Let's say that you were worried about political risk because the elections scare you more than going down to the basement to investigate a screaming furnace. What would be the best way to hedge against it?
Forget gold and bonds. Volatility is the only investment that performs well in the face of massive political shock, according to a recent study by Unigestion
A recent study showed that, whatever its prowess in discounting future earnings, the stock market is lousy at predicting elections. “The market has always been complacent with political risk,” said Florian Ielpo, head of macro research at Unigestion and a co-author of the paper. (The other two authors were Stéphane Dutu and Jeremy Gatto, also of Unigestion).
Case in point: Brexit.
“Two weeks before the vote, it seemed as if nothing was going to happen,” Mr. Ielpo said. Since the June 24 vote, which supported the United Kingdom's exit from the European Union, the U.K. market has fallen 8.13% in U.S. dollars, all of that loss from the sharp decline of the British pound.
The Unigestion study looked at the prices of gold, stock volatility, foreign exchange, bonds and the U.S. dollar a month before and a month after the past six U.S. presidential elections, starting in 1992. “What you want in a hedge is a tent-like return: Positive before and negative after,” Mr. Ielpo said. Only equity volatility produced that.
And there's plenty of political volatility in store, even after the U.S. election.
“When looking at the upcoming U.S. elections it seems only a few markets are pricing in the risk of an election surprise,” the study said. “Current polls show Clinton leads by a large margin. However, as we have seen with Brexit, polls can misprice such events.”
According to some research, the financial markets strongly prefer a Hillary Clinton presidency and could react with panicked selling should Donald Trump buck the polls and deliver a shocking upset on Nov. 8.
The U.S. election isn't the only potentially upsetting political event coming up. Italy will have a referendum on constitutional changes Dec. 4, which could trigger a general election next year. Austria will have the third round of its presidential election on the same date, which could lead to the election of an anti-immigration party. In France, anti-immigration and anti-EU Front National is expected to easily pass the first round of the presidential election in the spring of next year.
There are plenty of volatility ETFs and ETNs for the U.S. stock market, the largest of which is the iPath® S&P 500 VIX Short-Term Futures ETN (VXX). It's down 57.2% this year, according to Morningstar, but spiked to $67.32 on June 24 from $54.55 the previous day.
Why wasn't gold a better hedge against Brexit? “You use gold as a hedge against something bad happening for sure,” Mr. Ielpo said. One example: The collapse of a government, rather than an orderly change of power.
Volatility ETFs have yet to be embraced by advisers, who often argue that they add as much volatility as they take away. They are also subject to massive tracking error. But if you're looking to hedge against an upset, they might be the best solution.