As the World Fractures, Asset Allocators Are Doing... Nothing. Are They Insane?

Illustration by Justin Poulsen

Illustration by Justin Poulsen

A peek inside the psyche of today’s most important investors.

The two largest economies in the world are at each other’s throats. Natural disasters vie for attention with nuclear threats. Social media posts drive market movements.

And, somehow, Brexit is still happening.

Geopolitical advisory firm Eurasia Group has described the current global environment as “the most dangerous it’s been in decades.”

And BlackRock’s geopolitical risk indicator — tracking what the giant asset management firm views as the ten biggest risks to portfolios — has spiked to levels not seen since the heights of the European debt crisis.

Investors certainly seem worried about the possible dangers to their portfolios: Out of the 500 pensions, insurance firms, sovereign funds, endowments, and foundations surveyed by Natixis Investment Managers last fall, 77 percent predicted that geopolitical events would have a negative impact on portfolio performance this year.

Corporate defined-benefit-plan sponsors polled last year by consulting firm NEPC similarly cited political risks and geopolitical tensions as the top threats their portfolios face. Such risks also ranked as the biggest concern in a survey of 100 allocators by Murano Connect in late 2018 — as they did in a poll of 450 institutional allocators in attendance at the Context Summits conference earlier this year.

Asset owners — the investors responsible for trillions of dollars in retirement funds, charitable assets, insurance money, and the like — continually contend with geopolitical risks, according to Sanjay Chawla, chief investment officer at FM Global. As the steward of the property insurer’s $17 billion investment portfolio, Chawla says it’s his job to be prudent and manage the portfolio with a long-term perspective. That includes staying informed about geopolitical events.

It doesn’t necessarily include doing anything about them.

“We don’t see much action from our clients — and we wouldn’t encourage it,” says Phil Nelson, director of asset allocation at NEPC.

The Boston-based consulting firm is not alone in this stance on geopolitics. Russ Ivinjack, a senior partner at Aon, notes that he and his colleagues routinely advise allocators not to react to geopolitical events by changing their portfolios. Jay Kloepfer, director of capital markets research at Callan, similarly recommends that asset owners don’t stray from their strategic asset allocation plans.

Call it long-termism, or blame it on the time it takes to get the necessary board approval for investment actions. For a number of reasons, institutional allocators and the investment consultants who advise them largely believe that when dealing with geopolitical uncertainty, often the best course of action is to stay the course.

“Part and parcel of setting up strategic asset allocation is making sure you’re able to handle the ups and downs,” Kloepfer notes. “You expect there to be geopolitical upheaval that affects markets. You build a diversified portfolio, and you try not to react.”

At FM Global, for instance, Chawla says he avoids “knee-jerk” reactions to short-term price movements, instead focusing on being prepared by assessing the longer-term impacts of global events, such as which markets are most likely to benefit — or suffer — in the event of increased trade restrictions, or how the geopolitical environment could affect monetary policy.

“As investment decision makers, we have to be mindful and we have to be watchful of things that can drive markets in one direction or another,” he says. “But it can be very hard to predict which way things will go. You have to make long-term, thoughtful decisions.”

Some geopolitical events might cause markets to react sharply and spike or slide based on the latest headlines. But according to NEPC, most of these are one-off incidents — temporary storms that a well-designed portfolio can weather. A surprise election result, for example, might spur a sudden sell-off in equities — but, as Nelson points out, even the Brexit referendum only sent markets into a brief tailspin before U.K. stocks climbed back up to record heights.

“Often the stock market reacts to headline news events and the market sells off disproportionately compared to the actual impact,” Nelson says. “Let the markets overreact. Our starting bias is to say, Take no action.”

The contrarian argument, as put forth by Kloepfer, is that when there’s upheaval, there’s opportunity.

“Not that a plan sponsor would be able to take advantage of it,” he adds.

The Callan consultant notes that he hasn’t observed much propensity among plan sponsors to engage in tactical behavior on their own. And for good reason: As Ivinjack points out, governance structures — among other obstacles — limit asset owners’ ability to make effective tactical moves.

“Most institutional investors — if they’re like a pension fund or endowment or foundation and they have a committee or board — they’re not going to be capable of executing any type of actions based on what’s going on geopolitically,” the Aon consultant notes.

Asset managers, on the other hand, are equipped to react quickly to market-moving events if necessary. By investing with active managers, allocators are effectively able to delegate the responsibility for navigating geopolitical risks.

Especially in emerging markets, Ivinjack says, allocators rely on their external managers to evaluate geopolitical risks and make tactical moves on their behalf. “If something’s going on in Brazil, for example, they expect the manager to express a view positively or negatively,” he explains.

According to Kloepfer, Callan encourages clients who are concerned about volatility, geopolitical or otherwise, to hire managers that will invest in a way that’s thematic or risk-aware. Still, a “substantial portion” of client investments in U.S. public equities are in indexes — and passive is also “fairly well represented” in fixed-income.

“The irony as geopolitical risk becomes more in the forefront is that many investors are not hiring advisers who can be tactical on their behalf,” Kloepfer says.

Instead, they are going passive — and giving up that ability to respond to geopolitics.

Yet one specific geopolitical risk may ultimately require a response.

For all the geopolitical events that allocators deemed prudent to ignore, there’s at least one ongoing conflict that is demanding attention: the escalating trade tensions between the U.S. and the rest of the world.

Most other risks tracked by BlackRock’s geopolitical risk dashboard aren’t projected to be particularly dangerous to portfolios. Plotted on an x-axis measuring their potential impact on global equities, these hover near the left side of the chart, marked for low impact.

The possibility of a full-blown trade war, on the other hand, is so far along the x-axis that its projected impact on global equity markets is literally off the charts.

“When we look at U.S. action pivoting away from the free-trade orthodoxy — that has the potential to have real destructive effects on the global economy,” Nelson says.

The NEPC consultant says this “clear tail risk for most equity markets” has caused his firm to dial back its overweight position on emerging markets — an asset class where the consultants would otherwise be “extremely bullish.”

But with so much uncertainty remaining on trade policy, Brexit, and all the rest, Nelson says many of NEPC’s clients are left in a position that can be best described as “wait and see.”

Maybe the U.S. and China will broker a deal.

Maybe @realDonaldTrump will fire off another tweet that sends markets plummeting.

Maybe some other simmering geopolitical tensions will escalate into full-blown conflict.

“Most people would agree that there’s events that are unpredictable or just unactionable,” Nelson says. “That’s part of life — there’s really no way to avoid them.”