- Presentations
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- Managing Portfolio Risk with Gold Bullion
The World Gold Council is a non-profit trade association whose mission
includes demonstrating how gold bullion can play a useful role in today's
portfolio management. Most investors have a fixed perception of gold
and may not be aware of gold's ability to control portfolio risk. In
fact, many investors are surprised to hear that gold is helping a number
of portfolio managers to solve some interesting problems. It is helping
managers meet their fiduciary responsibilities when used as a risk management
tool. The calculations and methodology in this presentation are based
on authoritative outside sources.
The Hedging Instrument: Gold
There are some basic characteristics of gold that make it such
a unique asset. First, it is primarily a monetary asset, and partly a
commodity. As much as two thirds of gold's total accumulated holdings
relate to "store of value" considerations. Holdings in this category include:
central bank reserves, private investments, and high-caratage jewelry
bought primarily in developing countries as a vehicle for savings. Thus,
gold is primarily a monetary asset.Less than one third of gold's total
accumulated holdings can be considered a commodity: jewelry bought in
Western markets for adornment, and gold used in industry.The distinction
between gold and commodities is important. Gold has maintained its value
in after-inflation terms over the long run, while commodities have declined.Some
analysts like to think of gold as a "currency without a country'. It is
an internationally-recognized asset that is not dependent upon any government's
promise to pay. This is an important feature when comparing gold to conventional
diversifiers like T-bills or bonds which, unlike gold, do have counter-party
risk.
Determinants of the Gold Price
Econometric studies indicate that the price of gold is determined by two
sets of factors: "supply" and "macro-economic factors".Supply and the
gold price are inversely related. Besides new mining supply, the available
supply of gold in the market is made up of three major "above-ground sources":
(1) reclaimed scrap, or gold reclaimed from jewelry and other industries
such as electronics and dentistry; (2) official, or central-bank, sales;
(3) gold loans made to the market from official gold reserves for borrowing
and lending purposes. In recent years, the growth in gold supply has come
from "above-ground" sources. In the case of "macro-economic factors",
the U.S. dollar tends to be inversely related to gold, while inflation
and gold tend to move in tandem with each other. Also, high real interest
rates are generally a negative factor for gold. Overall, the impact of
the above determinants on the gold price is judged to be neutral-to-slightly-positive
at this time.
Effective Portfolio Diversifier
This statement summarizes the usefulness of gold in terms of "Modern Portfolio
Theory," a strategy which is utilized by many investment managers today.
Using this approach, gold can be used as a portfolio diversifier to improve
investment performance.
Gold is Negatively Correlated toOther
Assets
This chart demonstrates why gold is such a helpful diversifier. The bar
charts above display the correlation between gold on the one hand, and
various asset classes on the other. Gold is negatively correlated with
most other asset classes. For example, whenever long-term bonds decline,
there is a tendency for gold to go up. Whenever equities decline, there
is an even greater tendency for gold to go up.
Gold is Negatively Correlated to US Equities
In this chart we can see that gold is more negatively correlated to U.S.
stocks than any of the other asset classes that are typically used as
portfolio diversifiers (such as bonds, emerging market equities, and REITS).
This makes gold an especially effective diversifier for equity-oriented
portfolios.
Reversion to the Mean
Let's examine the relationship between gold and equities a little further.
Historically, the price of gold has generally moved in the opposite direction
to equities. In particular, the price of both equities and gold tend to
"revert to the mean" at certain points in history. During the recent years
of strength in the stock market and weakness in the gold price, many portfolio
managers have had reason to question what role, if any, gold can play
in a portfolio's performance.Yet considerÖthe stock market has been unusually
high compared to its mean, as this chart illustrates, and the gold price
has been unusually low compared to its mean. Therefore, the upside potential
for the gold price is perceived to be greater than the downside potential.Recently
it appears the stock market has had some reversion to the mean. The key
question is whether the market will continue to revert to the mean.
Ratio of Dow Jones Industrials to Gold
This chart displays the ratio of the Dow Jones Industrial Average to the
gold price since 1885. The ratio of these investments have experienced
marked peaks and valleys during major market cycles -- peaking once in
1928, a second time in 1965, and a third time in 1999. Since then the
ratio has turned downwards. Again the question remains: will the ratio
continue its decline?Key dates: 1896 Time of financial turmoil, and speech
by Williams Jennings Bryan on "Cross of Gold". 1932 Bottom of stock market
cycle. 1980 End of inflationary boom, resulting in the erosion of the
value of financial assets.
Gold Makes Portfolio Returns More Predictable
There are three main problems associated with traditional methods of asset
allocation:(1) Historical returns are not normally distributed Almost
all asset allocation studies that use mean-variance optimization assume
that the returns of the assets are normally or log normally distributed
and consequently can be described by their mean and standard deviation.
