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Feature
Hedge funds rely on consultants for advice on risky political
environment
Risky business
Author: Madison Marriage
Source: Hedge Funds Review | 04 Jul 2011
Categories: Hedge Funds, Strategy
Topics: Risk, European Central Bank, Greece, MENA (Middle East/North
Africa), Federal Reserve, Bank of England, Saudi Arabia, Middle
East,China, Energy, Commodities, Political risk

Hedge funds are using consultants and political advisors to monitor
political events such as elections, civil unrest and regulation,
particularly in the Middle East, North Africa and emerging markets.
“I don’t think I can remember a time when political risk has been so
important,” says Steven Bell, director of $1.3 billion asset
management company GLG.

Dithering by the eurozone and generally hostile exchanges between key
players, like the German Bundesbank and the European Central Bank over
the fate of Greece, is just one example of the kind of political risk
hedge funds now need to take into consideration for even the most
basic market trades. The surprise election of Peruvian left-wing
candidate Ollanta Humala in April is another.

Since the financial crisis, markets have been hit by the interference
of politicians. Quantitative easing makes it a headache for hedge fund
managers to second-guess what markets will do. Added to this are the
bigger political events such as the recent upheavals in the Middle
East and North Africa (Mena) region.

Regulators in Europe and the US are pushing through financial
legislation that could have unintended consequences for the hedge fund
community. Paying attention to politicians has become vital for many
managers who previously thought watching the Dow Jones or FTSE was
sufficient.

The political arena affects a range of hedge fund strategies and so
managers are employing a range of tactics to make sense of it.

Amer Bisat, partner and portfolio manager of two hedge funds at New
York-based Traxis Partners, says getting expert advice is crucial.
“Most of us are not political scientists, we are macroeconomists by
training. We all love to talk about politics and read newspapers. It
is a fun thing to discuss. But let’s be clear, we are all amateurs and
there is a science to this,” he comments.

Hedge funds can either bring a political scientist into their shop or
hire a consultant. The latter option is preferable, Bisat says, as
taking on board an internal advisor can be “inefficient”.

Although Bisat admits such advice may not translate directly into
returns, “you want to know what the distribution of probabilities on
political events and what the risks are. At least you will know the
various states of the world that are available out there politically.”

Apolitical
Chris Wright and Brian Ostroff, managing directors of Canadian
resource-focused investment management company Windermere Capital,
take a different approach to managing political risk: steering clear
of it.

Windermere Capital runs mining-focused hedge fund Breakaway Strategic
Resource Fund which tactically dodges political developments. “Some
funds thrive on [political risk]. We really try and steer clear of
trouble. It is hard enough to find a deposit, work that deposit, build
a resource and bring that into production. The odds are so stacked
against you from the very get-go that we try not to take on any
additional risks, mainly political,” Ostroff explains.

His fund disregards regions with a whiff of political impropriety,
ruling out most of Africa and large portions of Central and Latin
America.

Ostroff recalls a broker who tried to pitch an investment idea in
Uganda, claiming it was, comparatively speaking, a safe bet for
investment in Africa. “I said thanks but no thanks. One week later the
opposition candidate [Kizza Besigye] wound up getting shot in a
demonstration and there were riots,” Ostroff notes.

While avoiding politically unstable environments might lead to safe
investments in most cases, some events are simply unforeseeable,
Ostroff concedes. His Breakaway Strategic Resource Fund held a large
position in Peru which, fortunately for the fund, he closed earlier
this year when return objectives had been met and well before the
surprise election of left-wing presidential candidate Ollanta Humala
ahead of right-wing runner Keiko Fujimori. “That really came out of
nowhere,” Ostroff stresses. Humula’s victory now calls into question
the entire future of mining in Peru, believes Ostroff.

This is partially the result of politicians catering to
environmentalists in the run-up to elections, he claims. “A couple of
weeks before the Peruvian election the government in power started to
get tough on some of the mining companies. Bear Creek Mining [a
Canadian mining company focused on Peru] was really the target of that
pre-election manoeuvre,” he says.

Peru has some of the world’s largest supplies of commodities such as
gold, copper and phosphate. Any disruption to Peru’s mining capacity
brought about by political sentiment is likely to have a serious
impact on commodity supplies worldwide.

To benefit from this risk, Ostroff has devised a key theme for the
fund: scarcity and security of supply. “Being able to make investments
in companies that have these scarce commodities in secure
jurisdictions will ultimately win out,” he declares.

Regulation
GLG’s Bell identifies another key political risk: regulation. “People
are making major changes to financial regulation, making mistakes and
the credibility or public support for financial systems and banks is
very low,” he notes.

To keep track of such concerns, Bell talks to local analysts as “all
politics is local”. Although he has a good understanding of British
politics, “I can be surprised by German or US politics, so it is very
important to talk to local analysts. We are particularly keen to talk
to Spanish analysts in terms of whether the political process is going
to proceed smoothly in passing austerity measures and what the social
cohesion is to accept those,” Bell explains.

He notes the importance of the media for keeping up to date with
politics. However, he remains wary of certain news channels with a
definite political slant. “I felt there was a very distinct tilt in
the BBC and New York Times on the Japanese earthquake looking for
negative angles on the story in contrast to the Japanese press.
Reading the local press is absolutely crucial,” he affirms.

