Gold and safer strategic investment

by John Mulligan, Investment Marketing Manager, World Gold Council

Over the last eighteen months, the financial markets have experienced unprecedented levels of turmoil, with the value of equities and other assets plummeting to lows not seen in over a generation. This has caused many pension professionals to look more closely at the assets under their management and ask which can be trusted in a financial environment now littered with the debris of fallen institutions and polluted with toxic assets. More specifically, they have been forced to question whether their investment strategies offer a reliable means of balancing return potential and risk reduction.

Since the onset of the credit crunch, nearly all asset classes have suffered, with marked falls even in the value of those assets that many regarded as safe havens. And investments that were supposed to provide protection via diversification failed to perform as expected, heading in the same downward direction as mainstream assets. Consequently, some advisors and fund managers have expressed concerns that there is a lack of financial instruments at their disposal that can be relied upon to retain their value and offer true diversification. There is, however, a growing body of research to suggest that this might be addressed if they directed their attention to that most distinct of assets, gold.

Gold’s reputation as the traditional ‘safe haven’ and ‘asset of last resort’ for investors is well-established, but some commentators have suggested the yellow metal’s price, even though it has repeatedly broken record highs, has not lived up to their expectations. However, this argument fails to consider the impact of investors that were holding gold when the crisis really started to bite; many had little alternative but to liquidate their gold holdings to meet margin calls and cover obligations from exposure to other plummeting assets.

In reality, gold has outperformed both traditional and competing alternative assets throughout the crisis and has reasserted its virtues as a safe haven and source of diversification. While shares on the global stock markets lost an estimated US$14 trillion during 2008, the gold price remained strong and demand was soaring. In the last quarter of 2008 there were record levels of investment in gold, with unprecedented demand for bars and coins, particularly in Europe, resulting in shortages and waiting lists.

Between the last quarter of 2007 and the same period in 2008 there was an unprecedented rise of 369% in retail gold investment. In addition, there were large inflows into gold exchange traded funds (ETFs), securities that are traded on local stock exchanges and are fully backed by allocated bullion. In the first quarter of 2009, investors bought a record 469 tonnes of gold via ETFs, taking the total amount of gold in the ETFs by the end of the quarter to 1658 tonnes, worth US$48.6 billion.

Whilst recent growth in investment demand undoubtedly reflected a ‘flight to quality’, sparked by volatile and uncertain times, it should be viewed in the broader context of gold’s longer-term, sustained development as a financial asset. Although safe haven buying during the current stormy conditions has clearly been substantial, gold was on a steady upward trajectory long before dark clouds had started gathering on the horizon. The annual average gold price has risen for 7 consecutive years and ended the first quarter of 2009 over 215% higher than it was at the start of the decade. In contrast, the value of the UK equity market, as indicated by a range of FTSE indexes, fell at least 25% over the same period. But the primary case for investing in gold is not rooted in its return potential. There is a growing acknowledgement that the pursuit of returns can no longer be justified without a commensurate level of attention being given to the management and mitigation of risk. This has now gained impetus among institutional investors and their advisors, with an urgent reappraisal of the risk-return balance in their investment strategies.

Gold is many things to many people - a luxury good, a commodity and a monetary asset - and its price is driven by a more diverse range of factors than those which influence other assets. Gold’s value is therefore generally independent of the tendencies of other investments and prevailing economic indicators and thus it can be used to add diversification and balance to an investment strategy. The significance of this lack of correlation and its persistence over time and across geographies cannot be overstated. Portfolios that contain even a small allocation of gold can be proven to be generally more robust and better able to cope with market uncertainties than those that do not, showing improved stability and predictability of returns. The World Gold Council’s recent study, Gold as a Strategic Asset for UK Investors, used state-of-the-art portfolio optimisation software to examine whether an allocation to gold would be judged to contribute to optimal performance to a ‘typical’ UK portfolio, given specific risk and return expectations. The report concluded that a strategic allocation to gold is optimal and that gold’s benefits as a diversificatory asset are not easily duplicated:

This… highlights the importance and strength of gold’s diversification properties. Furthermore, contrary to popular opinion, the unique qualities that gold adds to an investment portfolio cannot be duplicated through a broader commodity exposure. When gold was added to the portfolio optimisation decision, a strategic allocation continued to be optimal, over and above any allocation to a broader commodity basket. (R. Wozniak, November 2008)

These findings were compatible with and supportive of similar research conducted by World Gold Council and portfolio optimisation specialists New Frontier Advisors in 2006 focusing on asset allocation for US portfolios. Broadly speaking, both studies suggested that inclusion of gold can improve consistency of returns when combined with a portfolio of more conventional assets - as little as 4% in a low / medium risk portfolio through to 10% in a higher risk one.

The reason for gold’s independence from other assets is rooted in its supply and demand dynamics. Demand is spread across several sectors – jewellery, medical, industrial and investment, and is geographically diverse. Furthermore, gold demand is, traditionally, greatest in dynamic economies that have been less severely damaged by the current malaise. Supply, on the other hand, has remained relatively flat over the past decade. The mining of gold is a complex and lengthy process and therefore cannot respond quickly to price rises or changes in consumption. Whilst it may be increasingly difficult to locate and extract new gold, modern mine production is now spread over many countries and therefore, unlike many other commodities such as oil, is far less susceptible to supply shocks in specific countries or regions which may result in sudden price instability. These fundamentals of the gold market help to buffer it from the impact of recession and also reduce its volatility, which is far lower than most other commodities.

Gold is also distinguished from many other assets by the absence of counterparty risk - like all physical commodities, gold is an asset that bears no default risk and is no one’s liability. However, in contrast to many other commodities and ‘alternative’ assets, gold is a highly liquid asset. Gold can be traded around the clock in larger size, at narrower spreads, and more rapidly than many competing diversifying assets and even than many mainstream investment vehicles.

What the events of the last year have shown is that we must always be prepared for the unexpected. This is where gold shines brightest. Gold’s capacity to retain its value when all else is failing, and the ease with which it can be traded, allow it to function as an insurance against the collapse in value of traditional asset classes. The real value of gold is not that it provides a quick, speculative fix, but its capacity to provide a sure and steady means of protecting wealth and to enhance the consistency of returns whilst reducing risk.

WRITTEN BY JOHN MULLIGAN,
INVESTMENT MARKETING MANAGER,
WORLD GOLD COUNCIL