Yet, historical returns are not in reality normally distributed.(2) Financial
StressTraditional asset allocation often does not work during periods
of financial stress when it is most needed.(3) Unanticipated InflationTraditional
portfolios do not perform well during these periods.The inclusion of gold
in equity portfolios addresses these three problems. Gold has been shown
to reduce both negative skewness (that is, portfolio underperformance)
and the number of outliers, by making the portfolio's distribution more
"normal" (point 1, above). Also, gold improves portfolio performance during
periods of stress and unanticipated inflation (points 2 and 3). Overall,
gold can be used to create portfolios that will have less "surprise" and
perform more in line with the investor's expectations created by the asset-allocation
process.
Effective Diversification During "Stress"
Periods
Traditional methods of portfolio diversification often fail when they
are most needed - that is, during periods of financial "stress" (instability).
On these occasions, the correlations and volatilities of return for most
asset classes (including traditional diversifiers such as bonds and alternative
assets) increase, thus reducing the intended "cushioning" effect of a
diversified portfolio. Consequently, the portfolio does not perform as
originally expected, leaving investors disappointed.This chart depicts
an "efficient frontier" curve (red line) using a new optimization procedure
which recognizes that periods of stress do in fact occur. The portfolios
included on the efficient frontier contain the following asset classes:
large cap equities, international equities, Treasury bills, long-term
Treasury bonds, small cap equities and gold. The assumption made in developing
this efficient frontier is that there is an equal likelihood of either
a stress or non-stress period occurring. Notably, gold appears in many
portfolios along the efficient frontier, ranging from very conservative,
low-risk portfolios (mainly bonds and T-bills) to aggressive, high-risk
portfolios (mainly equities).Next, Monte Carlo simulations of future returns
were conducted for stress and non-stress periods for a variety of portfolios
on the efficient frontier to test the consistency of their performance.
Based on the results of these simulations, a portfolio with a moderate
expected risk exposure of 11.6% (standard deviation) and an expected annual
return of 11.4% was selected (point A) for two reasons. First, this portfolio
had relatively consistent results during both stress and non-stress periods.
Second, the expected returns were near the level of returns for a typical
60% stock/ 40% bond portfolio. This efficient portfolio includes a 6%
allocation to gold.When stress conditions were simulated on the 6% gold
portfolio, the return (point B) was 11.1% (only 50 basis points lower
than the expected return of 11.4% for point A). Similarly, when non-stress
conditions were simulated (point C), the return was 11.5% (10 basis points
higher than expected in point A). Thus, the selected portfolio with 6%
gold weighting (gold line) had generally similar returns regardless of
whether the environment was stress (point B) or non-stress (point C) -
a desirable result.
Moderate-RiskPortfolio Performs Consistently
WellIn Both Environments
This chart compares the performance of efficient portfolios with both
higher and lower levels of expected risk and return during both stress
and non-stress environments. All of these portfolios contain gold. The
low-risk portfolio (in lower left corner) had a lower return and volatility
during non-stress periods, but a higher return and volatility during stress
periods. On the other hand, the high-risk portfolio (in upper right corner)
had a higher return and lower volatility during non-stress periods, but
a lower return and higher risk during stress periods. High-risk investors
are therefore, more likely to be disappointed during stress periods. The
moderate risk portfolio with 6% gold, performs closest to the expected
returns during both stress and non-stress periods. This portfolio is therefore
less likely to result in unpleasant surprises for the investor.
How to Buy
Gold bullion is available through brokerage firms and banks throughout
the U.S. Investors can choose the method of purchase and storage that
best meets the particular institution's needs. Investors can take direct
possession (physical delivery) or they can buy through a storage program.
In the latter case, the broker, banker or dealer uses a secure, third-party
depository to hold and protect the gold for a small fee.With a storage
account, the investor holds title to a specified amount of gold, which
gives him/her the right to demand physical delivery at any time. With
most storage accounts, the investor is allowed to buy and sell gold over
the phone and receives a complete record of all transactions for tax and
portfolio management purposes. Investors holding a minimum of 10,000 oz.
of bullion also have the option of earning a modest return through leasing
programs. Like other interest rates, gold lease rates vary based on market
circumstances and the length of maturity of the financial instrument.The
gold-linked instrument combines most of the attributes of an investment
in gold with all the advantages of a bond. A major attraction lies in
the broad range of structural variables that can be incorporated. An important
benefit of the gold-linked instrument is that it enables the investor
to buy gold with an income. The variables that can be built into the structure
are such that it can be tailor made to meet the needs of practically any
investor.
Conclusion
Why Gold Now?
Why is now a particularly appropriate time to be looking at gold? Much
of the U.S. stock market has weakened, and the inflation rate has stopped
declining. Meanwhile, the gold price has begun turning up from a very
low level. Accordingly, portfolio managers are focusing more on "preservation
of wealth" strategies rather than aggressively seeking capital gains as
they have done in recent years. They are increasingly recognizing the
need to diversify their portfolios into alternative assets, including
gold. To hold all one's investments in conventional assets such as stocks
and bonds is to run the risk of experiencing bad portfolio performance
due to the unbalanced structure of the portfolio. |