Why it’s not always worth trying to hedge against geopolitical risk

Why its not always worth trying to hedge against geopolitical risk_image

Written by James Weir

James specialises in the theory and best practice of portfolio construction and management. His success within national and international investment banks led him to become a Co-Founder of Steward Wealth and he is a regular columnist for the Australian Financial Review.
April 4, 2022

In times of geopolitical risk, it’s understandable that investors’ thoughts turn to what effects it will have on a carefully nurtured portfolio and whether there are ways to protect it.

That kind of protection is referred to as a “hedge” – ideally it will increase in value at times when markets are vulnerable to a fall in risk assets, such as equities.

There are many assets that can act as a hedge – for example, investing in real assets like property or art can provide a return that has no correlation to shares. However, not all portfolios are large enough to be able to diversify into expensive assets like these.

For more average-sized portfolios, the most commonly used hedges are those that trade on financial markets, such as gold, government bonds or the US dollar. All three can be accessed through ETFs that trade on the ASX.

However, there is no guarantee that what looks and sounds like a sensible hedging strategy will work. It can end up costing money.

The accompanying table looks at 12 of the most significant geopolitical events over the past 40-odd years, including wars and acts of terrorism, and how these three popular hedges performed during each of them. One caveat, as with any investment, is that the price of the different hedges is influenced by a variety of factors that are impossible to anticipate, so it’s unlikely the prices were influenced solely by the associated geopolitical events.

Changes to asset valuations during war and terrorist attacks

Why its not always worth trying to hedge against geopolitical risk_table

Gold is often touted as a safe haven investment when risk assets are sold off. It is interesting to note the average change in the gold price during the 12 events was a rise of only 0.7 per cent. However, with a range of negative 34 per cent to positive 27 per cent, the median change of -0.9 per cent is probably more helpful. To underscore just how unpredictable buying a hedge can be, it went up only 42 per cent of the time.

The performance of US government bonds is also surprising, given the role bonds are often perceived to play as being negatively correlated to shares. The average change was an increase in yield, meaning the price of the bonds went down. And once again, it was an even bet as to which direction the price would go.

Buying US dollars was also a pretty even bet, for a very low average return.

When you analyse the level and likelihood of returns from those three popular hedges, one message is clear: it’s really difficult to pick where markets will go and the trading costs to jump in and out could eat up a significant portion of any benefit.

Perhaps unexpectedly, the best performing asset in the table was US shares, which rose by an average of 3 per cent and the odds of a rise were much better at 75 per cent.

In another analysis of the effects of geopolitical events on the US benchmark share index, the S&P 500, LPL Research considered 22 separate events going all the way back to the Japanese attack on Pearl Harbour in July 1941.

Across a variety of wars, assassinations and terrorist attacks, the average decline in US shares was 4.6 per cent. Incredibly, the average time it took to recover all the losses was only 43 days. In other words, share markets have demonstrated tremendous resilience over many decades of turmoil.

During geopolitical events, such as Russia’s invasion of Ukraine, it can be difficult not to be swept up in the inevitable noise of expert commentators and media coverage.

It can feel like you should be doing something with your portfolio, but that’s not necessarily the case.

Hindsight bias, which makes things look obvious in retrospect, can make hedges seem like a great idea. But the data suggests a portfolio that is diversified across different regions and asset classes is a strong alternative. Smart investors should always remember that, over the long term, financial markets have a history of taking geopolitical events in their stride.

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product. You should also obtain a copy of and consider the Product Disclosure Statement before making any decision on a financial product. You should seek advice from Steward Wealth who can consider if the general advice is right for you.

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