Gold: Role in Institutional Portfolios

Gold: Role in Institutional Portfolios
November 2014
Sharp fall in gold prices warrants an asset allocation relook

We believe that the recent sharp gains in US equities have come, to some extent, at the expense of gold. Through this note we look
at the reasons behind the sudden decline in preference for the precious metal and why it makes sense to reconsider it now from a
portfolio rebalancing standpoint. We note the long standing benefits of diversification in investments and the role that gold can play
towards achieving an optimal risk-return portfolio. Our analysis of the past economic crises and market crashes also establishes our
view that gold as an asset class has been among the most useful diversification tools.
Over the last decade, the global economic crisis triggered an exodus of funds from risky assets to safe-havens such as gold, pushing
up the price of the precious metal significantly. Not only that, the QE-led economic recovery too favored gold as a potential inflationhedge. However, since early 2013, primarily due to tangible on-the-ground recovery of the US economy and the dollar, gold has been
losing favor with investors. With ETFs turning net sellers in 2013 and selling USD 44bn worth of gold (Q1 2013 - Q3 2014), gold prices
have fallen 29% from USD 1,676 per ounce at the beginning of 2013 to USD 1,194 per ounce, as on 20th Nov 2014. The decline is
much more severe (37%) when compared with peak price of USD 1,900 (per ounce) that gold registered in Sep 2011. Meanwhile, the
S&P 500well, we all know what happenedit registered its best year, in 2013, since 1997.
Recent Gold ETF demand, spot price and S&P 500 trend; Long-term spot gold and S&P 500 movement (below)
1600
200
1400
100
1200
1000
-100
800
-200
600
-300
400
-400
200
0
-500
Q3'12
Q4'12
Q1'13
Q313
Q2'13
Q413
ETF Demand (in tonnes, RHS)
Q114
Spot Gold Price
Q214
Q314
S&P 500
2,500
2,000
1,500
1,000
500
Spot Gold Price (USD/ounce)
Jan-14
Jan-12
Jan-10
Jan-08
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
Jan-78
Jan-76
Jan-74
Jan-72
Jan-70
S&P 500
Source: Bloomberg, World Gold Council Report, Aranca Research
Aranca 2014. All rights reserved. | info@aranca.com | www.aranca.com

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November 2014
Case for investors to leverage the fall in gold prices and go long its diversification benefits
First, what are these diversification benefits?
But divide your investments among many places; for you do not know what risks might lie ahead The Bible, in the book of
Ecclesiastes which was written in ~935 B.C., credits diversification as a method to cater to the uncertainties of life.
Coming back to our existence in Anno Domini, simply put, investors may improve the risk return profile of their portfolio by adding an
asset with lower than 1.0 correlation with the existing portfolio. Lower the correlation with the existing portfolio, better the risk reduction
potential. To substantiate, we illustrate the potential of diversification with mean-variance optimized portfolios holding US Equity, Global
ex-US Equity, Global Diversified Fixed Income, Global Real Estate and Gold. We start with Equity and build improved portfolios by
adding asset classes.
Diversification benefits, as measured by portfolio correlation, by adding different asset classes

PORTFOLIO I
PORTFOLIO II
PORTFOLIO III
PORTFOLIO IV
Equity
Add Fixed Income
Add Real Estate
Add Gold
Correlation with Portfolio I: 1.0
Correlation with Portfolio I: 0.04
Correlation with Portfolio II: 0.60
Correlation with Portfolio III: 0.06
Equity
100%
Equity
60%
Equity
50%
Equity
50%
US Equity
80%
US Equity
45%
US Equity
40%
US Equity
40%
International ex-US
20%
International ex-US
15%
International ex-US
10%
International ex-US
10%
Bonds
0%
Bonds
40%
Bonds
40%
Bonds
40%
Real Estate
0%
Real Estate
0%
Real Estate
10%
Real Estate
10%
Gold
0%
Gold
0%
Gold
0%
Gold
0%
Return
7.6%
Return
7.1%
Return
6.9%
Return
6.7%
Standard deviation
14.5%
Standard deviation
9.0%
Standard deviation
8.7%
Standard deviation
7.6%
Risk adj. return
0.79
Risk adj. return
0.80
Risk adj. return
0.88
Risk adj. return
0.52
Source: Bloomberg, Aranca Research

