This content is from: Portfolio

Developed-Market Investing with Emerging-Market Risk

Political volatility has long been a risk when investing in emerging markets. Now, experts say, it’s a concern for the developed world as well.

When putting money to work in emerging and frontier markets, investors have always had to assess the risks of shifting political winds. Now, according to financial executives, investors in developed markets are having to perform a similar analysis as well.

Karen McQuiston, head of institutional advisory and solutions at PGIM, the investment management business of Prudential Financial, says recent election surprises, including Donald Trump’s 2016 presidential win in the U.S., have made political risk “more relevant for certain institutional investors.”

What matters is the feedback from political risk to underlying economic and market conditions, she says. “It’s one thing to have a political regime you may or may not agree with. But what really matters is if there is a framework around it, so you can predict policy outcomes,” McQuiston adds. “We may be in a place that we can’t predict what will happen in the U.S.”

Ellen Ellison, chief investment officer of the University of Illinois Foundation, observes that this phenomenon applies to other developed markets as well, between the U.K.’s shock decision to leave the European Union and the emergence of far-right presidential candidates such as Marine Le Pen in France. Le Pen reportedly talked of implementing measures to prevent a run on the banks if she won, but her opponent, Emmanuel Macron, easily defeated her in a runoff election on Sunday.

“Political risk has become more of a developed-market phenomenon,” she says. “Think of Brexit. That’s new.”

Of course, those who are willing to invest amid uncertainty can also benefit. Ellison says the foundation’s analysts in the U.K. are evaluating the potential increase in exports. “You can view political risk from the other side of the coin. Dislocations create opportunities,” Ellison says.

Alyssa Rieder, chief investment officer of not-for-profit hospital operator Dignity Health, says that in response to the macro environment, she has decreased the foundation’s exposure to traditional fixed-income and public equities and increased the portfolio’s allocation to hedge funds as well as private equity. The foundation has allocated money to global macro hedge funds over the past year because Rieder perceives there are both risks and opportunities in the new political climate. “We’re hiring folks who can think about those risks,” she says.

PGIM’s McQuiston agrees with Rieder in that many institutional investors are depending on their managers to help them navigate increased risks. Active equity managers are closely evaluating which companies will be winners and losers, fixed-income managers are looking at the effects of trade policies on sovereign debt, and hedge funds may play currencies or make macro bets, she says.

Financial technology may be helpful when it comes to political risks, says Marina Gross, executive vice president of the portfolio research and consulting group at Natixis Global Asset Management. Gross says there are a number of analytical tools to help measure unusual risks as well as to better understand a portfolio’s currency and liquidity risks in different scenarios. But she cautions that it’s difficult to model political risk. There are “many blind spots,” she says.

Still, she’s not that worried. “Trump is bombastic, but at the end of the day the system works. I don’t think there is heightened political risk in the U.S.” She points to Brexit: after the news, there was a small blip of volatility at first, but then the markets performed fantastically.

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