Get a GRIP!

It has become commonplace among institutional investors to acknowledge geopolitical risks as a clear and present danger to their portfolios. Yet, very few institutions have a well thought out and coherent framework for addressing such risks. In this article, I call on investors to get a GRIP.

In the English language, in addition to getting a good physical hold of something, the expression ”getting a grip” has two meanings: to have a newfound understanding of a topic or concept, and to control one’s reactions or emotions.

I believe that with respect to Geopolitical Risk in Investment Portfolios (GRIP), it is important that investors do both, and the best way to start the process is for them to ponder, rationally and calmly, the following question: Is geopolitical risk in our investment portfolio remunerated?

I argue that the answer to this question will be different and specific to each individual organisation and fund. It will depend on how each investor answers the following five questions:

1.?????? Do we understand the nature of geopolitical risk?

2.?????? What is our investment horizon, liquidity, and strategy preferences?

3.?????? How are we positioned with respect to geopolitical divides?

4.?????? Do we have sufficient budget and resources to dedicate to geopolitical risk?

5.?????? How will geopolitical risk impact our notions of ‘alpha’ and ‘beta’?

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Defining the terms

Let us first define our terms. For purposes of this article, we define geopolitical risks as any material risks relevant to an investor’s organisation or portfolio, originating from and driven by interactions between state actors across multiple domains.

While we typically tend to think of risks in terms of financial losses, our definition is broader, including for example disruptions to the operations of an investment organisation from cyberattacks or adversarial actions by an unfriendly government. We also include various legal, regulatory, and reputational risks that can manifest from geopolitical developments.

Similarly, while we tend to think of geopolitical risk in terms of international conflicts and wars, our definition here is broader, including for example strategic and geo-economic competition over resources, markets, and technology in peacetime.

However, our definition is narrow with respect to relevant actors: we focus only on state actors on the international stage, excluding domestic political risks and risks associated with non-state actors (unless they become demonstrably relevant to the geopolitical dynamic at hand).

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This time IS different

Now that we have defined geopolitical risk, let us consider whether it is a familiar type of risk for investors. Arguably, geopolitics have driven and impacted human affairs throughout the recorded history. Therefore, it may seem strange to suggest that somehow ‘this time is different.’ But here is the catch: there is not a single living investment practitioner today who has actual experience managing geopolitical risks in the context of a multipolar world.

The geopolitical reality we see emerging today is not at all similar to that in which the current generation of investors have traditionally operated, which is to say in a US-led unipolar world. And it is not at all similar to that which our parents’ generation has experienced: a bipolar world with almost no meaningful economic and financial integration across the main geopolitical divide. Arguably, what is emerging today is much closer to the multipolar world of our grandparents and great-grandparents, as it existed between 1870 and 1945.

Therefore, as we ponder the nature of geopolitical risk, we need to be humble. We as investors need to acknowledge that there is a learning curve, that the relevant decision-makers in the boardrooms and C-suites need to be educated about it, and that we may need to rethink our existing approaches and some of the most fundamental tenets of our investment processes.

The nature of geopolitical risk

How should we as investors think about geopolitical risk? In very broad terms, I propose to distinguish between two different types of risk: short-term shocks and long-term shifts. Let us consider each in turn, using as an example the current case of US-China strategic rivalry across multiple domains.

An example of a major short-term geopolitical shock would be a ‘hot’ conflict erupting over Taiwan, which many pundits have been predicting during the last few years. Leaving aside the likelihood of any such eventuality, it would clearly be a major shock to the global economy and financial system, likely resulting in an immediate and material repricing across multiple geographies and asset classes.

Are we as investors prepared for this shock? Do we have contingency plans in place for such a scenario? Can we assess the types and approximate magnitudes of our exposures to this risk? What analytical frameworks and tools can we use? What actions, if any, can we take today to prepare our organisations and portfolios for this fairly low-probability, but extremely high-impact event?

