications tangential to the portfolio management process: marketing, sales, networking, and executive support, for example. While these pursuits are legitimate, they warrant different levels of effort from your team.

As you weigh the importance of geopolitical risk analysis, focus only on what directly contributes to your investment goals.

Consider your quantitative focus.

The increasing complexity of investment management has led to the development of sophisticated, often quant-driven risk management techniques. Geopolitical risk can be — but is not always — served by these tools. Accurate and timely data is lacking for many countries, and major shifts rarely develop as anticipated, which can make quantitative signposting both arduous and unrewarding.

As you build and resource your geopolitical risk management operations, balance quantitative and qualitative methods. Even the most sophisticated quant funds use thematic overlays for tracking geopolitical developments. Sometimes simple qualitative scenarios, enhanced by quantitative measurement and pressure-testing, are the best tools for your objectives.

Build and resource a process.

Once you have decided whether to incorporate geopolitical risk awareness into your process, focus on how you do that. Your approach doesn’t have to be complicated, but it must be structured and consistent.

Start with setting clear expectations and responsibilities. For some funds, an all-in focus on external threats may be appropriate. For others, such an approach would spread analysts too thin. Clear roles minimize wasted time and distractions.

It is possible — even likely — that geopolitical risks demand more attention than your team can manage. If that’s the case, acknowledge the mismatch. Differentiate “must-have” from “nice-to-have” analysis. Consider your internal strengths and lean on external research inputs where you do not have comparative advantage.

What does a successful process look like?

There is no one-size-fits-all approach to managing geopolitical risk, but there are tactics to help you work smarter — not harder — and keep your team focused.

Priorities: More headlines do not always mean more risk. Prioritize your risks using clear criteria. Best practice suggests assessing at least “likelihood” and “impact.” The more likely and meaningful a risk, the more bandwidth it deserves. Actionability is an important consideration as well: Can you do anything if the risk turns into reality? And what about optics? Can you ignore something, or will that appear negligent? The speed with which you can address a potential risk is another influence.

Scenarios: Developing scenarios and signposts can help focus your process. Geopolitical risks seldom evolve in a linear fashion, making them difficult to monitor and assess. Scenario planning can help mitigate risks, capture opportunities, and otherwise strengthen your risk management process.

Scenarios can take the form of qualitative analysis, quantitative measurement, or both. A simple framework for qualitative scenario building begins with a base-case assessment of the most likely outcome. From there, you can consider alternative futures, with a focus on what constitutes a change in key risks.

Signposts: How can you tell if risk is rising or falling? Then what? Signposts are useful metrics to track how your top risks may develop. Good signposts are based on the assumptions you’ve made upfront about the scenario and help determine whether a risk is materializing. Consider qualitative signposts like events or statements as well as quantitative ones based on financial or economic data. Share them across your team. If a signpost is triggered, have your team determine what it means for your portfolio. If signposts are quantified and automated, ensure your traders know the next steps.

Focus on policy, not politics: Identifying the right signposts takes some trial and error. One way to separate signal from noise is to distinguish politics from policy. Political developments can indicate changes in the risk’s likelihood or speed of evolution, but analysts can be knocked off course by following politics too closely. Focus on real economic or business outcomes.

Beware the armchair executive.

Over-participation by leadership in geopolitical risk discussions can create a drag on resources, especially given the expansive nature of these conversations. Executives present ideas or headline risks to stoke creativity or comprehensive analysis, but the fire drills this creates can derail an otherwise well-structured methodology.

Good executive buy-in throughout the process helps to allocate everyone’s time more effectively. Keep your leadership informed of priority risks so they can channel their impulses and effectively pressure-test your team’s thinking.

Mitigate risks, capitalize on opportunities.

An effective approach illuminates risks and opportunities amid uncertainty, but process can only take you so far. When the time comes, you must act on the intelligence you have. Risk response can be stressful and impede creativity at the moment when it is needed most.

Translate strong planning into strong execution. At the end of the day, you are balancing not only risk and reward, but also effort and reward. Teams that manage this balance well will be better prepared to protect against — and take advantage of — geopolitical risk.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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