2.6.2011

By Juan Carlos Artigas

This year has proven to be a roller-coaster year for most commodities, and investors in commodity-based products have certainly had anything but a smooth ride. Yet their appetite for these assets appears undiminished. Barclays Capital, in its bi-annual survey of investor attitudes to commodities – Commodity Cross Currents 2011 – reports that “despite difficult market conditions, historically high price levels and two years of exceptionally strong demand for commodity investments, enthusiasm for the asset class remains firm.” The report also notes that commodity investment is now far more common than it once was, with less than 10 per cent of surveyed investors lacking any exposure to commodities, compared with 35 per cent two years ago.

There have, however, also been a number of voices expressing concern at the volatility exhibited in many commodity markets, particularly very recently, and scepticism regarding the longer term diversification and hedging benefits of commodities. It should also be noted that commodity investment, by institutional investors as part of their overall portfolios, is probably still far smaller than many commentators presume. It is worth considering, therefore, not only the scope for potential further growth in commodity investment but the motivations that lie behind it. The World Gold Council has produced a number of research reports touching on these issues and, specifically in Gold: a commodity like no other, has examined the role of gold within the commodities complex, the main characteristics that make gold unique and its strategic benefits as an asset above and beyond this set of assets.

Indeed, 2011 is shaping up to be a very interesting year for gold. It has so far recorded average annualised volatility far lower than its historical trend over the past 20 years and at the same time; it has held its trading range. However, gold bears were quick to point to the sharp price correction in January as a sign of the end of gold’s decade long bull-run. This assertion has proven to be incorrect: the New Year price fluctuations, partly driven by profit-taking, were in fact viewed as a buying opportunity around the world given the growing consensus in the precious metal’s buoyant and stable outlook.

More recently, mid-April saw the price of gold hit new highs, breaking through the symbolic $1,500 (£617) per troy ounce mark for the first time, against the backdrop of macroeconomic uncertainty, rising geo-political risk and unforeseen natural disasters. Indeed, in such an uncertain background the price reached further all-time highs of $1,546.50 in early May.

But gold has not been the only commodity to perform well in the first few months of the year – silver saw an astonishing 60 per cent increase in price from the start of the year to the end of April and, more generally, the recent appetite from fund managers in diversifying into commodities has helped the overall sector perform strongly in 2011.

While notable and high-profile investment heavyweights have publicly locked horns over the gold’s price trajectory and their respective perceptions of fair value, wider, conflicting macroeconomic signals also played into the hands of gold bears. Shortly after setting a new high, gold prices dropped in early May, falling 1.6 per cent in a single trading session.

The prospect of tighter monetary policy in China and Brazil contributed to the correction, as did news from China that its full year GDP growth had risen into double figures, while Brazil’s central bank was vocal in its consideration of continuing to hike interest rates. Further positive economic news came from the US, with jobless claims falling and home sales picking up and improving investor confidence. Finally, higher margin requirements in futures contracts by the CFTC squeezed out some of the more leveraged market participants. Commodities came off sharply. Oil plummeted by $12 to $109/barrel and silver also shed a third of its value.

In spite of recent investor allocations, the outlook for the commodities complex was cited as precarious. But, should the recent commodity sell-off leave investors feeling cold about the future prospects for gold?
Silver has struggled to claw back its recent gains, with some market commentators vocalising their fears that this marked the start of a silver bear market. Oil is exhibiting greater resilience, but also greater volatility. Meanwhile gold rapidly pulled back from this correction, breaking the $1,500/oz mark again on 6 May, highlighting once again that it moves independently of other assets, partly as it is driven by a different set of fundamentals than the rest of the commodities complex.

The World Gold Council (WGC) has looked in detail at what makes gold different. As a result, our analysis demonstrates why investors should always consider an allocation to gold as an asset in its own right to diversify their portfolio, enhance long term performance and minimise risk.

Our analysis shows that if part of a commodity allocation is directly assigned to gold, as opposed to a commodity fund (which may contain a small gold exposure), portfolio performance is improved, while the potential for loss is reduced. The statistical analysis shows that a modest, consistent holding of gold increases long-term risk adjusted returns in a way that an allocation to a commodities basket alone does not.

Furthermore, portfolio performance is not only improving, but there is also a reduction in the potential for loss in a portfolio, as gold decreases its so-called Value at Risk (VaR).

Specifically, for example, an investor with an asset allocation to a simple benchmark portfolio (50 per cent equities, 40 per cent fixed income, 10 per cent commodities) during 2008 would have reduced portfolio losses by between $200,000 to $400,000 on a $10 million investment by allocating 5 per cent to 10 per cent of the overall portfolio directly to gold. Stepping back, we find the same investor, over the past 20 years, would have increased average annual portfolio gains by around $100,000 to $200,000 by directing a similar allocation to gold.

Commodity allocations have become more common among investors seeking diversification. Globally, commodity assets under management more than doubled between 2008 and 2010 to nearly $380 billion and it is often assumed that an investor in commodity baskets will by default profit from gold’s inherent ability to protect wealth. But, we now know that an allocation to an outright position in gold provides benefits that cannot be replicated simply by investing in a wider commodities basket.