Portfolios constructed through a constrained mean-variance optimization. Period of analysis: Jan 1990 to Aug 2014. Proxies used for asset class exposures are as follows:
- US Equity: S&P 500 Index; International ex-US Equity: MSCI EAFE Index; Fixed Income: Global Diversified Fixed Income Index (Citi WGBI ex US, Citi US GBI and Citi US
Investment Grade Corporate); Real Estate: EPRA NAREIT; Gold: Gold Spot Prices
Diversification risk-return assessment across portfolios with different asset-mix
16%
1.0
0.88
0.8
0.80
0.79
12%
0.6
8%
0.52
0.4
14.5%
4%
7.6%
7.1%
9.0%
6.9%
8.7%
6.7%
7.6%
0%
0.2
0.0
Portfolio 1
Portfolio 2
Return
Standard Deviation
Portfolio 3
Portfolio 4
Risk Adj. Return

P a g e |2

November 2014
As we add a new asset class to the preceding portfolio, in an optimized allocation, we are able to demonstrate the risk-return improving
potential of diversification. Even though portfolio returns decline slightly, the standard deviation of the each subsequent portfolio
declines as well. At the extreme, we are able to increase the risk adjusted return (return per unit of standard deviation) from 0.52 for
Portfolio I to 0.88 for Portfolio IV.
Gold has put its hand up when needed the most: Income yielding assets v/s zero yield gold
As stated above, as long as the correlation of the added asset class with the existing portfolio is less than 1.0, diversification benefits
should follow. That said, why should an investor source diversification benefits from gold which yields no income versus other income
yielding assets?
Assuming our base portfolio of 80% US equity and 20% International ex-US Equity, for the period of our analysis, Gold had the lowest
correlation (0.02) with the base portfolio versus that of Fixed Income (0.04) and Real Estate (0.62). Lower the correlation, higher the
diversification benefits.
Correlation with Base Equity Portfolio
Asset Class
Overall
Credit Crisis
Dotcom Crisis
Jan 90 to Aug 14
Sep 07 to Oct 09
Mar 00 to Oct 02
Fixed Income
0.04
0.20
-0.24
Real Estate
0.62
0.55
0.88
Gold
0.02
0.11
-0.10
Furthermore, historically, correlations have tended to increase between asset classes in times of crises affecting all asset classes;
somewhat defeating the purpose of diversification. However, if we look at the period spanning the credit crisis, as a diversification tool,
gold was the most effective in terms of its correlation with the base portfolio, thus delivering when most needed. Furthermore, real
interest rates are still negative in majority of the developed world; further strengthening the case for gold as an effective asset class in a
portfolio.
Investors allocation out of gold, and into US equities, calls for a portfolio rebalancing
Portfolios may NOT be operating at an optimal asset mix. Sell-off in gold warrants an asset allocation relook
6,000
6.0
5,000
5.0
4,000
4.0
3,000
3.0
2,000
2.0
1,000
1.0
Spot Gold Price
S&P 500
Ratio (RHS)
May-14
Jan-12
Sep-09
May-07
Jan-05
Sep-02
May-00
Jan-98
Sep-95
May-93
Jan-91
Sep-88
May-86
Jan-84
Sep-81
May-79
Jan-77
Sep-74
May-72
Jan-70
Average (RHS)

P a g e |3

November 2014
Gold valuations look favorable relative to US equities

We evaluate the relative valuation of Gold versus the S&P 500 by looking at the historical trend in the ratio of the S&P 500 to Gold
(spot). The average value, for the period of analysis (1970 to 2014) is 1.5. The current value of 1.7 is the highest in the past six and a
half years. While an increase in the ratio implies S&P 500s outperformance over gold, we hasten to point that since the start of 2013,
the S&P 500 has outperformed gold by nearly 67% 43% absolute gain in the index exacerbated by a 25% absolute drop in gold spot
prices. We therefore note the increased preference for riskier assets such as equities, to some extent, being realized at the expense of
gold (via ETF sales, etc.). As such, and in line with our view on golds diversification benefits, we believe the current scenario warrants
a re-look at the precious metal from a portfolio rebalancing standpoint.

