Noise - Chapter 9
Sources Of Noise: Geopolitics
Briefly: Geopolitics
Noise. Geopolitical events are virtually custom-designed to trigger behaviour that will result in you destroying alpha.
Wiring. You are hardwired to overestimate the impact of dramatic stories, and to underestimate the impact of less dramatic, but serious, stories.
Edge. If you invest as if you have an edge in geopolitics, but you really don’t have one, you will experience high levels of noise and pain.
I define a geopolitical event as one that falls into these four categories:
Political Events, e.g. upheavals, power shifts, regime changes.
Military Events, e.g. skirmishes, invasions, wars.
Environmental Events, e.g. earthquakes, floods, nuclear accidents.
Public-Health Events, e.g. epidemics and pandemics.
These events are unquestionably important to the people who are directly affected, but should you take account of such events in the exercise of your professional duties as a fund manager? The answers to the question tend to fall into one of two camps:
No. Don’t even bother.
Yes. Geopolitics really matters.
Don’t Bother
Here are three reasons you might choose not to bother with geopolitics:
Finance. The fundamental law of active management suggests that geopolitics is not necessarily the most fruitful of arenas in which to try and generate alpha.
Psychology. Notable geopolitical events are noisy and virtually custom-designed to trigger behaviour that will result in you destroying alpha.
History. On average, most dramatic geopolitical events have had a limited direct impact on the prices of securities.
Finance
The fundamental law of active portfolio management says that the probability of you generating alpha is a function of your skill (depth) and your number of investment opportunities (breadth).
Depth. Geopolitical events are characterised by low levels of predictability and high levels of complexity - dual factors that set the bar high for the required skill.
Breadth. Major geopolitical events are relatively infrequent; they offer you limited ability to have a number of independent bets in your portfolio at any one time.
Put simply, if you focus on geopolitics, you can’t bet that often and it’s very difficult to get it right when you do.
Psychology
Howard Marks, co-founder of Oaktree Capital Management, wrote that investors tend to get things wrong in two ways, first by reacting too little and later by reacting too much. He said: “One of the most notable behavioural traits among investors is their tendency to overlook negatives or understate their significance for a while, and then eventually to capitulate and overreact to them on the downside.”
The signs that a major geopolitical event is in the offing are frequently obscure and seemingly insignificant, but when the events manifest themselves they are usually accompanied by dramatic images and compelling narratives. These are precisely the types of noise that trigger your fight/flight instincts, which override your ability to be calm and sensible, and compel you to take the wrong action at the worst time, which results in the destruction of alpha.
History
Mary Callahan Erdoes, CEO of JP Morgan Asset & Wealth Management, has said that the only geopolitical event ever to have had a direct effect on markets was the Yom Kippur War between Israel and various Arab nations in 1973, which led to a sharp increase in the oil price.
The numbers seem to confirm her opinion. On average, the impact on equity markets of a range of crises has been muted, with losses from the initial sell-offs having been recovered within a month or so. However, there are numerous problems with this sort of analysis-lite, amongst them being: the limited utility of univariate analysis; the fact that averages obscure as much as enlighten; the arbitrary natures of the data set, the time scales, and the index of measurement.
If you were brave enough to overlook these issues, history would seem to suggest that, if you absolutely have to do something, you would be best served by doing the opposite of what you probably want to do. The numbers indicate that, if anything, you should fade the crisis and get longer into the teeth of any sell-off, and then hang on for dear life. Easy to say, hard to do.
Really Matters
Sir Michael Hintze, chief of $15 billion credit-focused firm, CQS Asset Management, believes that most fund managers ignore geopolitics until they can’t. For the most part, geopolitical risks are not properly understood and therefore they are mispriced and they represent an attractive opportunity set. One of the reasons that this mispricing arises is because of the difficulty in identifying what Hintze calls a transmission mechanism, the manner in which a geopolitical event is translated into a tradeable market event.
Although it’s a difficult way to make money for your clients, geopolitics can be a verdant field for alpha generation. If most fund managers have concluded that they should not bother, that might provide you with an attractive set of opportunities, made all the more attractive by the inevitable mispricings created by those who are suckered into playing but who don’t have the required skill.
Some fund managers make it their business to understand and exploit the pricing of geopolitical risks, the most famous of whom is probably George Soros.
Example: Soros Fund Management
George Soros became a household name 1992 as the man who broke the Bank of England. Before that time he was little-known outside the confines of the investment community, where he had built a reputation as an outstanding global macro trader.
The backdrop to his so-called trade of the century in 1992 was the formation of the European Exchange Rate Mechanism (ERM), which was designed as a way to reduce exchange rate variability in preparation for Economic and Monetary Union and the adoption of a single European currency. Although the ERM was formed in 1979, the UK only joined in 1990 at a rate of 2.95 deutsche mark to the pound, which turned out to be way too high. Membership of the ERM meant that the British government effectively guaranteed that sterling would trade inside a band of 6% against the currencies of the other ERM countries, and if sterling traded outside that permissible band the Bank of England would be obliged to intervene in the currency markets to bring it back into line.
