Sovereign wealth funds and the case for gold

Gold Investor, September 2017

19 September, 2017

Sovereign wealth funds and the case for gold

As part of the World Bank’s Reserves Advisory Management Program, Jennifer Johnson-Calari and Adam Kobor helped both central banks and sovereign wealth funds to build their investment management operations. Today, Johnson-Calari heads JJC Advisory and Adam Kobor is Director of Investments at the New York University. Both believe gold has an increasing role to play in central bank and sovereign wealth fund portfolios.

Adam Kobor
Director of Investments
New York University

Gold is nobody’s liability, its value deriving for millennia from its beauty and scarcity. As such, gold was the ultimate reserve currency held to settle transactions and back liabilities – first under the Gold and then the Dollar Standard. But, as the US currency gained prominence in the latter part of the last century, central banks and the IMF began to reduce their gold holdings. The “end of history” was declared and central banks accepted a fiat currency backed by the full faith and credit of the US government in its place.

Over the last decade, however, gold has risen to new prominence for sovereign investors as a portfolio asset, rather than a currency. Gold tends to preserve its value in real terms. Gold held or backed by London gold good delivery bars is highly liquid, both in the spot and ETF markets. And a gold allocation plays an important role in creating a robust portfolio that performs well over different economic regimes.

Chart 6: Central Bank Gold Holdings 1999-2016

Source: IMF

The changing role of gold can be seen in the trend of central bank holdings. As the US dollar became the accepted currency for global settlements, central banks shifted from gold to US government obligations. Following 2007, however, the “risk free” status of US bonds began to erode due to quantitative easing, questions around fiscal sustainability and domestic politics.

While still considered credit-risk free, government bonds no longer met the objective of capital preservation in real terms, as yields turned negative. In response, central banks sought to diversify across currencies, financial assets and gold.

As the US dollar became the accepted currency for global settlements, central banks shifted from gold to US government obligations.

Central bank and sovereign wealth fund investment objectives

From an institutional perspective, central banks and sovereign wealth funds have little in common. The primary mission of central banks is monetary policy. Sovereign wealth funds developed both to stabilise budgetary spending over boom and bust cycles and to invest revenues from government surpluses and the sale of finite natural resources across generations.

As institutional investors, however, the two have more in common than first meets the eye. Both seek to balance liquidity, capital preservation and returns from a global investment portfolio. Moreover, the timing of their liquidity requirements is uncertain but frequently concurrent, coinciding with periods of domestic economic stress.

Looking back over the past 20 years, as central banks experienced significant growth in foreign currency reserves, they increasingly split their reserves into two portfolios – a liquidity tranche designed to meet potential short-term liquidity requirements and a long-term investment tranche as a “war chest” for the future.

The investment tranche started to assume a more important role as monetary regimes shifted from fixed to floating exchange rates. Under floating-rate regimes, central banks did not have to hold their full arsenal in immediate liquidity to defend a fixed peg, as was previously the case. In some countries, the central bank’s investment tranche was transferred, at least in part, to a national sovereign wealth fund for management purposes.

During roughly the same period, sovereign wealth funds developed as rule-based organisations designed to allocate government surpluses between potential short-term budgetary requirements and long-term wealth preservation. Accordingly, many countries have split their national surpluses into distinct funds with different objectives. Stabilisation funds are primarily invested for liquidity to fund relatively unpredictable government budgetary gaps. Future funds are invested for long-term wealth preservation. And, like central banks, most sovereign wealth funds are required to invest the bulk, if not all, of their assets in foreign currency instruments.

In this new world, what role can gold play as part of a sovereign investor’s investment strategy?

Table 2: Economic regimes 1967-2017

  Economic growth Inflation Percentage observation
Normal expansion Positive Normal/low 53%
Overheated growth Positive High 30%
Stagflation Poor High 11%
Deflation Recession Low/negative 6%

The role of gold in sovereign portfolio construction

Each sovereign investor – whether a central bank or a sovereign wealth fund – has unique investment preferences dictated by their country’s economic structure, demographics and political preferences.

But gold can help to create a robust portfolio under a range of economic regimes.

Sovereign wealth funds and the case for gold - Chart 7: Overheated growth

Chart 7: Overheated growth

We use quarterly data over 1967-2017. Oil and gold returns are percentage change in spot prices. Recession periods are identified by NBER. To illustrate “high inflation” periods, we select quarters when quarterly change in CPI exceeds 1% (corresponding to an annual inflation rate of over 4%).

Source: IMF

Data as of

Sovereign wealth funds and the case for gold - Chart 8: Stagflation

Chart 8: Stagflation

We use quarterly data over 1967-2017. Oil and gold returns are percentage change in spot prices. Recession periods are identified by NBER. To illustrate “high inflation” periods, we select quarters when quarterly change in CPI exceeds 1% (corresponding to an annual inflation rate of over 4%).

Source: Authors’ calculations; Bloomberg; NBER

Data as of

Sovereign wealth funds and the case for gold - Chart 9: Deflation

Chart 9: Deflation

We use quarterly data over 1967-2017. Oil and gold returns are percentage change in spot prices. Recession periods are identified by NBER. To illustrate “high inflation” periods, we select quarters when quarterly change in CPI exceeds 1% (corresponding to an annual inflation rate of over 4%).

Source: Authors’ calculations; Bloomberg; NBER

Data as of

Sovereign wealth funds and the case for gold - Chart 10: Healthy growth

Chart 10: Healthy growth

We use quarterly data over 1967-2017. Oil and gold returns are percentage change in spot prices. Recession periods are identified by NBER. To illustrate “high inflation” periods, we select quarters when quarterly change in CPI exceeds 1% (corresponding to an annual inflation rate of over 4%).

Source: Authors’ calculations; Bloomberg; NBER

Data as of

Table 3

Allocations US Treasuries IG Credit US Equities Gold Volatility Real Return Sharpe Ration
LT Portfolio 1 20% 20% 60% 0% 10.1% 5.2% 0.41
LT Portfolio 2 19% 19% 53% 10% 9.0% 5.2% 0.46
ST Portfolio 1 40% 40% 20% 0% 5.3% 4.1% 0.57
ST Portfolio 2 38% 38% 16% 8% 5.0% 4.1% 0.61

History: 1967-2017

The correlation between the price change of gold and a US dollar index has been -0.38 on a rolling twelve-month basis.

Jennifer Johnson-Calari and Adam Kobor worked closely with central banks and sovereign wealth funds in building their investment management operations with the World Bank’s Reserves Advisory Management Program (RAMP) from 2000-2013. Jennifer Johnson-Calari currently heads JJC Advisory and Adam Kobor is Director of Investments at the New York University.

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