How to build a risk-ready portfolio (and 4 key points to keep in mind)

The value of your share portfolio or super fund probably isn’t the first consideration when you think about threats in the world around us – nor should they be. But as the tragic events continue in Europe and, more recently, Middle East tensions escalate, we’re reminded of their flow-on effects – just as we were when the COVID virus first crossed international borders and sparked rolling travel bans and manufacturing shutdowns.

Such events are part of the macro-economic landscape that politicians and investment professionals are paid to consider. It’s why a chapter in the Intergenerational Report, which sets out the key trends to shape our economic landscape over the next 40 years, is devoted to national security and regional stability.

In a recent interview, Schroders Australia CEO and CIO Simon Doyle reflected on how investment portfolios factor in geopolitical risk. Looking beyond the events playing out currently, he believes wealth inequality lies at the heart of many such risks. 

“For a long period of time, we’ve seen monetary policy supporting the divergence between the rich and poor and that’s flowing through to political systems,” Doyle says.

Doyle explains how his team’s portfolio construction process reflects a range of risks. He also addresses a fundamental question about how geopolitical risks are weighted within Schroders’ multi-asset investment approach.

A key point lies around how such global shocks manifest within the broader financial system, Doyle noting that an initial energy market rout followed by an inflation shock is what transpired as the Russia-Ukraine war broke out.

“That was the risk that needed to be protected against. It wasn't the flight to quality that you would normally get through a war, for example,” Doyle said.

“You need to understand, in terms of either responding to or protecting from a geopolitical event, how the nature of that shock is likely to translate into the things that you might want to do in a portfolio.”

International trade agreements are another big factor for global markets, explains Doyle, as US-China tensions simmer alongside the “hot wars” in Europe and the Middle East.

In the following interview, Doyle discusses how different investments – including financial, manufacturing and commodities assets – might respond to geopolitical risks. He also explains how his team prepares for a range of risks, including those related to liquidity, inflation and recession, and names four key things investors should remember as the best forms of risk protection.

Edited Transcript

David Thornton: Hello, and welcome to Livewire Markets. I'm David Thornton.

Recently, Treasury released the Intergenerational Report, which sought to identify the key trends that will shape the economic landscape in 40 years' time. One of those trends is geopolitical risk. Now sadly, recent events in the Middle East and Eastern Europe have brought geopolitical risk into sharp focus. Joining us today to discuss geopolitical risk and how to protect portfolios from it, is Simon Doyle, CEO at Schroders.

Simon, thanks for joining us.

Simon Doyle: No, my pleasure. Thanks for having me, David.

LW: The hedge fund manager, Paul Tudor Jones, recently said on CNBC that we're currently facing the most threatening geopolitical environment since World War II. Do you agree? 

Simon Doyle: Well, it's a big statement, and I think certainly there's a much more heightened focus on geopolitical risk for a couple of reasons. We're seeing evidence of that in the Middle East and in Ukraine, but I think there are some more fundamental reasons sitting behind that. 

Obviously, the balance of economic and military power between China and the US has shifted a lot, certainly over the last 10 years. And that's starting to come into much sharper focus. And I think the impact of that, which we saw through COVID and the potential disruption to supply chains and so on, was the impact on the trend to globalisation. These are some reasons I think that's happening.

The other reason why I think geopolitical risk is in much sharper focus at the moment is simply the whole wealth inequality idea. For a long period, we've seen monetary policy supporting that divergence between the rich and the poor, and that's flowing through into political systems. 

There's both a shift in the power balance within the global economy, and I think within economies, there's much more underlying tension coming through that wealth inequality factor. Both those things are elevating the potential for significant geopolitical instability.

The objective measures of it, you look at the risk metrics that a number of institutions do, certainly the trend is on the up.

So it's certainly there, it's certainly heightened. Is it bigger than it has been at any time in the last 70 years or so? I'm not sure about that one.

LW: What's one geopolitical risk that stands out in your memory, and what risks did it pose directly to the portfolio?

Simon Doyle: One that acutely sticks in my mind is September 11. I was in New Zealand. I remember distinctly, as most people remember where they were, I was in the Ibis Hotel in Wellington, turned the TV on, and planes were crashing into buildings. 

No one really knew what was happening, because this was such a shock. It was such a left-field event. It really shook the fabric of how we thought about both the vulnerability of the US, and the potential for those sorts of issues to happen.

And from a personal perspective, it's like, "Well, if they've just shut down US airspace, how am I going to get home if this ends up landing back in New Zealand?" So I think it shook everyone up.

