The golden era?

Natalie Dempster asks whether the time has come for pension funds to consider gold

The gold market has moved firmly into the spotlight recently as the world watched the gold price surge to all-time highs of over US$1000. One of the key drivers of the price has been the behaviour of investors who bought US$13.7 billion worth of gold last year alone.

Historically, investors have been drawn to gold in times of financial stress and gold’s role as a safe haven has been particularly important to investors in recent months following the sub-prime mortgage crisis. Continued weakness in the dollar and growing financial uncertainty saw a widespread loss of investor confidence and a subsequent ‘flight to quality’. High inflows in gold investment, driving the price to record heights, are evidence of gold’s capacity to provide a sure and steady means of protecting wealth, particularly in troubled times.

However, gold‘s unique investment properties make it attractive to investors looking to protect their portfolios, even when conditions are more stable and price performance is not quite so spectacular. Perhaps the most compelling reason for investing in gold, and certainly one of particular relevance to pension professionals, is its role as a long-term or strategic asset.

The rationale for including gold in a portfolio may be fairly intuitive given its lack of correlation with other assets, which makes it an effective portfolio diversifier. What is less intuitive, is how much gold?

A joint study by the World Gold Council and Boston-based New Frontier Advisors set out to answer this question in a report published in September 2006. This month, the World Gold Council has released a summary version of the original report which confirms gold’s role in enhancing portfolio performance.

The study also finds a role for gold in portfolios that already contain commodities. This reflects gold’s lack of correlation with most other commodities, as well as with financial assets. According to the report, gold competes well with small cap and emerging market equities as a diversifying asset.

Despite gold’s proven role as a long-term asset and portfolio diversifier, the composition of the vast majority of pension funds remains restricted to a few asset classes, with most schemes focusing primarily on bonds and equities. It has been argued that this narrow focus is flawed in that it fails to consider assets that may bring greater diversity and therefore greater flexibility and balance to a portfolio.

Portfolio optimiser
Portfolio diversification operates on the principle of not putting all your eggs in one basket – by investing in a diverse range of asset classes, investors can reduce the likelihood of substantial losses arising from a change in market conditions that are particularly damaging for a specific asset class or set of assets that tend to react in a similar fashion.

A portfolio optimiser is a computer programme that works to create the ‘optimal’ portfolio, one that achieves the highest level of return for a given level of risk or the lowest level of risk for a given level of return. For a given set of assets,
and risk and return assumptions, the computer programme runs numerous combinations of the assets to find the most optimal portfolios.

Good in theory, but in practice traditional portfolio optimisers performed poorly, with small changes in the inputs liable to lead to vastly different outcomes in the make up of an optimal portfolio. Portfolio optimisers typically required absolute certainty in all of their inputs, a far cry from the reality of financial markets. Consequently such techniques were often rejected as producing outputs which were too inflexible and fragile.

New Frontier Advisors sought to address this issue with their patented Resampled Efficient Frontier (REF) technology. This technology generates hundreds of optimal portfolios, based on small variations in the original inputs, then averages them. The results are more stable and robust, with small changes in the inputs leading to only small changes in the composition of the optimised portfolio.

The study by the World Gold Council and New Frontier Advisors set out to see whether a typical US investor could enhance their portfolio performance by including gold. And if so, how much gold is needed?

How much gold?
The starting point for the study was to define realistic risk-return expectations for a set of assets excluding gold and then examine the composition of the optimal portfolios produced by the REF process. The same steps were then repeated with a portfolio with gold included in the mix. It became clear that including an allocation to gold helped to enhance portfolio optimality across the risk spectrum.

The amount of gold required to achieve expected returns in an optimised portfolio varies depending on the level of acceptable risk: 1-2% for a low risk portfolio, 2-4% for a medium risk one, and close to 10% at higher levels of risk.
The results also suggested that portfolios that already contain an allocation to a diversifying asset, such as a commodity basket, should still benefit from adding gold. This reflects gold’s lack of correlation with most mainstream financial assets and also with other commodities. The study looked at several alternative scenarios. Interestingly, it found that gold competes well with small cap and emerging market equities as a diversifying asset. Yet, while allocations to the former are commonplace, allocations to gold remain low. It can be argued that this reflects a lack of awareness by many financial professionals of the strategic benefits gold can offer as an asset.

The case for gold
Gold’s potency as a diversifier – its tendency to move independently and not be influenced by external factors in the same way as other markets – is rooted in its supply and demand dynamics. More specifically, the geographic and sectoral diversity of gold demand help insulate the precious metal from western economic cycles.

Demand for gold is widely spread around the world. If we examine jewellery consumption, which represents the source of the majority of gold demand, five countries – India, China, USA, Turkey, and Saudi Arabia – represent nearly 60% of global demand, and each has a market driven by a very different set of socio-economic and cultural factors.
Growing demand for gold from diverse sources, coupled with relatively flat levels of supply, have provided a positive price environment for several years now, with the value of gold on a sustained upward trend well before its recent meteoric rise. The recent surges have, however, also been accompanied by a rise in short-term volatility.

The issue of unwanted volatility is, quite understandably, of enduring concern to pension professionals. However, many investors are surprised to learn that, over the long-term, gold is less volatile than a blue chip stock index, such as the S&P 500. For example, the average volatility of gold since 1984 has been around 12.5%, compared to 14.7% for the S&P 500, one of the world’s most liquid stock market indices. Furthermore, gold volatility tends to be highest when its price is on the rise, whereas equity markets tend to be most volatile when they are failing.

Current market conditions have also raised concerns regarding the corrosive threat of rising inflation, but gold has long been sought out as a protector of wealth, and independent research has substantiated gold’s importance as a long-term hedge against inflation. While gold’s value may deviate in the short term, its purchasing power will hold over
the long run.

There is now firm evidence to suggest that even a small allocation to gold can improve the stability of
a portfolio primarily based on more conventional assets. However, while investment demand for gold continues to increase, allocations to gold and other commodities remain relatively minor when calculated as a percentage of overall assets of most funds. We therefore have to ask, is it time to consider gold as a strategic asset?

To download the full version of the World Gold Council’s Gold as a Strategic Asset report, please visit www.research.gold.org/research.

Written by Natalie Dempster, Investment Marketing Manager, World Gold Council