Pension Funds Online

Gold: Is it Worth it for Pension Funds to Wait and Longer?

UK investment in gold grew sharply during 2009. According to Bloomberg News, and based on Royal Mint data, UK individuals bought over 170% more gold coins in 2009 than were purchased in 2008 (and 2008 had already exhibited strong growth in demand for gold). Similarly, purchases of gold-based ETF securities traded on the London Stock Exchange last year created demand for over 52 tonnes of gold. At the height of the financial crisis (during the end of 2008 and early 2009), there were reports in the media of demand for gold being such that long queues had formed outside bullion dealers and waiting times for physical gold products had grown to weeks and even months. 

Yet, despite the burgeoning surge in interest by individual investors and private wealth managers, the UK pension industry has yet to embrace gold as an asset class. Whilst there has been much written of the shift to investment in alternative assets in recent years, this is still only a relatively minor trend. The vast majority of funds still consist largely of a very narrow band of assets. Estimates by IFSL Research in its recent Pension Markets 2009 suggest that the UK pension fund industry, worth an estimated £1.7 trillion by end-2007, are mostly vested in domestic and international equities (26% and 30% on average respectively), and domestic and international fixed income (26% and 4% on average respectively), whilst having only allocated an average of less than 15% to all other asset classes, such as cash and real estate. On the other side of the pond, however, some US pension funds, for example, the Teacher Retirement System of Texas and the Pennsylvania Public School Employees Retirement System, have realised the benefits of investing in gold and have added an exposure to the yellow metal. Several thought leaders in the US pensions industry, among the first to diversify via an allocation to commodities, are now coming to recognise the additional positive attributes gold can offer.

There are many good reasons why UK pension professionals should consider a similar change in strategy. If we start by focusing on recent history, gold was one of the few assets to deliver positive returns throughout the financial crisis.  Between June 2007, when the first signs of the financial crisis started to unravel, and March 2009 when the economic downturn started to show signs of bottoming out, the price of gold rose by over 50% in sterling terms. In 2009 gold rose by 14% (GBP/oz) in the London PM fix and in 2008 the yellow metal increased by 43% (GBP/oz) outperforming against most financial assets in an otherwise abysmal year.

Table 1: Annual total return in pound sterling for selected assets (%)

But why is this? What insulated the gold price from the effects of one of the worst bear markets for a century?

The answer lies in gold’s fundamentals, or price drivers, which are much broader than those which influence other assets and extend well beyond its recent stellar performance. Gold fulfils a quite unique range of functions, at both an individual and a societal level: it is a luxury consumer item, a commodity and even a monetary asset. Its price is driven by a much broader range of factors than those which influence other assets. Demand is spread across several sectors: jewellery, medical, industrial, and investment. Also, its price drivers are geographically diverse, both in terms of demand and supply, minimizing the chance of its value being unduly impacted by geopolitical or idiosyncratic risk. Gold is therefore generally independent of the tendencies of other investments and prevailing economic indicators.

Motivations for buying gold differ. In World Gold Council surveys conducted throughout 2009, the most widely cited reasons by investors for gold buying were threefold—gold’s dollar hedge properties, its ability to provide protection from possible future inflation, as well as a source of diversification in their portfolios.

Gold’s properties as a hedge against inflation are well known and extend back for several centuries, whilst the use of gold as an effective hedge against movements in the US dollar is also widely acknowledged.

For UK pension funds, perhaps the most compelling reason to invest in gold is that it can provide diversification in a fairly simple and transparent manner, with the added benefit of centuries’ worth of history as a reliable, relatively stable asset. Unlike many complex investment products, it is a hard, ‘real’ asset that carries no default risk.

After its recent sequence of record-breaking highs, there has been much speculation as to where the gold price might be heading next. While it would be foolish to deny that timing is crucial when deciding to invest in an asset, it also pays to take a wider and longer-term perspective. One of gold’s primary roles is that of an insurance policy against “tail risk”, providing protection during times of widespread weakness in other asset prices. Of course, the form that this protection takes can vary according to portfolio composition and the level of risk that a pension fund is willing to tolerate or able to absorb —a factor which came to light during the height of the 2007-2008 credit crisis. For relatively risk averse investors with allocations to gold, returns were cushioned during an otherwise abysmal period. At the other end of the risk spectrum, evidence emerged that some leveraged institutions were forced to sell a portion of their gold holdings (one of the few assets that had held their value in relative terms) to meet margin calls. Effectively, these institutions with higher risk exposure were forced to “make a claim” on their “insurance policy”.