In terms of portfolios, you can't predict those things. So I think it comes back to the idea of why we build diversified portfolios, understanding why we own assets in portfolios for the long run and the underlying value of assets is incredibly important, it's because you can't actually protect for those things. But I think what's interesting from that, and I think you saw that in the Ukraine, we saw it through COVID, in a way we saw it through the global financial crisis, was there's a couple of things that matter.

I mean, one is what position you're in when those shocks occur, and the other is the policy response. And I think markets are inherently selfish. I think market participants are inherently empathetic to the impact of those events, but markets themselves are inherently selfish. And what tends to drive the response is the policy response. And typically, we now see more supportive policies coming through.  

There's the shock, but often the shock creates the opportunity. And I think whether it was September 11, whether it was a global financial crisis, whether it was COVID, there's the impact, but then there's the policy response, and I think that's the two aspects I think that portfolio managers need to be most acutely aware of.

LW: How much weight do you give to geopolitical risk versus other forms of risk when constructing the portfolio?

Simon Doyle: Geopolitical risks tend to be very low probability, very high-impact events in a lot of cases. And so, do you explicitly protect a portfolio for an event that you think is quite unlikely, but if it does happen, could have a big impact? Or do you say, "Well, let's manage that risk in the context of managing other risks in the portfolio, and making sure that I've got the flexibility to respond should that occur"? And I think it's quite difficult to protect portfolios for geopolitical risk specifically.

I tend to think about it through the portfolio construction process. It's about balancing out, in a multi-asset context, investment returns and where are they going to come from. And if events do occur, which throw things off course, where are they likely to come from? 

And markets that are expensive, whether it be equities, whether it be bonds, you're much more exposed to any shock if markets are expensive, if there's a lot of good news priced in. Whereas if assets are cheap, then you can probably carry more risk in a portfolio because you've got a lot more of an inherent buffer.

The other thing is, generally, how you think about the price of protection. Whether it be through just buying options or buying insurance, so put options and buying, that downside, insurance can be expensive. This is where it comes back to the idea that, if events don't occur, then you are just really paying away a premium.

Generally, we focus on having a robust, through-the-cycle portfolio that's driven by those factors. But if the risks are starting to appear, then we can skew the portfolio to help at least lean against those parts of the market that are most vulnerable.

LW: Is it possible to protect the portfolio against these kinds of risks without necessarily predicting geopolitical outcomes per se?

Simon Doyle: It's hard to protect a portfolio for something that might be a very small probability. I mean, you can protect it, but the chances are it won't happen. And that's the problem – you have a portfolio that's really well protected should, for example, China and the US go head-to-head over Taiwan. But if that doesn't happen, you've basically just built a portfolio with a single theme in mind, and that's not going to deliver your overall outcome. So it's always a balance between your inherent objectives and managing those risks as they become greater or reduce, and the price of protection. 

The other dynamic to consider is how does that risk manifest itself.

If you think about Russia-Ukraine, from a market perspective, ultimately there were probably two key things. One was it ended up being an energy shock, which then translated through into an inflation shock. And that was the risk that needed to be protected. 

So, it wasn't the flight to quality that you would normally get through a war, for example. US treasuries didn't rally, they sold off. Central banks actually started tightening policies to combat inflation. 

You need to understand, in terms of either responding to or protecting from a geopolitical event, how the nature of that shock is likely to translate through into the things that you might want to do in a portfolio.

LW: Which asset classes are more susceptible to geopolitical risk, and which are more protected against geopolitical risk?

Simon Doyle: It still depends very much on the nature of the shock. 

Let's say US and China are now lobbing missiles at each other – my instinct, would probably be a flight to quality by Treasuries, by US dollars. But if you're going to see growth collapse, you might actually see that being incredibly inflationary for the world. 

As supply chains are disrupted, shortages exist, so that may not be the way that plays out. So, the normal  "flight to safety" assets may not actually work as well in that circumstance, but certainly, energy would become quite scarce, oil, commodities, and so on would probably rally quite strongly in that sort of event. The nature of the event will, I think, dictate the path of protection that's taken.

From a client perspective, the normal questions we get are, "Are my assets safe?" So it's like, return of capital as opposed to the return on capital. 

And it's, "Can I get my money back?" Liquidity. 

And often you get a request to test liquidity in portfolios, even if you don't get those redemption requests coming through, as investors seek to raise capital and move out of risky markets. 

The challenge is that's the short-run response. The long-run response is still needing to take advantage of the dislocation that occurs in markets to help generate long-term return outcomes, which clients ultimately still want.

LW: With governments becoming increasingly protectionist and isolationist, which industries are most exposed to a "weaponisation" of trade?

