It never rains, but it pours. Which, for most of us, is precisely the moment that we remember – with a certain degree of bitterness – how we so nearly picked up our umbrella before rushing out of the door. And so it is with gold. For two decades, the world has enjoyed unprecedented economic growth, during which time fund managers have unremittingly insisted that there is no room for gold in a modern investment portfolio.
All of a sudden, gold funds are performing better than any of their non-gold holding competitors, individual mining equities are continuing to outperform the still volatile global equity markets, and the gold price is maintaining its year long rally, surpassing, on the way, the $300 an ounce level. It is clear that fund managers and private investors are rapidly reaching for their umbrellas as uncertainty and volatility descend all around them.
Of course, none of this should come as a surprise. Gold’s role as a safe haven from economic uncertainty is well established and based on overwhelming statistical evidence going back decades, and even centuries. A recent survey of fund managers and analysts conducted by the World Gold Council found that over 70% understood gold’s role as a safe haven and even more appreciated its unique correlation with equities, bonds and currencies. Furthermore, out of a selection of commonly used portfolio diversifiers, gold was found to be the one with the lowest correlation to the Standard & Poor’s 500 index for the decade ending in December 2001 (Figure 1). Indeed, the correlation is much lower, and often negative, during stress times than at other times, meaning that when portfolios are at most risk, gold can be relied upon to deliver stability and growth. There is no doubt that in recent times many portfolios could have benefited from gold’s unique defensive qualities.
The surprise, therefore, is not that gold is performing well, but that most fund managers have chosen to ignore the metal’s unique diversification role until now. It is true that some are now restructuring their portfolios to include an exposure to gold but those who have taken full advantage of gold’s safe haven role are those who anticipated and expected economic volatility before the storm broke, and diversified their portfolio accordingly.
So why have investment managers largely ignored gold until now? The answer lies primarily in the phenomenal growth in equities over the last 20 years, which delivered such spectacular and seemingly never ending returns that there seemed little need for a such an effective defensive diversifier as gold. The weakness of this approach lay in its unquestioning optimism, which blinded its adherents to the possibility of an equity depression such as that we have recently experienced. But even in bull stock markets, there is a strong case for including gold in portfolios, based on the yellow metal’s unusual correlation dynamics.
The importance of correlation between the assets contained in an investment portfolio is well understood by investment professionals. It has long been a tenet of portfolio management theory that the inclusion of assets that have low or negative correlation with other assets in the portfolio helps to reduce overall portfolio risk. However, a growing problem is that it is becoming increasingly difficult to find such assets.
Traditional asset allocation in the UK, for example, in the 1990s sought to reduce risk exposure by increasing the weight of domestic and foreign bonds (see Figure 2). The proportion of total assets invested in both domestic and foreign equities fell correspondingly. However, as the correlation between bonds, cash and equities tends to increase during times of stress, diversification along these lines offers little reassurance. The inclusion of a small proportion of gold in a portfolio makes it possible to increase the weight of higher-return, riskier assets such as equities, whilst maintaining a constant level of risk. In other words, it is possible to maximise growth by investing a larger percentage of a portfolio in high growth assets (eg equities) as long as it is balanced by a more effective and negatively correlated asset (eg gold).
Other investors have attempted to immunise themselves from inflation by investing in inflation-indexed bonds, which have been issued by the UK (index-linked gilts) and US (TIPs) governments, the European Central Bank and several other countries including South Africa and Brazil.
The ability of inflation-indexed bonds to protect US or British investment portfolios against inflation is, as yet, largely untested and unproven because inflation has remained low since they were introduced. However, we do know that inflation indexed bonds (IIBs) have structural deficiencies due to the fact that they are adjusted solely according to consumer-price data (CPI) and on a lagged basis. Linking bonds to consumer price indices is a fault, because any such index has inherent imperfections as a measure of the general price level. They often signal inflation that is not present and or fail to register inflation that is. Similarly, while the par value and coupons are linked to the index, the market price is not, meaning that while the principal of the bond is indexed, the market value is not.
Gold does not suffer from these defects, and its immunisation powers during inflationary times are well documented. The ratio between percentage movements in the price of gold and in the consumer price index is at least five to one, enough to contribute substantially to offsetting the loss in value of the other assets in the portfolio due to inflation. This is precisely the quality that IIBs lack. Even if they themselves are immune from inflation, they do nothing to protect the rest of the portfolio.
So if gold is such an effective diversifier, why do many investment professionals still resist its advantages? Firstly, they point to gold’s supply and demand fundamentals as a reason as to why they should avoid the precious metal. Essentially, these concerns centre on two areas:
o the likelihood that newly mined gold supply will outstrip demand;
o the fear that central bank selling will swamp the market and depress the gold price.
Investors are apparently unaware of the dramatic downturn in gold exploration expenditure, by more than 60% from 1997 to 2000, and the implications that this is likely to have on the future supply of gold. Even last year, industrial and jewellery demand for gold outstripped gold mining production by over 400 tonnes. In addition, recent research estimates that, failing a significant upturn in the gold price, global gold production is likely to fall by almost 30% by 2010. Since 1988, physical demand for gold has consistently outstripped fresh supply and it is clear that this will continue well into the foreseeable future.
What about the central banks? Altogether some 32,000 tonnes of gold, valued at approximately $300bn, is held by the official sector, and it is this significant possible extra supply that is of most concern to investors. Should the governments of the world decide simultaneously that gold is no longer a worthwhile investment to hold, then investors fear that the market will be awash with gold for which there is insufficient demand. The consequence of this on the gold price, they argue, is obvious. However this is not likely to happen for a number of reasons.
Firstly, in September 1999, 15 European central banks agreed under the Washington Agreement on Gold, to limit both the level of their sales and lending of gold to the market for a five-year period until September 2004. As things stand, some 85% of official sector holdings are in the hands of the signatories of this agreement or those associated with it. A substantial part of the other 15% has already been lent to the market and is no longer available for sale. This agreement, a renewal of which is likely and already under discussion, should provide investors with the reassurance that they need.
If that were not enough, investors should think carefully as to whether offloading gold is really in the interest of central banks. The Washington Agreement was signed because the central banks wanted to provide clarity to the market, for the very reason that they did not want the value of their reserves to drop as a result of unstructured sales. It is certainly not in the interests of central banks therefore dramatically to increase the supply of gold into the market, depress the price of gold and pay the consequences should they subsequently wish to liquidate more of their assets.
So, whilst many investors understand the diversification role that gold can play in a portfolio, most misunderstand the need to maintain an exposure even during times of economic growth. Not only can this help when economic uncertainty inevitably raises its head but it can also help to maximise returns during periods of rapid equity growth.
Katherine Pulvermacher is manager, investment research, at the World Gold Council in London