One of the issues is that many investors assume they have a higher exposure to gold than they actually do in a commodity basket fund. But within indices such as S&P Goldman Sachs Commodity Index (S&P GSCI) or the Dow Jones UBS Commodity Index (DJ-UBSCI) gold’s weighting typically ranges between just three and seven per cent. Thus while investors typically get some exposure to gold when using one of these indices as a benchmark, its total weighting is small. For example, for an investor with a ten per cent overall allocation to commodities, the effective exposure to gold is as low as 0.3 per cent using the S&P GSCI and only as high as 0.7 per cent when using the DJ-UBSCI.

In previous studies, the WGC has demonstrated that a gold allocation of between two and ten per cent of the overall portfolio is required to increase risk-adjusted returns and protect investment performance. The findings in our new report suggest that portfolio managers and investors who already have exposure to commodities in their portfolio stand to benefit from including gold as a separate strategic asset class, without compromising long term returns, by decreasing the VaR.

The findings of the report are clear: including gold as a standalone asset in a portfolio is proven to provide better risk adjusted returns than through having a zero per cent allocation – even if the investor already has exposure to gold through a diversified commodity basket. But why?

Gold’s behaviour is a direct consequence of the dynamics of the gold market: a market where the sources of demand and supply are diverse and complementary. For example, the technology and industrial sectors account for a much larger portion of demand for most other metals, including silver.

Gold is, in many ways, synonymous with luxury and wealth, but it has wide-ranging uses. Half of all gold in above-ground stocks exists in jewellery form, but it is also an important financial asset and is considered by many as a currency in its own right. It is a proven as a store of wealth and an efficient diversifier of risk. It also acts as a reliable and essential component used in a range of electronics, medical and dental applications and is continually proving its wider relevance as an innovative enabler to new technologies.

Gold is a scarce yet prevalent element, but the geographical diversity of mine production contributes to gold’s lower volatility relative to other commodities, as it makes it less subject to geopolitical and other idiosyncratic risks such as variations in weather due to climate patterns.
According to GFMS Gold Survey 2011, as of 2010, it is estimated that approximately 166,600 tonnes of gold have been mined over the course of human history.

However it is more common to estimate the size of the financial or investable gold market by looking at private investment and official sector bullion holdings, which are considered to be in near-market form. Together these two components account for approximately 36 per cent of all above ground stocks or approximately 60,000 tonnes of gold.

Using the 2010 average price of gold of $1,224.52/oz, the size of financial gold holdings is equivalent to $2.4 trillion. To put that in context, the gold market is larger than any single European sovereign debt market, yet it is no-one’s liability. The gold market is even comparable to the size of the US government-guaranteed debt ($2.7 trillion), otherwise known as the agency market. By comparison, above ground silver stocks represent a smaller market. Industry estimates suggest that identified silver bullion stocks by the end of 2009 were around 31,000 tonnes.

Even with the conservative assumption that the actual amount of silver available to the market in terms of bars and coins is twice as large, at an average price of $20.25/oz for 2010, the size of the financial silver market would be equivalent to $40.5 billion dollars (less than 2 per cent of the gold market). Furthermore, as of 2009, total above ground stock estim-
ates for copper and platinum were a much smaller $7.6 billion and $3.5
billion respectively.

This diversity of demand, combined with gold’s supply buffer, means that it is less exposed to swings in business cycles, typically exhibits lower volatility and tends to be significantly more robust at times of financial duress than other physical goods. In turn, this causes gold’s correlation to other commodities and other asset classes to be low. Indeed, gold’s physical attributes and functional characteristics truly set it apart from the rest of the commodity complex.

Over the past decade, commodities in general have benefitted from growing demand spurred by the dynamics of global economic expansion. Countries such as China, India, Russia and many others in Latin America, Eastern Europe, the Middle East and South Asia have been the driving forces behind a ten-year trend of rising commodity prices.

Gold is no exception, with its price rising for the past ten consecutive years. But, while gold has not always had better returns than other commodities, it has exhibited consistently lower volatility. At an annualised rate of 15.9 per cent over the past 20 years, gold’s volatility is lower than all individual commodities except livestock. It is even lower than that of diversified commodity baskets such as the S&P GSCI and the S&P GSLE.

As we have seen, gold has been very much front of mind for many investors across the world given the recent price correction and market volatility.
Our view is that the longer term performance of gold demand and supply remains positive and that the current price level is very much sustainable, well within statistically ‘normal’ growth trends and driven by strong market fundamentals, with considerable scope for additional development in key geographical and sectorial markets.

Moreover, gold’s ability to move independently of most assets usually held by institutions and individuals and to hedge against inflation and currency fluctuations, means that it is highly effective as a preserver of long term wealth and should form a foundation of any long term investment portfolio, giving investors the confidence to invest, especially in periods of economic uncertainty.

For risk management professionals, fund managers and investors alike, this will hopefully provide some serious food for thought over the role of gold as a standalone asset that is set apart.