Simon Doyle: One of the themes of the last 10 or 15 years has been the export of deflation, or disinflation, from the low-cost manufacturers. That was great in one sense, but it really meant hollowing out of manufacturing in places like Australia and in the US. We're now seeing, through that onshoring process, factories being built in the States, and there's more evidence of production occurring here in Australia. From an industry perspective, it's not really related to the shock itself, but it's recognising those trends you're talking about. 

I think there has been a recalibration away from finance, for example, to goods-producing industries, and manufacturing. I think a lot of the scenarios that you can think of at the moment would actually be quite good for commodities. So, I think participants directly or indirectly in resources, I think will be beneficiaries of those sorts of events.

What does less well are things sensitive to interest rates, those events tend to be bad, from an inherent economic point of view, but also inflationary. Things like financials and property trusts could suffer in those sorts of environments.

But of course, all these things depend on the response, and I think there are industries that are likely to benefit. There's an infrastructure rebuild desperately needed in certain parts of the world to redress some of that wealth inequality. So, those sorts of industries, anything that has inflation-protected cash flows, could do quite well. 

In any circumstance, there'll be winners and losers, but I think they're the parts of the economy that would likely do structurally much better.

LW: Especially in industries with physical goods, how are these supply chains able to recalibrate, as you say?

Simon Doyle: It's remarkable how flexible things can be. I remember when COVID hit and we had those trying to manufacture latex gloves and hand sanitiser. And you had the gin manufacturers turning to producing hand sanitiser. I know we've still got some of the world's most expensive hand sanitiser at home.

People can adapt pretty quickly in the short run, but obviously, you can't set up a chip manufacturing plant overnight. That takes time. That's where I think COVID has probably been a shot across the bow in terms of what can happen if supply chains get disrupted. A lot of that pre-work is happening now but in a lot of industries, it does take time to retool.

LW: What does the geopolitical risk management process look like at Schroders?

Simon Doyle: We start by recognising that there's a whole raft of risks, and it's part of the broader portfolio construction process. 

So say, in a multi-asset sense, we start from the perspective of saying, "Well, what do we think is the central case that is most likely to unfold? Are equities cheap or expensive?" 

That has a bearing on their return outcome and has a bearing on risk. A bond rate of 0 or 4, 5%, has a bearing on the returns and the risk going forward. And we start by constructing a portfolio based around that central case.

Then we need to manage a whole bunch of other risks. So, liquidity, inflation risk, for example, recession risk. And I think it's really a function of how likely we think those events are, what impact they'll have, and what is the price of protection. 

And often we'll go, "Well, we could see this scenario unfold, let's have maybe a bit more duration than we would otherwise have, or a bit more cash than we would otherwise have," and that gives us some flexibility. And, "Look, option protection is actually really cheap, so we can hold some explicit downside protection in the portfolio."

In other cases, we might say, "Look, it's just not feasible, it's so unlikely, we don't really feel we need to do anything. We need to monitor that."

But we have some scenario planning in place, where we'll say, "Well, if this happens, then following from that, these things will happen, and then we'll quickly move to embed some downside protection in portfolios." 

But we inherently see the best risk protection mechanisms include the following:

• own cheap assets, 
• don't devalue liquidity, 
• avoid expensive assets, and 
• don't be too greedy in terms of reaching for return in stretched markets.

LW: So it's really about balancing downside risk, and protecting from downside risk against capturing upside risk?

Simon Doyle: That's right, because downside risk can come in a number of ways, it doesn't necessarily need to be a geopolitical risk factor. I mean, 

Believe it or not, there are economic cycles, which we've forgotten a little bit about. We were reminded over the last couple of years that inflation can exist if you overstimulate, put too much money, too much liquidity into the system, and you'll end up with inflation. So there are the normal risks that processes need to manage – geopolitical risk, by its nature, is just hard to predict. 

No one predicted, well, we could sort of see the scenarios, you can see the vulnerability, whether it be in Israel at the moment, or you could see the vulnerability in Ukraine, but no one really predicts that, "Okay, this is going to happen, and this is going to set off this particular set of events."

It's always a balancing act, but again, that's why we build diversified portfolios, because actually, the future is uncertain. Those events are hard to predict, and so we need things in portfolios that give us the ability to manage for those risks, both to try and protect or at least mitigate the impact, but also then importantly, to take advantage of the opportunity that it creates. 

Throughout time there've been those dislocations, but inevitably there's been a good opportunity created, from a market perspective, and that often leads to some pretty strong returns over the medium to long run.

Take advantage of opportunities wherever they exist

With the flexibility to invest across a broad range of asset classes, Simon aim's to help investors grow their wealth with a reduced risk of losing money when markets fall. Visit the Schroders website to learn more.

Managed Fund

Schroder Real Return Fund - WC

Multi-Asset

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