Portfolio Risk Management
Amid the uncertainties surrounding mainstream asset classes, risk management has become a hot topic at investment conferences. Alternative investments, by definition, skirt the constraints of rigorous benchmarking.
As a result, a variety of alternative assets are being promoted as portfolio diversifiers. But buying diversifiers such as hedge funds, private equity, commodities, real estate, timber and agricultural land, fine art, put options and so on is one thing. Selling them when one needs the cash is quite another. Gold's liquidity is one of its critical investment attributes.
Investors strive to reduce the volatility or risk profile of their portfolios without diminishing their expected return. Alternatively, they seek to enhance portfolio returns without increasing risk. To do this they seek poorly correlated asset classes which, being driven by different economic forces, tend not to rise and fall together. This is the essence of portfolio diversification. The trouble is that traditional diversification often !ails when most needed. Research shows that the correlation and volatility of many ostensibly poorly correlated assets tend to converge during financially unstable periods.
Gold's pre-eminent investment characteristic is its low or negative correlation, with other commonly held asset classes. The more negative the correlation between the diversifier and the pre-existing portfolio the lower the overall volatility of the new portfolio leading to enhanced rehm1s. As well as being negatively correlated with most assets, gold tends to become more volatile during periods of financial stress. This is helpful because the greater the volatility of a negatively correlated asset the more it reduces portfolio risk. In short, gold could have been designed for portfolio management. Gold is as relevant today in the 21st century as it ever has been.
The World Gold Council recently commissioned a study using a new methodology that takes into account the behaviour of various asset classes during both stable (nonstress) and unstable (stress) periods. Using this approach, it is shown that even a modest allocation to gold can improve the consistency of a wide range of portfolios on the efficient frontier. In other words, portfolios that contain gold are generally more robust than those that do not.
In view of gold 's investment properties, it may be asked why every portfolio manager in the world has not already allocated a portfolio weighting to gold. The simple answer is that there are a number of both genuine and perceived barriers to investment. The WGC is actively seeking to lower these barriers or remove them altogether.
Foremost among them is ignorance, which can generate perceptions that are frequently wrong. This has led to indifference at best, and frequently to quite forcefully expressed negative perceptions about gold. The majority of today 's fund managers blissfully ignore gold and its role as a portfolio diversifier. Bearing in mind the twenty-year downtrend in the dollar price of gold, it is difficult not to feel a modicum of sympathy. Gold has closely tracked the decline in inflationary expectations as expressed in the field on the US long bond. But how much longer can this trend continue before the spectre of deflation strikes?
Gold has also suffered from the extraordinary strength of equities. Stock indices have diverged dramatically above their long-term trend and, even after recent setbacks, many feel that valuations remain stretched. Some question to the likelihood of continued dollar strength. Conversely, the gold price has diverged markedly beneath its long-term trend. And yet annual constm1ption outstrips mine production by more than 50 per cent while production is expected to fall in the medium term. Central banks, which have filled the primary supply deficit in recent years, are also likely to increase either their sales or lending to the market. lt would be rational to expect both equities and gold to revert to their respective means. The logic of holding gold as a portfolio diversifier is increasingly compelling.
The majority of investors are unaware of the market fundamentals. Even those who have heard, for example, of what has been called the Washington Agreement on Gold (WAG ) have scant understandi.ng of its implications for the market. Prior to WAG, investors were led to fear an overwhelming tidal wave of central bank selling swamping the market. To a great extent, they still do, even though that danger has receded dramatically. Neither are they aware of the dramatic downturn in gold exploration expenditure, by more than 60 per cent from 1997 to 2000 and what that implies for the future of newly mined gold supply.
There are other widely held misperceptions. For example, it is frequently said that gold is both difficult and expensive to buy. Largely because distributors have not actively sought new customers the distribution network is admittedly poor. But this is changing as bullion banks realise that their customer base is dwindling. However, the transaction costs on gold are extremely competitive, as the table on the following page shows.
Investors seldom refuse to buy equities because the transaction costs are too high. Few of them even know what those costs are. Yet, as this table shows, there is a relative advantage of at least 16 basis points rising to two percentage points or more in favour of gold on a one-year round trip. This table gives the lie to the misperception that dealing in gold is expensive.
Even then there will be investors who, though they desire an asset with gold's special investment attributes, find the concept of owning glowing bars of gold difficult to accept. There exist investment vehicles that may be more suited to their particular style.
Straightforward and efficient examples are the depository schemes and metal accounts operated by a number of depositories and investment banks. Gold bars may be bought and stored on either an allocated, that is segregated, or an unallocated, unsegregated basis. The former provides complete security while unallocated gold afford. the opportunity of putting it on interest-bearing deposit - although the security is then dependent on the security of the bank itself.
A gold-linked convertible bond or structured note provides a securitised investment in gold. This is a hybrid, combining most of the attributes of an investment in gold with all the advantages of a bond. An important benefit is that the gold convertible bond enables an investor to buy gold with a yield. And it can be structured to provide not only income but also capital protection.
This article has touched upon some of gold's remarkable investment properties and debunked some of the misperceptions that can be a barrier to investment. ln the sort of markets to which we have sadly become accustomed, none of us can afford to sit idly by waiting for eager investors to call. Investors do not buy gold in these conditions; it has to be sold to them. This is what we at the World Gold Council are doing.