Hedging against political risk improves portfolio performance beyond diversification

Hedging against potential political risks is a better strategy to improve international stock portfolio performance than simply diversifying, according to new research by Durham University Business School.

The researchers found that by managing political risk, investors can build stronger more resilient portfolios without sacrificing the benefits of international diversification. This strategy improved performance for investors in major markets like the US, Eurozone, and Japan.

The study was undertaken by Stavros Zenios, Professor of Operations Management and Finance at Durham University Business School, alongside his former PhD students Somayyeh Lotfi, from the University of Central Lancashire and Giovanni Pagliardi, a Lecturer in Finance at BI Norwegian Business School, and Professor of Statistics Efstathios Paparoditis, from the Universty of Cyprus.

The researchers wanted to understand how hedging against political risk affected investment portfolios, compared to a broad market index – a benchmark that represents the overall performance of a wide selection of investments in the market.

With international portfolios facing huge political risk – especially in today’s world of regional conflicts, climate change, and electoral backlash against incumbents – the research sought to understand how investment managers can ensure they are making the portfolios as resilient as possible.

To do so, the authors reviewed historical data on monthly returns across the period of 1999-2019. This data focused on international portfolios from a broad sample of 22 developed and 20 emerging. The researchers assessed the political risk of each of these countries using an asset pricing model with a political risk factor (P-factor).

They then used a model to test whether hedging the political risk against significant events and unexpected shocks had a positive impact on the investment portfolio performance. They tested their model for American, European, and Japanese investors, both during this time frame but also for more recent periods that were not included in the data.

The researchers found that political risk hedging can be effective during unexpected shocks like the ones following the COVID-19 pandemic and the war in Ukraine. The researchers also found that this political risk hedging can lead investors to focus more on their home markets.

"The world is growing increasingly volatile, with political shocks—from geopolitical tensions and climate shocks to regulatory upheavals—reshaping markets at an unprecedented pace.”, says Professor Zenios.

“For investment managers, ignoring political risk is no longer an option; it must be as integral to portfolio strategy as economic or financial analysis. An ability to navigate political unpredictability will define the winners in global investing."

The researchers say that portfolio managers should consider these findings when it comes to future investment decisions – especially in emerging economies where political risk is often high. In order for investors to maximise their portfolio performance they should look to hedge their bets not just diversify their portfolio.

If you would like to receive the full research paper, or speak with the researchers, please contact Peter Remon at BlueSky Education – peter@bluesky-pr.com +44 (0) 77 235 228 30.