The markets have been fairly calm in the run-up to the May 7 general election, but it’s never too late for them to react to the political uncertainty. If polls are any indication, the formation of another coalition government will be difficult.
Some long-term investors may not be fazed by political uncertainty
The election comes at a time the UK economy has picked up and shows no sign of slowing; the IMF has forecast 2.7% GDP growth in 2015.
But markets dislike political uncertainty. Historically they have priced it into the underlying assets, showing higher volatility as investors come to terms with the unforeseen changes.
Some investors, particularly those thinking mid- to long-term, may not be fazed by short-term political uncertainty, preferring to ride out the election wave, even if there is some market volatility along the way. These investors might do best to stay with an existing FTSE All-Share or FTSE 100 ETF or index tracker.
But investors concerned about the effects of political uncertainty may consider tactical use of ETFs to shield their portfolios.
Low/minimum volatility strategies, which are part of the growing strategic beta subset of ETFs, select and weight their constituents on the basis of historical volatility, reducing the fund’s risk relative to a standard benchmark.
Although no ETFs currently offer a low/minimum volatility strategy with 100% exposure to the UK equity market, investors could consider the iShares MSCI Europe Minimum Volatility UCITS ETF, which offers about 30% UK exposure. It charges a TER of 0.25%.
Currency fluctuation is another possible side effect of political uncertainty, so investors may also want to consider currency-hedged versions of their ETFs. UBS, which has become the main provider of currency hedged ETFs in Europe, offers UBS ETF MSCI UK 100% Hedged to USD and EUR, currently the only currency-hedged UK-focussed ETF. It is suitable for those investors who want to maintain their UK exposure but protect against a possible devaluation of sterling versus the US dollar or euro.
Looking at the mid- to long-term, many analysts have focussed on austerity as the key election issue, but the real systemic risk, and the main contributor to political uncertainty that will affect investors is the EU referendum. If it takes place or is moved forward from the touted 2017 date – a plausible outcome in the event of a Conservative-led coalition – the aforementioned ETFs provide suitable options to protect against potential market volatility and sterling depreciation.
While iShares MSCI Europe Minimum Volatility UCITS ETF may not be a perfect portfolio fit for all investors with its 30% UK exposure, the economic impact of an EU referendum is likely to ripple throughout Europe. In such a case, minimising volatility more broadly may make sense.
Alternatively, investors anticipating negative consequences for the UK economy from the EU referendum may want to consider minimising – or even eliminating – UK market exposure. One way to do this while preserving developed world exposure is through an ETF that tracks the MSCI World or FTSE Developed World, which have about 25% exposure to Greater Europe and 5-10% exposure to the UK.
Two options are db x-trackers MSCI World (DR) 1C and Vanguard FTSE Developed World ETF, with TERs of 0.19% and 0.18%, respectively. Alternatively, the iShares MSCI Europe ex-UK, which charges a TER of 0.40%, excludes UK exposure altogether.
While no one can predict which party will be first past the post, the flexibility and variety of ETFs offers investors a way to make core and tactical investment decisions to address the effects of political uncertainty.