Many institutional investors were woefully unprepared for the consequences of what transpired in Ukraine in February 2022 and in Israel in October 2023. If the US and China were to come to blows in a major geopolitical crisis in East Asia, the potential impact on the global economy and financial markets would likely be on a whole different order of magnitude. And this time, for anyone in a position of fiduciary duty overseeing other people’s money, there will be no place to hide. After the lessons of Ukraine and Israel, it would be indefensible to be caught unawares and unprepared.

Now let us consider the risk of a long-term geopolitical shift using a simple thought experiment. Imagine yourself being in charge of a globally diversified portfolio in July 1914. After many years of investing in various markets, you feel that you have a pretty good grasp of how the global economy works, the fundamentals of international trade and capital flows, and the foundations of the international monetary system, which has been operating on a universally recognised gold standard for almost half a century. You would be forgiven for thinking that the next thirty years would probably not be too different.

Then fast-forward to July 1944, as the Bretton Woods conference lays the foundations of a completely different world order, with a fundamentally different set of rules and agreements governing the global economy, international trade, capital flows, monetary system, and financial markets. Even if you as an investor successfully survived through the multiple short-term geopolitical shocks of the previous three decades, in order to genuinely thrive in the new world order you would have needed to be very good at strategic long-term thinking as well.

What will the world look like thirty years from now? Nobody knows for certain, but one can build a number of very different, yet plausible scenarios. In one of them, the US-led unipolar world order of the last thirty years successfully reasserts and reinvents itself. Given that our existing approaches to portfolio management have been optimised for precisely such a world, if you as an investor make a conscious bet on this outcome, it may be perfectly rational not to change anything about your current investment practices. But as a responsible fiduciary, can you show that you have done your homework and demonstrate how it led you to the conclusions that justify such a long-term bet?

Investment horizon, liquidity, and strategy preferences

Geopolitical risk may impact investors differently, depending on their preferences with respect to investment horizon, liquidity, and strategy. To illustrate this point, consider two extreme opposites on this spectrum: a global macro hedge fund (GMF) and a future-generations, endowment-type sovereign wealth fund (SWF).

The former will typically have a short horizon (e.g., one year or less), will trade highly liquid instruments (e.g., futures and options on major indices and interest rates), and will have a strong bias towards trend-following and convexity in its portfolio construction and risk management (e.g., buying on the up and selling on the down).

The latter will typically have an intergenerational horizon (e.g., multiple decades), will invest close to half or more of its portfolio in illiquid instruments (e.g., private equity and infrastructure), and will have a strong bias towards contrarian investing in its portfolio construction and risk management (e.g., buying on the down and selling on the up).

These two radically different investor profiles imply very different exposures to geopolitical risks. A GMF is exposed only to short-term shocks, and will be much more nimble in its ability to exit a losing position in liquid markets, especially considering the relatively smaller size of the typical fund. Also, it will often have the ability to put on hedges in advance to mitigate short-term risks. And when it comes to long-term shifts, it has the luxury of not worrying too much about them.

An SWF is exposed to both short-term shocks and long-term shifts. With respect to shocks, it will have a much harder time than a GMF exiting even its more liquid positions, due primarily to its typical size, but also because of a variety of non-financial considerations (e.g., governance, politics, bureaucracy, relations with the host country, etc.) With respect to long-term shifts, an SWF has even bigger and potentially more consequential exposures, which may leave it holding geopolitically “stranded assets.”

Positioning with respect to geopolitical divides

Different investors will face different geopolitical risks depending on where exactly they are located. For example, SWFs from Norway and China will be treated very differently by the US authorities, even if both funds try to purchase exactly the same asset in the US market. Similarly, the level of geopolitical risk and uncertainty surrounding direct investments into China will likely differ depending on the origin of the funds.

Imagine a run-of-the-mill public pension fund somewhere in the middle of the United States. If the geopolitical rivalry between the two nations intensifies, there is a high probability that the US politicians and regulatory authorities will scrutinise any China-related investments by US public pension funds, with a view to getting them to divest. What should the trustees of such a fund do? What can they do? If, as discussed below, they are also constrained in terms of their budget and resources, then the only rational choice is to comply and divest.

