Geopolitical Risk and the Cross-section of Fund Returns

Abstract

This study examines the pricing implications of geopolitical risk on the cross-section of fund returns. We estimate fund exposure to the geopolitical risk index and find that funds with negative exposure (i.e., in the most negative beta quintile) generate 6.27% higher annualized risk-adjusted returns compared to those with positive exposure (i.e., in the most positive beta quintile). This finding is consistent with the predictions of Merton’s (1973) Intertemporal Capital Asset Pricing Model (ICAPM), which posits that geopolitical risk is a state variable. According to ICAPM, increase in geopolitical risk adversely affects future investment opportunities and consumption; consequently, funds positively correlated with geopolitical risk act as hedge assets. The heightened demand for these assets drives up their prices, leading to lower expected future returns. We further examine whether funds in our sample posses the ability to successfully time geopolitical risk. We find that approximately 4.76% of active funds exhibit a significant positive correlation between the geopolitical risk timing coefficient and geopolitical risk beta, suggesting that timing skill is more prevalent among top-performing funds. These results indicate that investors who are averse to geopolitical risk demand compensation for holding negatively exposed funds and are willing to pay a premium for funds with positive exposure. Our findings have important implications for asset pricing, portfolio allocation, and risk management, particularly for investors seeking to understand the relationship between geopolitical risk and expected asset returns.