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Mensuel : Edition de décembre 2010
Rubrique : Finance/Economie
Titre : WORLD GOLD COUNCIL
Gold : Hedging against Tail Risk
Article : By Juan Carlos Artigas and Nitin Tuteja, Investment Research, WORLD GOLD COUNCIL

In today’s tough investment environment, asset allocation is a fundamental question any investor or money manager faces: how best to distribute resources across competing assets. It is not a simple problem and there are many approaches to solve it. One method that is widely used in finance is based on modern portfolio theory, which, in turn, relies on three asset characteristics: expected return, volatility and correlation to other assets. This method works on the assumption that, in the long-run, assets tend to react in similar ways depending on the macroeconomic and financial conditions they face. Consequently, correlations among assets combined with their individual volatilities allow an investor to reduce the overall risk of a portfolio without necessarily sacrificing long-term expected returns.

In periods of economic expansion, and especially prior to 2007, many investors concentrated on return seeking strategies at the expense of incurring higher risk. While these kinds of strategies may prove effective in some periods, events such as the recent 2007-2009 financial crisis have brought back into perspective alternative strategies that place more emphasis on risk management. By using lessons learned during these tough times, investors may be better prepared when a new unforeseen event occurs. There are cost-effective strategies that can provide such protection without sacrificing returns. Recent findings by the World Gold Council (WGC) show that gold can be an integral part of these strategies for both short and long-term investors.

Traditionally, investors have looked at gold only as an inflation hedge or as a safe haven. However, gold’s main value stems not only from these traits, but also from its role as a unique source of diversification within an investor’s portfolio. Gold also preserves wealth and acts as a currency hedge. Moreover, it helps to manage risk more effectively by protecting against events that may be infrequent or unlikely but have extreme negative consequences and are often referred to as “tail risks”. Gold’s market dynamics of demand and supply make it an ideal candidate for portfolio diversification as well as for risk management purposes. First, gold’s volatility characteristics are often misunderstood. Many people tend to equate the behaviour of the price of gold to that of other commodities, which often are very volatile, whereas the volatility of gold over the past 20 years has been, on average, around 16%. Leaving aside individual commodities such as oil, the general commodities complex, as measured by the S&P Goldman Sachs Commodity Index, with an average volatility of 21% over the same period, has been around 30% more volatile than gold.

Even equities in the US, Europe and abroad tend to be more volatile than gold. For example, European equities, as measured by the MSCI Europe Index, have experienced higher volatility at around 19% during the same period. Moreover, unlike other assets, gold tends to exhibit lower volatility when prices fall than it does when prices rise. This is contrary to what tends to happen with equities as their volatility tends to increase as prices fall.

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Second, gold tends to have little or no correlation with many asset classes. More importantly, unlike other assets typically considered diversifiers, gold’s correlation to other assets tends to change in a way that benefits portfolio returns. For example, while long-term gold correlation to equities is usually very small, it tends to decrease as equities fall and increase as they rise. In fact, history shows that gold’s correlation to equities became more negative during periods of economic and financial distress.

Conversely, other commodities increase their correlation to equities during these same periods, as most industrial-based commodities tend to follow the business cycle. Thus, gold’s reaction to external factors such as financial and economic conditions tends to benefit investors and, in particular, helps them manage risk more effectively.

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There are various reasons behind gold’s relatively modest volatility and lack of correlation to other assets. Not only is the gold market deep, liquid and supported by the availability of large above-ground stocks, but the various sources of supply allow the market to absorb unexpected shocks and, due to its availability in multiple regions across the world, it is less susceptible to geopolitical risks. Moreover, the gold market is affected by a myriad of factors. Some of these factors, such as inflation and currency movements are tied to developments elsewhere in financial markets, but many more such as fashion trends, marketing campaigns, the Indian wedding season, religious festivals, gold mine exploration spending, new discoveries of gold, production costs and central banks’ strategic reserve decisions that are particular to the gold market, highlight gold’s uniqueness relative to other assets.

The combination of volatility and correlation, along with expected returns, helps investors allocate resources more effectively. In particular, by using portfolio optimization, an investor can select the weight a particular asset has in order to improve the risk-adjusted returns in a portfolio. Optimal asset allocation produces a myriad of different combinations that form the so-called “efficient frontier”, depending on the level of volatility an investor is willing to tolerate. Research performed by the WGC shows that, in an efficient frontier simulation study using multiple different optimal asset allocations, 68% of the time adding gold to a portfolio increased returns for a given level of volatility. This meant, on average, a 3.4% increase and as much as 22% for some risk-return combinations. On the contrary, for the other 32% of portfolios for which gold did not increase returns, the average decrease was -0.4% and the maximum decrease was -0.8%. In particular, including gold into the asset mix increased the value of the portfolio as measured by the maximum information ratio (expected return divided by volatility). In other words, investors choosing to include gold in their portfolios are likely to obtain similar returns at a lower level of risk than investors who don’t.

Moreover, research shows that portfolios which include gold are not only “optimal” in the sense of delivering better risk-adjusted returns, but also have smaller potential losses. Specifically, the study shows that even relatively small allocations to gold, ranging from 2.5% to 9.0%, can increase risk-adjusted returns and help reduce the weekly 1% and 2.5% Value at Risk (VaR) of a portfolio by between 0.1% and 18.5% based on data from December 1987 to July 2010. (Conceptually, VaR is a way of measuring the maximum loss an investor can expect to have in a given portfolio, with a certain degree of confidence, during a specified period of time.)

Moreover, looking at past events typically considered to be tail risks, such as Black Monday and the recent 2007-2009 recession, the study shows that in 18 out of 24 cases (75%) analysed, portfolios which included gold outperformed those which did not. In particular, it found that in the period between October 2007 and March 2009, an asset allocation similar to a benchmark portfolio (50-60% equities, 30-40% fixed income, 5-10% alternative assets) which included an 8.5% allocation to gold, was able to reduce the total loss in the portfolio by almost 5% relative to an equivalent portfolio without gold. In other words, adding gold would have saved about US$500,000 on a US$10 million investment.

To summarise, there is a strong case for an allocation to gold as an asset class on its own merits. Gold is part commodity, part luxury consumption item and part financial asset, in particular a currency and, as such, its price does not always behave like other asset classes and especially other commodities. Gold also has other distinctive characteristics that make it extremely useful in periods of financial distress. For example, the gold market is highly liquid and many gold bullion investments have neither credit nor counterparty risk. As such, investors can benefit greatly from considering gold as part of their portfolio allocations.
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