Now imagine a sovereign wealth fund or a large family office located in Saudi Arabia, UAE, Qatar, India, or some non-aligned nation in South East Asia and Latin America. While they must be careful to follow all the legal and regulatory implications of any rules and sanctions introduced by the West, there is no reason for them to automatically divest from China and cut ties. In fact, assuming they have sufficient resources at their disposal, they have every incentive to reorganise their operations in such a way as to allow them to access all markets, including the US and China. They can be genuinely contrarian: the more their Western and Chinese peers are forced to sell indiscriminately due to geopolitical pressures, the better prices can be obtained.

Budget and resources

In the case of an under-resourced, run-of-the-mill US public pension fund, there is no upside to geopolitical risk, only downside. So the answer is clear – divest and cut off any exposures. In the case of a well-resourced fund located in a non-aligned country, geopolitical risk, if managed properly, presents not only downside, but also potential upside. So the answer is also clear – devise the necessary frameworks and protocols to take full advantage of the emerging opportunities.

But what happens with very well-resourced and highly sophisticated funds that find themselves located in a particular geopolitical camp? Think of public pension funds and SWFs located in Canada, the Netherlands, Norway, Sweden, Denmark, Japan, Australia, and New Zealand. Their levels of sophistication and resources could certainly enable them to pursue investment opportunities arising from geopolitical tensions, but how would their governments, regulators, and other stakeholders look upon such a proposition? And what would be the reaction of their ultimate beneficiaries and the general public?

‘Alpha’ and ‘beta’ redefined by geopolitics

Depending on how each investment organisation answers the four questions above, they may find themselves in a situation where they must redefine their traditional notions of ‘alpha’ and ‘beta’. For example, our run-of-the-mill US public pension fund will likely need to exclude all geopolitically risky assets from their investment universe and redefine their long-term risk-neutral exposure – i.e. their ‘beta’ – as a basket of passive indices covering only the geopolitically ‘safe’ Western markets. Some may even go further, and in the spirit of ESG and sustainability, adopt customised indices that overweight ‘freedom’ and ‘democracy’ over ‘tyranny’ and ‘autocracy’.

For our hypothetical SWF or family office in the non-aligned world, assuming they have managed to reorganise their portfolio management operations to hermetically seal off investments that happen across geopolitical divides, the very notion of ‘beta’ has become more attractive: all else being equal, the level of de-correlation and diversification in their total portfolio should improve over time as the global economy and financial markets get more fragmented. And with respect to ‘alpha’, there should now be more opportunities to be contrarian and buy ‘geopolitically stranded’ assets that others are forced to indiscriminately sell.

As for the well-resourced and sophisticated funds in the West which may find it difficult to operate with the same degree of pragmatism as their peers in the non-aligned world, the redefinition of ‘alpha’ and ‘beta’ may be more subtle. Yes, they may be forced to divest and exclude Chinese assets from their portfolios, so their investment universe may effectively shrink and their ‘betas’ become less diversified. But that does not mean that they couldn’t benefit from new ‘alpha’ opportunities arising from geopolitical risks in their investable markets.

Conclusion

Let us now answer the question posed at the start of this paper: is geopolitical risk in an investment portfolio remunerated?

The answer is no, if the fund in question: (1) does not understand the nature of the risk; (2) does not have sufficient budget and resources to analyse and manage it; (3) is located within a specific geopolitical camp, leading to political, regulatory, and reputational pressures.

The answer is yes, if the fund in question: (1) has a good grip on the nature of the risk; (2) has sufficient budget and resources to analyse and manage it; (3) is located outside of specific geopolitical camps and has the luxury of acting pragmatically on it.

The answer is maybe, if the fund in question: (1) has a good grip on the nature of the risk; (2) has sufficient budget resources to analyse and manage it; (3) is located within a specific geopolitical camp, leading to political, regulatory, and reputational pressures.

Based on the above, there is only one conclusion that applies to all investors: whatever their eventual decision regarding geopolitical risk, it would be indefensible and downright negligent to ignore this risk by not undertaking the necessary organisational and portfolio review, starting from the board level and going all the way down. In other words, all investors need to get a GRIP.