Issue 12
Gold in Today's Investment Portfolio: An Idea Whose Time Has Come
Equities, particularly in the United States, continue to achieve new highs in an almost effortless fashion, leaving certain investors concerned about the potential for a sharp correction. Price-to-earnings (P/E) ratios at historically high levels and dividend yields correspondingly low suggest that the stock market is becoming increasingly vulnerable.
Equities, particularly in the United States, continue to achieve new highs in an almost effortless fashion, leaving certain investors concerned about the potential for a sharp correction. Price-to-earnings (P/E) ratios at historically high levels and dividend yields correspondingly low suggest that the stock market is becoming increasingly vulnerable.
Accordingly, this is an appropriate time to examine the advantages of including alternative assets - such as gold - in an investment portfolio. In the United States, investment managers wary of, a stock market correction are now shifting their focus toward strategies aimed at ' preservation of wealth ' - in effect, seeking to take out 'insurance policies ' for their portfolios. Gold is one alternative that has been gaining the attention of a growing number of investment managers. In its dialogue with US institutional investors, the World Gold Council has identified at least t 200 tonnes of bullion held by leading pension funds. In 1997 alone, at least 50 tonnes of gold were purchased by these funds.
Why Gold?
According to Council research, there are four main benefits of holding gold in a portfolio : ( I ) gold is an efficient portfolio diversifier ; (2) it is competitive with conventional diversifiers (such as Treasury bills); (3) it is more liquid than other ' alternative' assets; and (4) gold can enhance portfolio returns.
An Efficient Portfolio Diversifier
Gold is the only asset which is negatively correlated to, virtually all other asset classes (including conventional assets, such as stocks and bonds), meaning that its price tends to move in the opposite direction from them. For instance, when equities enjoy good returns, gold tends to have a low or negative return (see charts below).
Because gold is negatively correlated with most asset classes, its inclusion in an investment portfolio leads to a considerable reduction in the volatility of that portfolio. This reduction in volatility, in turn, improves portfolio returns. For instance, it is difficult for a portfolio to recover losses when the declines in asset prices are large.
Gold's usefulness as a component of a portfolio is particularly noticeable in the case of international investments. Research has shown that adding gold to a portfolio comprising a basket of currencies enhances the portfolio's return and/or reduces portfolio volatility: gold is also negatively correlated with several main currencies. The mix of gold and currencies that make up an 'efficient' portfolio is determined by the use of an optimizer. This is a mathematical formula which calculates the specific asset-mix for a portfolio which will result in either a maximum return for each level of volatility or a minimum level of volatility for a given return. At times, gold 's benefits can be particularly advantageous for US investment funds with holdings in emerging markets that are considered particularly 'risky'.
Finally, gold brings benefits to portfolios involved in meeting corporate obligations - as in the case of companies meeting their pension liabilities. First, the benefits are especially strong in the case of companies particularly vulnerable to inflation-related wage demands. An example would be a company whose labour force is highly skilled and therefore likely to win demands for increased wages. There is an especially strong need for that corporation to invest in asset s (such as gold ) that provide protection against inflation. Second, gold can be useful to those pension funds that arc ' w1der-funded' (that is, where the market value of the corporation's pension assets is lower than the present value of projected pension liabilities). Since adding gold to a pension portfolio reduces its volatility, it permits the inclusion of higher return assets in that portfolio without increasing the overall level of risk. And, third, in the case of pensions with intern national liabilities, the inclusion of gold in a pension fund's portfolio provides an effective hedge against foreign-currency fluctuations, as seen earlier.
Competitive with Conventional Portfolio Diversifiers
US Treasury bills, US bonds and options (such as put options on the S&P stock-market index) are frequently considered to be superior portfolio diversifiers in comparison to gold. Yet it can be demonstrated that a standard portfolio consisting of Treasury bills without gold is more volatile than a portfolio with gold. Furthermore, since the gold price is usually more volatile than real ( after inflation) Treasury bill yields and is also negatively correlated to those yields, including a small proportion of gold in a Treasury bill portfolio provides an excellent hedge against its yield fluctuations. This advantage of gold is an important consideration for short-term money managers.
Turning to bonds, this asset class no longer acts as a strong portfolio diversifier vis-a-vis equities. On the contrary, returns on bonds and equities have been moving in the same direction in recent years, while gold has continued to be negatively correlated to both, making it the superior diversifier.
Finally, investors often believe that the purchase of a put is the best way to protect the value of a portfolio against a stock market decline. This is not necessarily true. Research demonstrates that gold holds certain advantages over a put. For instance, the purchase of a put option is often expensive, especially when the wider lying index is volatile, turns diminishing the expected return on a portfolio. Also, the value of a put not exercised will decline until reaching zero at maturity, whereas gold will maintain its value.
More Liquid than Other 'Alternative' Assets
Gold is highly liquid and can even be considered a good proxy for cash. Unlike equities of even the world's largest corporations, bullion can be traded 24 hours a day in markets around the world. Other measures of the degree of golds liquidity include: (1)the turnover of gold in world markets is as large as the turnover in several major currencies; (2) the bid/offer spread for gold transactions is as narrow as for such assets as equities and high grade bonds; (3) changes in the gold price during a typical trading clay are small; and (4) it takes about the same time to execute a gold trade as it does in stocks and bonds.
Gold's usefulness as a source of liquidity was powerfully demonstrated during the stock market crash of October 1987 when bullion held its value. Meanwhile, all sectors of the equity market - including gold equities - declined sharply.
