Independent Pilots Financial Services is part of the Benchmark Capital Group, backed by FTSE 100 company Schroders. Our investment committee often draws upon Schroders vast resources. This piece is written by one of their investment writers.
Markets are once again in thrall to geopolitics following recent events in the Middle East. Our research shows what such periods can mean for investment performance.
Last week’s assassination of Qassem Soleimani, the head of the Iranian Revolutionary Guards’ overseas forces, has reignited tensions in the Middle East and sent tremors through asset markets.
The oil price has risen sharply to over $70 a barrel at the time of writing, amid concerns that tensions in the region will impact supply.
Meanwhile, the value of assets perceived as “safe havens” such as gold, the Japanese yen and US Treasuries has also risen. Indeed, the price of gold at one point on Monday hit its highest level since April 2013 ($1580 per troy ounce).
It’s early days, but so far markets have responded as one might expect if you look at previous bouts of heightened geopolitical risk.
Last year our economists published research into the impact of geopolitics on markets. They found that it can significantly impact investment returns and that an active investment approach can help navigate such turbulent times.
How does geopolitical risk affect markets?
Geopolitical risk can refer to a wide range of issues, from military conflict to climate change and Brexit. We look at it as the relationships between nations at a political, economic or military level. The risk occurs when there is a threat to the normal relationships between countries or region.
Heightened geopolitical risk tends to trigger investors to move away from riskier assets like shares and towards perceived “safe” assets.
This negatively impacts stock market returns, while government bonds benefit (particularly those with short maturities as they are perceived as the safest).
Geographically, investors also shift their money away from the perceived riskier regions such as emerging markets and towards developed markets like the US.
This is illustrated below, by the performance of four different assets (US shares, global shares, gold and US government bonds) during three major geopolitical events.
How did our analysis work?
Our economists Keith Wade and Irene Lauro looked at five different periods of heightened geopolitical risk since 1985.
To do this they used the Geopolitical Risk Index (GPR), which reflects automated text search results of the electronic archives of 11 national and international newspapers. It captures the number of mentions of key words such as “military tensions”, “wars” and “terrorist threats”.
They defined periods of geopolitical risk as whenever that index went above the 100 mark, which you can see below.
Our economists created a “safe” and a “risky” investment portfolio and compared their performances during these periods. 
Of course, no investments are truly “safe” or risk free. Investment values go up and down and you don’t always get back the amount you originally invested.
We use the term “safe” merely to distinguish between the relative stability of assets like US government bonds (which the US government is highly unlikely to default on) versus shares, which are relatively “risky” (companies regularly go bust). We could equally have called them “less volatile” and “more volatile” portfolios.
What did our analysis show?
Our analysis shows that in the short-term the portfolio of “safe” assets delivers higher returns than the risky portfolio in three out of the five periods considered.
When the returns were “risk-adjusted”, this was also the case. Risk adjusted returns refers to the Sharpe ratio, which measures the return of an investment compared to its risk.
We also looked at how a diversified “60/40” portfolio (60% risky assets and 40% “safe” assets) compared. We found that it performed worse than the “safe” portfolio (both in total returns and risk-adjusted).
What if you wait until after the geopolitical risk subsides?
The results were particularly interesting when our economists extended their analysis to six months after the GPR index falls back below 100. This enabled them to get a better idea of how an investor would have performed if they had held onto their risky portfolio through the turbulence and then allowed markets to recover their poise.
They found that over the extended time period the risky portfolio outperformed the safe portfolio in four of the five periods (the exception being 9/11 and the Iraq invasion). The risky portfolio also scored better than the safe portfolio in risk-adjusted terms in each of these four periods.
However, an investor would have had to withstand considerable volatility to realise the benefits of the risky portfolio so we threw into the mix a “dynamic” portfolio. This would involve an investor implementing a safe portfolio as soon as tensions start to rise (the GPR goes above 100) and switching to the risky portfolio when they dissipate (goes back under 100).
For an individual investor this would likely not be practical with their own portfolios. However, it’s likely the best option for those who entrust an active fund manager that takes geopolitical risk into account.
This dynamic portfolio did well, delivering a higher return (both total and risk-adjusted) than the risky portfolio in three out of the five periods and higher than the safe portfolio in four out of the five periods. The analysis showed that active fund managers can potentially avoid some of the losses and still enjoy much of the benefits from taking geopolitical risk into account.
 The safe portfolio allocates 50% to the US 10-year benchmark government bond, with the rest equally distributed among gold, Swiss franc and Japanese yen. The risky portfolio comprises 50% in the S&P 500, the rest allocated evenly between the MSCI World and MSCI EM Equity indices. After 2007 we also include a basket of local EM sovereign debt made up of local currency sovereign bonds of Turkey, Brazil, Mexico, Russia and South Africa