ALTERNATIVE INVESTMENTS - GOLD

Investing in Gold and Precious Metals

During the runup in the value of stocks and the weakening status of gold, investors may have forgotten that gold is a unique asset with a negative correlation to most other assets,especially equities. Its role as a diversifier can reduce portfolio risk in either quiet or inflationary periods.
Some basic characteristics of gold make it a unique asset. First, it is pri-marily a monetary asset. 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 jew-elry bought primarily in developing countries as a vehicle for savings.
Second, gold is partly a commodity although less than one-third of gold’s total accumulated holdings can be considered a commodity. These holdings include 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, such as T-bills or bonds that, unlike gold, do have counter-party risks.
PRICE FACTORS
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. In addition to supplies from new mining, 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 borrow- ing 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.

GOLD AS A DIVERSIFIER
What makes gold such a highly effective portfolio diversifier?
“Including gold within an existing portfolio could improve investment performance by either increasing returns without increasing risk or by reducing risk without adversely affecting returns,” concludes Raymond E. Lombra, professor of economics at Pennsylvania State University.
This statement summarizes the usefulness of gold in terms of Modern Portfolio Theory, a strategy used by many investment managers today. Using this approach, gold can be used as a portfolio diversifier to improve investment performance.

Figure 1 demonstrates why gold is such a helpful diversifier when you compare 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 prices to go up. Whenever equities decline, there is an even greater tendency for gold prices to go up.

Figure 2 shows that gold is more negatively correlated to U.S. stocks than any of the other asset classes that are typically used as portfolio diver-sifiers (such as bonds, emerging market equities, and real estate investment trusts or REITS). This makes gold an especially effective diversifier for equity-oriented portfolios.
Let’s examine the relationship between gold and equities a little further. Historically, the price of gold has generally moved in the direction opposite to the trend in equities. In particular, the price of both equities and gold tend to “revert to the mean” at certain points in history. During the years of strength in the stock market and weakness in the gold price in the last half of the 1990s, many portfolio managers had reason to question what role, if any, gold could play in a portfolio’s performance.
Historically, however, they could look at the levels of each market and quickly conclude that the stock market was at an unusually high level and that the gold price, in contrast, was unusually low with an upside potential perceived to be greater than the downside potential. Figure 3 captures these two developments —high stock prices and low gold prices.

The key questions for portfolio managers as the 21st century began were: When will the stock market “revert to the mean” —that is, move downward —and when will gold prices revert to their mean —that is, move up? Regardless of whether they were a bull or a bear on the stock market, the mere threat of a market correction should have alerted them to the advan-tages of diversifying their portfolio into alternative assets such as gold.


Figure 4 displays the ratio of the Dow Jones Industrial Average to the
gold price since 1885. The ratios 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 July 1999 (at 45). Since 1999,
the ratio has turned downward, prompting the question: Will the ratio con-
tinue to decline?
would turn downwards —either the price of gold would rise and/or the value of the stock market would decline.

STRESS FACTOR
Traditional methods of portfolio diversification often fail when they are needed most —that is, during periods of financial stress or 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.


