Gold: Role in Institutional Portfolios | Aranca Articles and Publications

Gold: Role in Institutional Portfolios
November 2014
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Page | 1 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 inflation- hedge. 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 500…well, we all know what happened…it 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)
Source: Bloomberg, World Gold Council Report, Aranca Research
-500
-400
-300
-200
-100
0
100
200
0
200
400
600
800
1000
1200
1400
1600
Q3'12
Q4'12
Q1'13
Q2'13
Q3’13
Q4’13
Q1’14
Q2’14
Q3’14
ETF Demand (in tonnes, RHS)
Spot Gold Price
S&P 500
0
500
1,000
1,500
2,000
2,500
Jan-70
Jan-72
Jan-74
Jan-76
Jan-78
Jan-80
Jan-82
Jan-84
Jan-86
Jan-88
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
Jan-14
Spot Gold Price (USD/ounce)
S&P 500

November 2014
P a g e | 2
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
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
PORTFOLIO I
Equity
Equity 100%
US Equity 80%
International ex-US 20%
Bonds 0%
Real Estate 0%
Gold 0%
Return 7.6%
Standard deviation 14.5%
Risk adj. return 0.52
Correlation with Portfolio I: 1.0
PORTFOLIO II
Add Fixed Income
Equity 60%
US Equity 45%
Internationalex-US 15%
Bonds 40%
Real Estate 0%
Gold 0%
Return 7.1%
Correlation with Portfolio I: 0.04
PORTFOLIO III
Add Real Estate
Equity 50%
US Equity 40%
International ex-US 10%
Bonds 40%
Real Estate 10%
Gold 0%
Return 6.9%
Correlation with Portfolio II: 0.60
PORTFOLIO IV
Add Gold
Equity 50%
US Equity 40%
Internationalex-US 10%
Bonds 40%
Real Estate 10%
Gold 0%
Return 6.7%
Correlation with Portfolio III: 0.06
7.6% 7.1% 6.9% 6.7%
14.5%
9.0% 8.7%
7.6%
0.52
0.79 0.80
0.88
0.0
0.2
0.4
0.6
0.8
1.0
0%
4%
8%
12%
16%
Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4
Return Standard Deviation Risk Adj. Return

November 2014
Page | 3
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
-
1.0
2.0
3.0
4.0
5.0
6.0
0
1,000
2,000
3,000
4,000
5,000
6,000
Jan-70
May-72
Sep-74
Jan-77
May-79
Sep-81
Jan-84
May-86
Sep-88
Jan-91
May-93
Sep-95
Jan-98
May-00
Sep-02
Jan-05
May-07
Sep-09
Jan-12
May-14
Spot Gold Price
S&P 500
Ratio (RHS)
Average (RHS)

November 2014
Page | 4
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 500’s 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 gold’s diversification benefits, we believe the current scenario warrants a re-look at the precious metal from a portfolio rebalancing standpoint.

November 2014
Page | 5
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 Management Style Potential Benefits Potential Drawbacks
Physical Gold
Passive
 Ownership of real gold
 No counterparty risk
 Large investment required
 Credit risk
 Storage and insurance costs
Gold Mining Stocks
Active
 Dividend potential
 High liquidity
 Potential for Alpha
 Exposure to equity and stock specific risks
 Returns will differ from physical gold
Structured Products
Passive
 Easy access to investors
 Protection of principal
 Customizable to cater to varied investors
 Interest risk
 Counterparty risk
 Limited upside potential
 No alpha potential
Gold Futures
Active
 High liquidity
 No counterparty risk
 Leverage potential
 Leverage
 Standard contracts
 Forward curves may be in ‘contango’
Gold Mutual Funds
Active
 Potential for returns over and above movement in gold
 Returns will differ from those of physical gold
Commodity Trading Advisors (CTA)
Active
 Transparency
 Low liquidity
 Returns will differ from those of physical gold
 Not accessible to all investors
Hedge Funds
Active
 Active management of varied instruments and contracts
 Low liquidity
 Tax inefficient
 Not accessible to all investors
Source: Gold: A Primer by Merrill Lynch Wealth Management, Aranca Research

November 2014
Page | 6
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
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
Further decline in prices
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
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
Inability in meeting inflation targets
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!
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
Change in monetary policies
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

November 2014
Page | 7
ARANCA DISCLAIMER
This report is published by Aranca, Inc. Aranca is a customized research and analytics services provider to global clients.
The information contained in this document is confidential and is solely for use of those persons to whom it is addressed and may not be reproduced, further distributed to any other person or published, in whole or in part, for any purpose.
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Further, this document is not an offer to buy or sell any security, commodity or currency. This document does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The appropriateness of a particular investment or currency will depend on an investor’s individual circumstances and objectives. The investments referred to in this document may not be suitable for all investors. This document is not to be relied upon and should not be used in substitution for the exercise of independent judgment.
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