Economic strategists, fund managers and the guardians of our collective wealth are preoccupied with attempting to determine whether the green shoots peeping through the debris will be short-lived or represent a real return to stability. We also have to hope that they give appropriate consideration to some of the issues which might have contributed to the vulnerability of assets and what steps might now be taken to better protect them in the future. Of course, hindsight is a wonderful thing, and it is perhaps a little too simple and easy now, standing in the wake of the crisis, to suggest that the return expectations of investment professionals during the bull run that ended so dramatically in 2008 were both overly optimistic and unsustainable. But it would be equally remiss of asset managers and policy makers not to examine the factors that lead to such a failure of foresight and what drove them to pursue strategies that proved so fragile when faced with the corrosive consequences of the credit crunch and subsequent recessionary pressures.
It can certainly be argued that many in the investment community were blinkered by an overly narrow focus on the search for returns, which in turn helped further fuel the bull run. This resulted in a vicious cycle of investors taking on increasing amounts of risk to chase higher and higher returns, whilst paying less attention to risk and diversification during this period. Even as clouds gathered on the horizon, many asset managers remained complacent about risk levels within portfolios, believing they were sufficiently diversified. The probability of a negative event was perceived to be very low and the possible consequences judged to be too insignificant to cause serious concern or prompt a change in attitude or policy. In reality, this “tail risk” proved to be much greater than expected and its consequences were both severe and far-reaching.
Awakening complexity
As a result of the widespread shortcomings in portfolio risk management, investors have now been forced to return to the fundamentals of asset allocation and diversification and re-examine the robustness of investment strategies. What has become apparent is that much of the diversification that had taken place was equity portfolio diversification, as opposed to true diversification across asset classes. Recently voiced concerns that diversification theory – which underpins the ability to manage risk in a portfolio – had been proven by recent events to be flawed failed to acknowledge that it was the narrow range of assets used to implement diversification that undermined the effectiveness of asset allocation strategies.
Moreover, to the extent that some asset managers and investors had started to move into other asset classes, much of this was put into practice through complex investment vehicles and strategies that were poorly understood. The decimation of the hedge fund industry and the concurrent decline in property values should now have taught investors that merely moving a portion of their assets away from core equity holdings does not necessarily represent an effective diversification strategy.
To the surprise of many market participants, whereas the reactions of most asset classes converged as market conditions worsened, an age-old but recently neglected asset, gold, proved to be one of the few true diversifiers, uncorrelated to mainstream asset behaviour and impervious to the economic downturn. And, as gold’s value held while oil and broader commodity indices plunged during the second half of 2008, it quickly became apparent that gold is not just another commodity – its qualities as both a monetary asset and an enduring safe haven set it apart from the struggling commodity complex as recessionary pressures mounted.
This unique independence as an asset is reflected in a robustness in the demand for and price of gold across the economic cycle that is not apparent in most other assets. Put simply, most portfolios are strategically biased towards assets that perform well during periods of economic strength, but provide limited support during periods of sharp economic downturn. Effectively, gold’s resilience during periods of crisis provides a form of portfolio insurance. Beta, or market risk, can negatively affect even the most defensive equity portfolios as evidenced in the recent turmoil. From an asset allocation perspective, the absence of a positive correlation in the gold price with the price of other assets makes it a powerful diversifier within a broader portfolio. Even gold’s correlation with a broad commodity basket, while positive, is generally lower than is widely thought.
Looking beyond the recent gloom and current uncertainty, gold can also add value to a portfolio during buoyant economic times. As with other commodities, demand for gold benefits from rising incomes and spending levels during periods of economic growth. In the case of gold, this occurs not just through industrial demand as with other precious metals, but also through demand for gold jewellery. Gold is unique in the range of geographical and sectoral drivers of demand and these help buffer it from specific regional or cyclical shocks. Furthermore, gold offers well-established inflation and dollar hedging attributes. These attributes are relevant from the point of view of both strategic and more tactical asset allocations.
Inflation/deflation
Gold’s inflation hedging ability continues to be an important driver of investor flows. The stimulus measures of quantitative easing, in its various forms, taken by governments across the globe to address the economic crisis carry their own health warning. While the immediate concern may be that major economies struggle to crawl out of a liquidity trap and enter a period of deflation, it is widely acknowledged that the stimulus packages, if successful, also make future inflation far more likely. Currently, gold is benefiting from a fear of future inflation as well as deflation. For those investors concerned about future inflation, it is gold’s historical outperformance during previous periods of high inflation that is proving to be an important motivator. Conversely, in a deflationary environment it is gold’s safe haven status that helps allay investors’ fears, reflecting the likelihood that deflation is the result of continued extremely weak economic conditions.
While each of gold’s long run attributes may be important in its own right, it may not be intuitively clear how they fit together and influence gold’s interaction with a broader portfolio of assets. In other words, if gold’s attributes are judged sufficient to warrant gold’s inclusion within a portfolio, should this allocation be primarily tactical due to current conditions, or are the arguments strong enough to warrant including gold as a core or strategic holding? And, if gold is identified as a foundation asset, how much gold is enough?
World Gold Council recently carried out a series of research studies to examine these questions using patented portfolio optimisation software developed by Boston-based economists and asset allocation specialists, New Frontier Advisers. Long-run returns for a range of assets that might form the core holdings of a typical investor or fund entered into the system and then gold was added with the objective of determining if an allocation to the yellow metal would prove optimal and what size that allocation should be. The studies (for sets of both US and UK oriented assets) produced broadly compatible results; that an allocation of gold is optimal, ranging from around four to ten percent, depending on levels of risk tolerance. It is worth noting that the return expectations for gold used in the studies were conservative and asset managers and investment strategists may consider larger allocations easily justified, particularly during times of uncertainty.