Figure 5 depicts an efficient frontier curve using a new optimization
procedure that recognizes that periods of stress do, in fact, occur. The port-
folios 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 port-
folios (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 simu-
lations, a portfolio with a moderate expected risk exposure of 11.6 percent (standard deviation) and an expected annual return of 11.4 percent was selected (point A) for two reasons: (1) This portfolio had relatively consistent results during both stress and non-stress periods, and (2) the expected returns were near the level of returns for a typical 60-percent stock/40-percent bond portfolio. This efficient portfolio includes a 6-percent allocation to gold.
When stress conditions were simulated on the 6-percent gold portfolio
(point A), the return (point B) was 11.1 percent (only 50 basis points lower
than the expected return of 11.4 percent for point A) and the standard devi-
ation was 17.8 percent. Similarly, when non-stress conditions were simulated
(point C), the return was 11.5 percent (10 basis points higher than expected
in point A) and the standard deviation was 7.6 percent. Thus, the selected
portfolio with 6-percent gold weighting had generally similar returns, regard-
less of whether the environment was stress (point B) or non-stress (point C)
—a desirable result.
ASSET ALLOCATION
Three main problems are associated with traditional methods of asset allocation:
1. Historical returns are not normally distributed. Almost all asset allo-
cation studies that use mean-variance optimization assume that the
returns of the assets are normally or log-normally distributed and, con-
sequently, can be described by their mean and standard deviation. Yet, historical returns, in reality, are not normally distributed.
2. Financial stress. Traditional asset allocation often does not work dur-
ing periods of financial stress when it is most needed.
3. Unanticipated inflation. Traditional portfolios do not perform well
during these periods.
Including gold in equity portfolios addresses these three problems. Gold
has been shown to reduce both negative skewedness —that is, portfolio
underperformance —and the number of outliers by making the portfolio’s dis-
tribution more normal (see Point 1 previously). Finally, gold improves port-
folio performance during periods of stress and unanticipated inflation (see
Points 2 and 3).
Therefore, 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.


To illustrate the beneficial effect that low volatility can have on portfo-
lio returns, the returns of two hypothetical portfolios are compared in
Figure 6. The arithmetic average annual return for both portfolios is the same — that is, 10 percent. However, the standard deviation of the portfolio on the left is lower (1.10 percent) than that of the portfolio on the right (16.43 percent). This means that the low-volatility portfolio’s compound annualized return of 10 percent is greater than the high-volatility portfolio’s return of 9 percent. Accordingly, an initial $10,000 investment in the less-volatile portfolio yields nearly $1,000 more by the end of the sixth year than the more volatile portfolio —that is, $17,711 versus $16,746.
COMPETITIVE EDGE
Gold is competitive with conventional diversifiers such as bonds, put options on the S&P 500 Index, and Treasury bills for several reasons:
Gold serves as an excellent source of liquidity —that is, the ease with
which an investor can move out of gold into cash without incurring a
loss of value. In this sense, gold can even be considered a proxy for cash.
Gold is an international commodity that can be readily bought and sold
24 hours a day in one or more markets around the world. This cannot
be said of most investments, including equities of the world’s largest cor-
porations.
Bullion transactions generally feature narrow bid/offer spreads.
Gold contracts can be bought and sold easily on a number of exchanges. Gold can be converted into cash in a relatively short period of time, much faster than alternative investments such as real estate, venture capital, or timberland.
Gold’s role as a source of liquidity in a portfolio was powerfully demonstrated during the stock market crash in October 1987. All sectors of the equity market (including gold equities) declined sharply at that time. Meanwhile, bullion maintained its value throughout that episode, acting as the insurance policy that it is designed to be in a portfolio.
PRUDENT INVESTMENT
U.S. regulations issued under the Employee Retirement Income Security Act (ERISA), including the “prudent man rule,” endorse the total portfolio theory, under which each investment is viewed in light of the entire portfolio held by a pension fund. Gold can be considered as a potentially valuable investment in its role as a risk reducer.
In enacting the ERISA regulations, the Department of Labor has specifically refused to prohibit investments in precious metals. In fact, there have been no reported cases in which investment in precious metals by ERISA plans has been challenged.
Thus, an investment in gold can be considered prudent and permissible under ERISA if the elements of the prudence standard are satisfied.
INVESTMENT CHOICES
Gold bullion is available through brokerage firms and banks throughout the United States. Investors can choose the methods of purchase and storage of gold bullion that best meet 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, thirdparty 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, investors are allowed to buy and sell gold over the phone, and they receive 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.
Now is a particularly good time to be looking at including gold in an investment portfolio. Since 1999, the U.S. dollar has softened, much of the
U.S. stock market has weakened, and the inflation rate has stopped declin-
ing. Meanwhile, the price of gold has begun to turn 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 invest-
ments 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.
NOTES
1 A Monte Carlo simulation using GARCH techniques was conducted assum-
ing the selected portfolio experienced 5,000 five-year periods of stress and non-stress.