P a g e |4

November 2014
Appendix 1: Which investment medium for gold?

The gold bull-run of recent years has seen the development of various new gold investment products. Today, investors have access to
a variety of options to allocate their portfolios to gold; ranging from Gold-based structured products/ETNs to equity investments in gold
mining companies and ETFs. These options, however, supplement the more direct and easier option of physical gold. The final
selection of investment medium will be a function of two portfolio decisions: allocation scope (strategic or tactical) and investment
term (short, medium or long)
Comparison of Investment Mediums

Asset Class
Physical Gold
Gold Mining Stocks
Structured Products
Management Style
Potential Benefits
Potential Drawbacks
Passive
Ownership of real gold

No counterparty risk
Large investment
required
Credit risk
Storage and insurance
costs
Active
Dividend potential
High liquidity
Potential for Alpha
Exposure to equity and

stock specific risks
Returns will differ from
physical gold
Passive
Easy access to
investors
Protection of principal
Customizable to cater to
varied investors
Interest risk
Counterparty risk
Limited upside
potential
No alpha potential
Leverage
Standard contracts
Forward curves may be
in contango
Gold Futures
Active
High liquidity
No counterparty risk
Leverage potential
Gold Mutual Funds
Active
Potential for returns

over and above
movement in gold

those of physical gold
Active
Potential for Alpha

Transparency
Low liquidity
those of physical gold
Not accessible to all
investors
Active
Potential for Alpha

Active management of
varied instruments and
contracts
Low liquidity
Tax inefficient
Not accessible to all
investors
Commodity Trading Advisors

(CTA)
Hedge Funds
Source: Gold: A Primer by Merrill Lynch Wealth Management, Aranca Research

P a g e |5

November 2014
Appendix 2: Tactical allocation in the short-medium term Bulls v/s Bears!

While long term strategic gold allocation will be driven by a mandate to run a diversified portfolio, tactical allocation in the short term, will
likely depend on which side of the gold debate investors find themselves.
Tactical opportunities: Potential catalysts
Bulls Case
Bears Case
Equity risk premiums may rise again
Further decline in prices
The US economy is no way out of the crisis and on a definite upward

path. Combined with risk from Europe and Japan, any increase in
uncertainty in the equity markets and possibility of a softening dollar
could revive demand for gold
Even though retail consumption has held up, investment

demand has been the primary catalyst in current times.
Continued USD strength and strong numbers for the US
economy could put further pressure on gold prices
Euro worries still abound
Inability in meeting inflation targets
Slow growth, deflation pressure and political chaos have put pressure
on the Euro (and other currencies). Any uptick in risk could drive
institutional & speculative money to an alternative currency; most likely
gold
The price of gold has traditionally been volatile and has

demonstrated weakness in periods of low inflation.
Accordingly, in current times, indications of any inability
on the part of developed countries in meeting inflation
targets could facilitate a rapid decline in Gold
The China and India factor!
Change in monetary policies
Gold will continue to hold consumption and investment value in China

and India. Rising disposable incomes and higher inflation expectations
could support gold show positive signs for gold in Asian markets
The withdrawal of QE by the Fed, could enhance the

value of US dollar, leading to a shift of investments from
gold to currency
Political risk
Tensions in the Middle East and Eastern Europe are still abound and
any potential breakouts represent upside potential for gold
Source: Aranca Research
Research Note by: Anant Wagh with contributions from Nitisha Pagaria and Anuj Goel

P a g e |6

November 2014
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Sharp fall in gold prices warrants an asset allocation relook

ETF Demand (in tonnes, RHS)

Spot Gold Price

Spot Gold Price (USD/ounce)

Source: Bloomberg, World Gold Council Report, Aranca Research

Aranca 2014. All rights reserved. | info@aranca.com | www.aranca.com