Beyond the recent economic environment of uncertainty and gloom, it is worth remembering that gold can also add value to a portfolio during buoyant economic times. As with other commodities, demand for gold benefits from rising incomes and spending levels during periods of economic growth. In the case of gold, this occurs not just through industrial demand as with other precious metals, but also through demand for gold jewellery (particularly in the vibrant developing economies where jewellery purchases often include an inherent investment motive).

Moreover, in a study published by the World Gold Council in November 2008, Gold as a Strategic Asset for UK Investors, it was shown that, in a fairly conventional asset mix, a strategic allocation to gold between 4% and 10% is optimal, and an allocation can be statistically justified even in a portfolio that already includes a broader commodity exposure. The results of this study highlight the importance and strength of gold’s diversification properties. Indeed, contrary to popular opinion, the unique qualities that gold adds to an investment portfolio cannot be duplicated through a broader commodity exposure.

The fact that gold can improve the risk-adjusted returns in a portfolio should not come as a surprise to anyone familiar with gold’s characteristics as an asset, particularly its qualities as a diversifier and its relatively tame volatility. Gold tends to have low correlations with respect to many asset classes, especially those typically included in pension fund portfolios. For example, it is statistically uncorrelated to T-bills, gilts, UK, US and European equities; it tends to have a small correlation with global bonds. Even gold’s correlation to the S&P GS Commodity Index (a production-based commodity basket commonly used as a benchmark) while positive, is generally lower than is widely thought at less than 0.2, on average, over the past 3 years.

When it comes to volatility, gold tends to vary less than benchmark equity indices in the UK and abroad. During 2009, the yellow metal posted an annualized volatility of less than 23%, lower than the FTSE 100, MSCI Europe (excluding UK) and MSCI US indices. It was also 30% less volatile than the S&P Goldman Sachs Commodity Index during the same period. Furthermore, gold has a very unique characteristic, one that is often overseen: negative returns tend to be less volatile than positive returns, contrary to many risky assets, such as equities, for which the opposite happen.  

Table 2: Return, volatility and correlation of gold versus selected assets during 2009

One of the hard lessons learned during the recent turbulent economic times is that shocks, which cannot be predicted, can change dramatically the performance and behaviour of assets in a portfolio. Thus, the diversification benefits that gold offers are appealing for investors looking to manage the risk profile of their portfolio, in particular pension funds. Gold has a role to play regardless of cyclical factors or economic conditions.

Most portfolios remain strategically biased towards assets that perform well during periods of economic strength, but provide limited support during periods of sharp economic downturn. Effectively, gold’s resilience during periods of crisis provides a form of portfolio insurance while the typical market risk of many assets can negatively affect even the most defensive equity portfolios. From an asset allocation perspective, the absence of a positive correlation in the gold price with the price of other assets makes it a powerful diversifier within a broader portfolio.

So why have institutional investors not made adequate use of gold’s characteristics in balancing investment and market risk?

Historically, access has been a sticking point as the prospect of taking physical delivery of gold can be distinctly unappealing to large institutions, many of which are equally unable to play in the derivatives space.

However, the advent of gold-backed Exchange Traded Funds (ETFs), which can be traded economically like any other share, means it has never been easier for investors to access gold within a liquid market. Since December 2003, gold ETFs listed in the London Stock Exchange have been available. For example, Gold Bullion Securities, ETFS Physical Gold and ETFS Physical Swiss Gold Shares are currently listed in the LSE (in both dollar and sterling), with a combined 230 tonnes of gold holdings at the end of 2009, currently worth around 5 billion pounds.

Pension funds continue to face tough choices. Corporate sponsors are under severe market pressure; members have become despondent as a result of the barrage of bad news played out in the media; and investment managers are trying to stabilise even modest performance against continuing volatility. Growing concerns about central banks’ exit strategies and the impact of quantitative easing on future inflation only compounds the situation. 

Balancing medium-term asset allocation decisions that may harvest upside potential, while ensuring that assets are protected on the downside, will be challenging even for those with deep resources. It is now more relevant than ever for UK pension funds to consider the advantages of gold as a foundation asset to diversify risk, reduce the variability of returns and hedge inflationary or currency fluctuations.