Capturing Political Alpha

CAPM / Alpha Theory 23 May 2010

By: Miran Ahmad, CAIA, Editorial Board

When it comes to investing, it is indeed All About Alpha.   Jane Li’s post on these pages ‘Examining “Real Alpha” and “Exotic Beta” in Mutual Funds’ serves as an excellent starting point for the case that asset managers can still create bona fide alpha over their passive-only counterparts.  But what about political alpha?

For Starters

What is political alpha? It is the additional returns generated by an active investment manager assessing, navigating and positioning investments to benefit from the political landscape and impact of political legislation and regulation. Political alpha can be seen as a subset in the overall alpha-generating space.

The creation of self regulating organizations and industry groups like Alternative Investment Management Association (AIMA) and the Managed Funds Association (MFA) testify that asset managers and institutional investors are growing more conscious to the potential and real influence political decisions have upon the financial landscape. Private Placement Memorandums (PPMs) reflect heightened awareness to ‘political risk’ by including it alongside other risks associated with investing in alternative vehicles:

“General economic and market conditions, including …the changes in laws, national and international political environments may affect the success of the Funds. The U.K. Financial Services Authority (the “FSA”), the SEC, other regulating bodies and self-regulating organizations and exchanges are authorized to take extraordinary measures in the event of market emergencies. These factors … may affect substantially and adversely the business and prospects of the Funds.”

Traditional Models

Politics and political decisions even make a cameo appearance into conventional pricing models (ie. modified CAPM) in the form of ‘political risk’ premiums found when valuing emerging equity securities or through adding a historically 3-7% premium on top of similar maturing U.S. Treasuries to gauge expected returns of emerging market fixed income securities.

Re = Rf + B(Rm – Rf + CRP), where CRP is ‘Country Risk Premium’

Such political risk premiums are value-added estimates that try to capture and compensate investors in emerging markets securities for potential political instability that could adversely affect accessibility or liquidity in the local market. How one truly estimates the necessary risk premium for a country facing a potential coup d’état is beyond me.

What little impact political environments have on financial analysis seem to be primarily focused on political risk in underdeveloped countries (i.e. 1998 Russian/2001 Venezuelan defaults, Thai coup, Greece austerity plan, Turkish instability).

What about capturing the political alpha for developed countries such as the United States or Great Britain?  Taking a step back, is there even political alpha to capture? If so, what financial mindset or framework do we view such pieces of legislation or regulation?

The Money in Political Alpha

From the chart above we can see that political decisions ranging from expanding government (i.e New Deal) or engaging in armed conflict (i.e. Korean War, Gulf War) ripples through the financial market. One academic research article points out the significant excess returns of the stock market under U.S. Democratic presidents is 9 percent higher versus their Republican counterparts in a value weighted portfolio. From those results, one could reasonably deduce that simply predicting who will win an upcoming presidential campaign may prove to be a source of alpha. If political alpha was a security type, then its binary outcomes (success or failure of a particular candidate, bill, regulation or legislation) lends itself naturally to the world of options. For example, political alpha can be captured by being ‘long’ a call option, where the market moves significantly to price in the new legislative or regulatory landscape under the auspices of Efficient Market Hypothesis (EMH). The passage of the 2010 healthcare reform saw heavy price and volume movements in healthcare-related stocks and indices.

Conversely, some alpha can be captured by being ‘short’ a call option, betting the reaction of the market to be less than anticipated. The 2008 coordinated ban of short selling by numerous regulatory agencies came as a result of regulators believing such a ban would suppress the downward stock spiral many ‘too big to fail’ institutions found themselves in.

We can see from the chart above that such actions may not necessarily produce the desired results. In fact, Ian Marsh and Norman Niemers’ Cass Business School study on whether the ban accomplished its desired effects stated the following conclusion:

“We find no strong evidence that the imposition of restrictions on short selling in the UK or elsewhere changed the behaviour of stock returns. Stocks subject to the restrictions behave very similarly both to how they behaved before the imposition of restrictions and to how stocks not subject to the restrictions behave”.

So What?

While Jane Li’s article argues technological advances and quant trading strategies diminish arbitrage and technical based alpha returns, political alpha seems a viable alternative for those willing to make their bed with politics.

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