Politics matters
Whenever I write about politics, I risk getting angry emails from readers who do not agree with my politics. Especially when I write about Trump and his administration’s complete loss of any sense of reality (let alone decency) some people tend to write to me I should rather stick to investing and economics than politics.
But politics matters for investing, whether you like it or not. And being able to realistically assess the economic effects of policies and elections is a key advantage if you want to make money. The crucial thing for investors is not to take the world as they want it to be but as it is. Believing in political fantasies might keep you in the good graces of politicians and maybe your circle of politically like-minded friends, but it certainly won’t help your portfolio.
How big the difference between investors who understand political trends and their impact on the economy and market can be is relatively easy to show. A group of researchers from the University of Central Florida has measured the “political leaning” of US equity hedge fund portfolios. They have done that by estimating if a stock’s return has higher returns if a Democrat is in the White House or a Republican. The average political sensitivity of hedge fund portfolios is shown in the chart below. A positive value indicates that the portfolio benefits more from a Republican in the White House while a negative value indicates it benefits more from a Democrat.
Political sensitivity of US equity hedge fund portfolios
Source: Chen et al. (2020).
On average, hedge fund managers hold portfolios that benefit more from Republican administrations. This, by the way (and just to make some conservative-leaning readers mad), is not the result of Republican Presidents being better for business. Historically, both the US economy and the US stock market have done better under Democratic Presidents than under Republicans, so if they were acting in the interest of their portfolios, hedge fund managers should root for Democrats to win the White House.
Yet, what is also visible is that around the time of a Presidential election, hedge fund managers shift their portfolios in the direction that benefits the likely winner of the election. Sometimes, like in the case of the victories of George W. Bush and Barack Obama, this may come as a surprise requiring a significant adjustment of the overall portfolio as the party in control of the White House shifts. But investors who are better at predicting the outcome of Presidential elections clearly have an advantage because they can position their portfolio more aggressively towards the stocks that will benefit from the eventual winner and do so before other investors do.
The alpha earned by hedge fund managers varies significantly depending on their ability to incorporate Presidential elections into their portfolios. While the bottom quartile of hedge fund managers by political sensitivity (the measure shown above) earn an annualised alpha of 1.2% in the election year, the top quartile managers that are best able to exploit politics in their portfolios earn an alpha of 5.6%. In years when party control of the White House switches, the best managers can even increase their alpha to 8.3%. Politics matters quite a bit.
“Political alpha” of US equity hedge funds
Source: Chen et al. (2020).