We live in uncertain times. We have endured unprecedented turmoil in financial markets and are still unclear as to the consequences, shape and final cost of the plans to exit recession and government deficits. The solvency of several nations remains in question and the threat of civil unrest simmers on the streets of these distressed countries. The fallout from the financial crisis still pervades all sections of society and the investment community in particular is struggling with the fact that recent events eroded not only wealth but also confidence.
While investment strategists and asset managers may now have their eyes firmly fixed on recovery, they will need to widen their horizons beyond the pursuit of immediate return opportunities and focus on broader and longer term objectives if they are to help safeguard our collective wealth and contribute to rebuilding a secure and prosperous future.
This is particularly vital when we look at how developed nations are planning to care for their ageing populations. For a growing percentage of the world’s inhabitants, their future retirement will depend on individual action rather than institutions. A socio-cultural shift away from savings and the well-publicised poor performance record of many pension funds means the pensions and retirement industry faces a generation that may no longer recognise its value or trust its efficacy.
This is not a question of image, advertising or even better communication. Rather, it is a question of a fundamental shift in perspective and a corresponding change in strategy. This does not, however, necessarily imply a major and costly disruption to current investment planning. Relatively small changes can have a significant impact.
The search for assets that can be relied upon to protect wealth and stabilise investment strategies has driven investors back to one of the oldest assets known to man, but one that can also now be proven to offer unique benefits in the context of contemporary investment strategies, and that is gold.
While gold’s role as an insurance policy and protector of wealth in uncertain times has certainly helped support its recent sequence of record-breaking price highs, it is worth noting that its value was on the rise well before the first dark cloud was spotted on the horizon. The annual average price has risen for eight consecutive years and, at the time of writing, the price (the London pm fix) is 192 percent higher than on the same date five years ago having recently reached a new all time high.
The most significant driving force behind gold’s sustained bull run has been the growth in investment demand. While jewellery markets were undoubtedly hit by high local prices and the severe constraints on discretionary spending caused by the credit crisis, it is fair to say that this was more than compensated for by the surge in demand from investors.
However, although gold is now increasingly in the spotlight, it was for many years neglected by the vast majority of investors, in a financial environment characterised by a glut of exciting new products, and the promise of bountiful and rapid returns. Even those attracted to its long term wealth preservation and inflation hedging properties often found it cumbersome to access, not wishing to be burdened by issues of physical ownership, storage and security. Fortunately, the arrival of the gold exchange traded funds (ETFs) did much to address these concerns, simplifying access to gold as an asset by allowing it be bought and traded on stock exchanges just like any share. Gold ETF holdings now represent over 1800 tonnes of gold, currently worth around $70bn.
As the gold investment market has developed over the last five years, so have the number and type of products and channels available, such that there is now a range of gold products to suit a variety of investor requirements and profiles.
We should also not forget the resurgence in demand for physical gold. This has been particularly strong in the West, where retail investors, shocked at the fragility of banks and financial markets, have sought security in gold ownership. European demand for gold bars and coins over the last few years has exceeded 200 tonnes per annum, whereas in previous years it often failed to rise above single figures. It can be argued that, while many of these buyers undoubtedly turned to gold as a ‘flight to safety’, their motivations were underpinned by other qualities much sought after by investors but frequently lacking in many strategies and products on offer: simplicity, transparency and security.
Although this reawakening of investor interest in gold has recently driven the price to new highs, gold’s primary appeal as an investment lies not in the generous returns of recent years, but in its independent tendencies which help reduce risk. Investors are increasingly realising that, over time, they will need to address the vulnerability of their assets to both recessionary pressures and the corrosive effects of inflation.
Furthermore, given the experience of the last few years, increasing attention is now being given to ‘tail risk’ – basically, the impact on investments of previously unforeseen or underestimated events. Unfortunately, the vast bulk of portfolios contain few investments that can withstand such shocks and prosper in all these circumstances.
The events of the last three years have exposed these inadequacies. The reality is that many investors were simply too narrow in their focus, investing in assets with drivers which are closely linked. In other words, they had failed to adequately diversify their investments and were therefore overly exposed to negative risks or ‘bad beta’.
Portfolio diversification is used to mitigate risk by ensuring an investor takes allocations in a range of assets, the values of which move independently of one another. This provides the portfolio with greater balance, allowing it to be more robust and stable when faced with a range of market conditions.
When most commodity prices fell in tandem with oil, gold did not respond in the same way. Similarly, when hedge funds and property prices plummeted, gold held its positive price trend. Investors are increasingly acknowledging that they need an asset, such as gold, that can act as a counter-balance to the riskier investments that they may be drawn to in pursuit of alpha.
This resilience and lack of correlation with other assets is rooted in the fundamentals of the gold market. The gold price is driven by a much broader range of factors than those which influence other assets. Unlike most traditional investments, the geographical and sectoral diversity of gold demand help insulate it from economic shocks which have a negative impact on mainstream assets. Gold is many things to many people – a luxury good, a commodity and a monetary asset – and its price is therefore driven by a very wide range of factors which cause it to respond very differently to market forces and economic conditions than most other investment vehicles.
On the supply side, while annual mine production is fairly flat, it is no longer rooted in any specific region or country, making it less vulnerable to geopolitical or physical disturbances. Furthermore, there are sources of supply beyond newly mined gold, such as from recycled (scrap) gold, which contribute to gold exhibiting relatively low levels of volatility, comparable to equity indexes and certainly lower than most commodities.
Gold’s relative lack of risk is a key factor in helping restore investor confidence. Gold, as a real asset, carries no default or counterparty risk – its value does not depend on someone’s ability to pay and it cannot be debased.
However, unlike many other real assets and so-called ‘alternative’ investments, gold can be sold quickly and
with relative ease as the gold market is global and highly liquid.
The role of gold as an ‘insurance asset’, providing enduring security that can be used to reassure investors that broader investment strategies are sufficiently robust to protect their savings and wealth, is, of course, nothing new. It is mirrored even at the national level by the trends in how governments are seeking to protect our collective reserves. A recent survey of the evolution in central bank attitudes towards gold, published by the World Gold Council, concluded: “…the crisis which started in 2007 has proven once again that boom tends to be followed by bust and that economic nirvana still eludes humankind. As long as this remains true there will still be a compelling case for gold as a reserve asset for nations, just as there is for gold as an investment for individuals and institutions.”
It can be argued that investment professionals of all types should bear this simple but enduring fact in mind. On the road to recovery, they may well be attracted to riskier investments in pursuit of significant return opportunities, but they first need to be confident their asset choices provide a stable foundation for sustained growth and are sufficiently cushioned against a range of risks. This is the confidence gold can offer.
Marcus Grubb is MD of Investment at the World Gold Council