Maintaining proper analysis of politics can result in a lot of work
without much of an impact on returns, Bell says. “I very rarely invest
on the basis of a prediction of politics.”

To profit from the present mix of political risks in the eurozone,
Bell decided to “distil them in a Spanish credit default swap [CDS].
If [the eurozone] collapses we found we could encapsulate that in a
Spanish CDS,” he explains.

Similarly the political ongoing risks in the MENA region is reflected
in the oil price, what Bell terms “distilling [political risk] into
something quantifiable”.

London-based consultancy Exclusive Analysis also attempts to quantify
political risk. Using information from over 1,000 sources it breaks
political risk down into several components: political stability and a
number of risks including regulatory, taxation, currency and
corruption risk.

These criteria are then entered into a database called Cream which
creates political forecasts, allocating each area of risk a score of
one to 10. The ratings cover a range of factors such as civil unrest,
war risk and terrorism risk.

According to Brian Lawson, special economic consultant at Exclusive
Analysis, hedge funds are a new source of demand for such
intelligence. Lawson identifies China, Brazil, commodities and energy
as the main areas where hedge funds are interested in gaining
political information.

Lawson believes his company can help a hedge fund discern fact from
fiction when it comes to investing in markets mistakenly perceived
either as risky or attractive.

Ishan Bhaskar, global economist at Exclusive Analysis, points to
Vietnam as an example. He thinks many are mistakenly put off investing
in the country because of its communist government and what he says
are “alarmist” reports in the English-language financial press.

Inflation in Vietnam is just shy of 20%, coupled with a large current
account and trade deficit, but “when you look at foreign direct
investments into Vietnam, it is another story,” he says.

While Bhaskar and Lawson do not offer straightforward investment
advice, “we are identifying indicator events and trends and what these
are likely to do to prices,” says Bhaskar.

Exploring outcomes
Mark Ford, director of Cross Border Information (CBI), a consultancy
offering advice on Africa and the Middle East, says clients look for
situations where the perception of political risk differs from
reality. According to Ford, CBI provides hedge funds with insight into
potential political outcomes.

According to Ford, the central political issue in MENA markets is
succession. “In Tunisia we all know Ben Ali is gone but who will
succeed him? In Egypt now that Mubarak is gone, are we going to get a
democratising government or is the Muslim Brotherhood going to come
in? With that sort of instability there are huge questions,
particularly when the boundaries between business and politics are non-
existent in places,” he explains.

Although Ford believes Saudi Arabia is politically stable at present,
he concedes succession risk is a major issue.

Seemingly immaterial and innocuous events such as a wedding can mask
important political meaning, Ford says. A Gulf marriage, “curious as
it seems from a Western perspective, probably is incredibly important
in informing us where the power in a particular ruling family lies,”
Ford maintains.

Exclusive Analysis’s Lawson believes the largest hedge funds should be
careful from whom they chose to gain political insights. There have
been a number of high-profile engagements in recent years with hedge
funds turning to leading political figures for advice.

Former deputy governor of the Bank of England Sir John Gieve advises
GLG. Lansdowne Partners uses former UK prime minister Tony Blair.
Former US secretary of state Condoleezza Rice and national security
advisor Stephen Hadley advise US hedge fund group Everest Capital.

Although Lawson admits “we should never play down the value of the
contacts, intelligence and information gained by very senior political
figures over an extended period of time”, no politician has all-seeing
knowledge spanning every market.

“If you have Condoleezza Rice or Tony Blair on your payroll,
fantastic. That may open a lot of doors. The danger is if that person
is perceived internally as the source of all information, they may
become a block to where you need to go,” Lawson cautions.

Limitations
On the other side of the debate, Gieve is frank about the limitations
of his advice. For example, GLG is currently most interested in
attitudes towards banks and banking policy in the UK as well as the
likelihood of a dramatic approach to regulation in future, according
to Gieve.

“They’re not looking to me for the definitive answers on these because
I am not in a position to give them. Alongside their direct contact
with politicians and wider [contact with] economists and analysts from
the investment banks, they are looking for a mix of views and then
it’s very much up to the investment manager what they can make from
that,” Gieve comments.

“On the whole, looking at political advice and certainly my advice,
there is very rarely a direct trade [for GLG]. I provide one
background factor in the equity world alongside all sorts of more
direct factors: is the company any good, are its profits going to be
any higher,” he adds.

“I’m one of a number of advisors GLG uses and I think that is pretty
common across hedge funds. I don’t think there is any magic in
political risk and broadly [hedge funds] try to adopt the same
approach: get a wide range of views on what is happening and what is
likely to happen,” he concludes.

According to GLG’s Bell, conversations with such high-profile figures
are “invariably interesting” but he would be surprised to “come out of
one of these meetings with a clear trade idea. Put it this way: a
really good political analyst is unlikely to generate as much return
to my fund as a really good strategist.”

Traxis Partners’ Bisat agrees the largest hedge funds often have
armies of former economists from the Federal Reserve, European Central
Bank and the Bank of England. They can provide some useful insight, he
says but he cautions again making investment calls based purely on
political risk.

“Political risk is never about predicting with certainty. Nobody can
tell you what is going to happen in politics tomorrow,” Bisat concludes.


Read more:http://www.hedgefundsreview.com/hedge-funds-review/feature/2082101/hedge-funds-rely-consultants-advice-risky-political-environment#ixzz1R9J15hGr
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