Soros said that the ERM was a very sophisticated system that worked well under conditions of equilibrium, and offered very little opportunity for currency speculators like him. But he saw the first hints of impending disequilibrium even before the UK joined the ERM, in the form of challenges to the prevailing geopolitical situation. A series of revolutions in Eastern Bloc countries, such as Poland and Hungary, set in motion civil unrest in Eastern Germany, which culminated in the fall of the Berlin Wall in November 1989, which in turn led to the reunification of Germany in October 1990, the collapse of the Soviet Union, and the end of the Cold War in 1991.
Reunification created inflationary pressures in Germany that the Bundesbank was constitutionally obliged to quell by raising interest rates, which placed great stress on members of the ERM whose economies were then in recession, such as the UK. The British government would ideally have cut rates to stimulate growth but this would have pushed the pound below its permissible level.
Soros said, “As the pressure on sterling built up, it became really exciting.” He saw a trade with asymmetrical risks: if the British government somehow managed to stay the course and prevent sterling from devaluing, he would have limited losses, given the existing pressures on the pound; but if they couldn’t maintain their support, sterling would break out of its artificial band and devalue significantly. So, in August 1992 his Quantum Fund put on a $1.5 billion short sterling position.
On Tuesday, 15 September 1992, the president of the Bundesbank gave an interview in which he said that one or two currencies in the ERM could come under pressure. Stanley Druckenmiller, lead trader and portfolio manager for the Quantum Fund, told Soros that he understood this to be a catalyst for a big fall in the pound and that he intended to steadily increase their short position. Soros agreed about the catalyst, but disagreed about the strategy. “Go for the jugular,” Soros told Druckenmiller. They hit every bid going into Black Wednesday and massively increased their short position to around $10 billion. The BoE was an aggressive buyer during the morning in an attempt to prop up the value of sterling, but their interventions in the currency market had little effect, so by late morning the governor of the BoE announced a 200 bps rise in interest rates.
Soros said, “This was an act of desperation that signalled to us that the British position was untenable. It encouraged us to continue selling sterling even more aggressively than we did before.” And the BoE was obliged to be on the other side of the trade and to keep throwing its foreign reserves at the problem. But neither their buying of sterling nor the rate hike had had the desired effect, so that afternoon the governor of the BoE announced a further 300 bps rate increase, effective the following day.
Soros said, “The British government assured the public up to the last minute that the ERM was rock-solid. They may have influenced some investors, but they certainly didn’t convince us.” So he kept on shorting sterling, taking the position up to around $15 billion, which was enough to give the currency a final push over the edge. By early evening of Black Wednesday it had become clear to the British government that it could no longer keep sterling within the required band, and at 7:30 pm they announced that Britain was to leave the ERM. When the pound floated it lost 25% of its value against the US dollar; the Quantum Fund added $4 billion to its NAV; and George Soros became a household name.
Edge
Both of the approaches to geopolitics (Don’t Bother and Really Matters) are valid in a general sense, but they are not both valid for you. To put it bluntly, if you belong in the Don’t Bother camp but you act in the Really Matters camp, you are going to experience high levels of noise and equally high levels of pain.
Identifying in which camp you belong is important, and it is a function of your assessment of your edge. The difference between being on the winning side or the losing side of a trade, absent dumb luck, is whether you have an edge.
Soros was able to exploit the noise that arose from a particular geopolitical configuration because he had an edge of four parts:
Geopolitical Smarts. He had a deeper understanding than his competitors of the geopolitical situation and its possible consequences.
Trading Smarts. He was able to construct a position with asymmetrical risks.
Fire Power. He had enough capital to influence the outcome.
Balls of Steel. He was willing to commit the equivalent of 100% of his fund’s NAV to a single trade.
If you decide to take action in your portfolios because of geopolitical events, even if you call that action risk management, it would be a good idea to take action only if you have an edge, because if you don’t have an edge when you play against the likes of George Soros, you’d better hope that you’re lucky. Hope and luck are not ingredients of an investment process that will deliver superior long-term results.
If you have an edge in geopolitics, then you should design your investment process around that edge; otherwise you’re leaving alpha on the table. Conversely, if you don’t have an edge, then have the courage to admit it and be disciplined about not taking investment action as a result of geopolitical events; otherwise you will be gifting alpha to those that do have an edge. A third option is that, if you don’t have an edge but you want one, you might consider buying it or building it.
References
Grinold, R. (1989) ‘The fundamental law of active management’, The Journal of Portfolio Management, Spring edition.
Memo written on 14 January 2016 by Howard Marks to investors in Oaktree Capital Management: ‘On the couch’.
Article in the Financial Times on 1 May 2018 by John Authers: ‘Milking Milken.’
Interview with Michael Hintze in Australian Financial Review, published on 26 July 2017.
Soros, G. (1995) Soros on Soros: staying ahead of the curve. New York: John Wiley & Sons, Inc.
Mallaby, S. (2010) More money than god: hedge funds and the making of a new elite. New York: Penguin Press.