Marcus Grubb summarises a new study of the diversification benefits that gold offers to a euro-based institutional investor

The euro-zone crisis has left professional European investors anxious and perplexed as to the security of their assets and how to protect them from an increasing barrage of risks. The events of the past four years will undoubtedly have a lasting impact on global financial markets.

We have witnessed the collapse of large financial institutions, the bailout of banks by national governments and unprecedented levels of monetary policy expansion. From late 2009, as national governments reached for their economic stabilisers to stave off depression, already lofty debt levels increased further, precipitating a US debt downgrade and two European debt crises, the first since the foundation of the euro-zone in 1999.

Despite equity markets starting 2012 on a strong footing, pressure on euro-zone countries to contain the debt crisis and stimulate growth weighs heavy on markets. Further rounds of QE are also failing to reinflate economies, while the big hangover - Greece - remains a long-term threat to stability. The debt levels of other euro-zone countries are also an ongoing concern and the burden they potentially impose on the community’s more buoyant economies may be under the spotlight again soon, with a series of national elections looming over the next year or so.

For investors, the range of negative scenarios that might rationally materialise this year or next makes planning to ensure sufficient stability and growth a very difficult task indeed.

As such, many investors are struggling to regain their footing, not least in attempting to balance the need to generate returns in an environment of depressed real yields and tighter risk controls. Taking medium-term asset allocation decisions that may harvest upside potential, while ensuring that capital is protected on the downside, will be challenging, even for investors with deep resources. This has, in turn, refocused investor attention on assets that provide portfolio diversification - to mitigate the unpredictability of markets and reduce portfolio loss and volatility.

Diversification theory underpins the mitigation of risk in portfolio management, and is particularly relevant in unpredictable market conditions when correlations increase. The concept of portfolio diversification relies upon component assets representing a range of divergent tendencies combining to result in an improved balance of risk and reward. When considering investing across multiple asset classes, portfolio managers should be also adequately prepared for downside risk by monitoring volatility and asset co-variance and by introducing instruments that might offset any convergent behaviour across asset classes.

An investment that scores highly against these criteria is that age-old but frequently overlooked asset, gold. While gold’s sustained rise over the past decade and recent record price highs have now pushed it firmly into the limelight, its attributes as a portfolio component and risk management tool are still insufficiently understood.

While investors have traditionally held gold for its qualities as an inflation hedge and its secure status in times of trouble, recent research commissioned by the World Gold Council from New Frontier Advisors (NFA), ‘Gold as a Strategic Asset for European Investors’, aims to go one step further to address the current concerns of European investors by exploring its particular value as a source of diversification within a euro-based portfolio.

The paper explores gold as a strategic asset across five sets of asset-allocation scenarios, including four using historical data spanning 1986 to 2010, and one using the period 1999 to 2010. The cases cover a progression from basic to an expanded set of asset classes that may more relevantly reflect institutional practice.

The research uses the unique Resampled Efficient Frontier optimisation technology developed by NFA’s Richard and Robert Michaud to allow analysis of the statistical significance of gold for adding diversification value. For each data universe, three different sets of optimised asset allocations are utilised: without gold and commodities; with gold and without commodities; and with both gold and commodities. The analysis assumes that gold has zero real returns.

The paper finds that gold adds significant diversifying power due to its low or negative correlation with most other assets in an optimised portfolio context. It finds that an appropriate allocation to gold depends on risk level and competing assets in the optimisation universe, suggesting that an optimal strategic allocation to gold for euro-based investors ranges from 2-3% for the most diversified and lowest risk portfolios, to 4-9% for portfolios split 50/50 between equities and bonds, to as high as 10% for portfolios with the majority of assets in equities.

This independent study builds on the findings of previous studies commissioned by the World Gold Council concerned with identifying optimal allocations to gold to improve risk-adjusted returns, provide insurance against extreme events and act as a foundation asset for professional investors.

One such paper entitled ‘The Impact of Inflation and Deflation on the Case for Gold’, by Oxford Economics, suggests that gold’s share of an optimal medium-risk investor’s portfolio is around 5% in a base long-term economic scenario featuring 2.25% growth and 2% annual inflation. This rises in a more inflationary long-run scenario and for more risk-averse investors in a scenario featuring weaker growth and low inflation.

Gold’s ability to move independently of most assets and to hedge against extreme events as well as inflation and currency fluctuations has been proved time and again, and investor recognition of this is reflected in the 5% year-on-year increase in global gold investment demand for 2011. However, the vast majority of institutional investors still have little or no allocation to gold, calling into question whether investors are placing sufficient emphasis on hedging against risk. The evidence in favour of a continuous strategic allocation to gold has been growing for some time and would suggest that a considered reappraisal of gold’s benefits by the wider investment community is overdue.

In the past decade we have lived through the effects of two bear markets and have seen the prospect of sovereign default in Europe - a previously unthinkable situation more reminiscent of Latin America during the 1980s. The relevance of gold as a strategic asset is likely to continue to grow as it has unique properties which can protect investors’ portfolios from the corrosive effects of stagnation, negative real returns, high inflation and fiat currency debasement, in particular in the context of the euro area.

Marcus Grubb is managing director, investment, at the World Gold Council