Marcus Grubb

Managing Director,

Investment Strategy

Welcome to the sixth edition of Gold Investor. This issue contains three thought-provoking articles, and a common thread runs through them all: the balance between diversification and performance.

This is a highly relevant theme for two reasons. Firstly, our focus is on the value that gold can deliver to investors: gold has a well-recognised role in portfolio performance.¹ Secondly, we live in the shadow of the 2008-2009 financial crisis, with its harsh lessons on risk and how to use portfolio diversification to manage it.

In each article our analysts take a close look at a different asset class, examine its context and characteristics, and analyse how it compares to – and interacts with – gold.

Alternative assets can deliver outperformance but fare less well as diversifiers

First, in How gold improves alternative-asset performance, we scrutinised alternative assets – private equity, hedge funds, real estate, and commodities – to see if they deliver performance and diversification. We found good news, room for improvement and a few surprises.

The good news is that alternatives can deliver outperformance. Some investors may be surprised to find that gold returns outperformed some alternative assets and – an important diversification-and-performance point – has a correlation to equities that is lower than any alternative asset.

Juan Carlos Artigas

Director,

Investment Research

Gold is often labelled a commodity but it behaves more like a currency

In Gold: metal by design, currency by nature we make the case for gold as a distinct asset class rather than a commodity.

Many people find it odd that peas and courgettes (or zucchini in the US) are classified as fruits. Botany says that because they have seeds they must be fruits, but chefs use them as they would other vegetables. Our analysis shows that gold suffers from a similar kind of category confusion. It features in commodity indexes, but it responds to different economic factors (particularly those that drive currencies), is less volatile, and has a far lower correlation to the business cycle.

Gold can deliver on liquid alts’ promise of liquidity, returns and diversification

Finally, we look at ‘liquid alternatives’ (or ‘liquid alts’) in The most liquid of all ‘liquid alts’. Liquid alts offer investors a more liquid investment in alternative assets. They have grown dramatically since 2008 and are expected to keep rising: a Citigroup reports predicts that liquid-alt assets could reach US$1.3 trillion by 2017.

However, when we compared liquid alts to gold we found two interesting results. Gold meets the key criteria of liquid alts as it is a non-traditional asset or strategy, is more liquid than alternative assets, and is a transparent investment. In addition, gold does not have the drawbacks – including limited liquidity and relatively high costs – that may put some investors off liquid alts.

We hope you find this edition of Gold Investor informative and stimulating. If you have comments or questions on any of the articles please get in touch at investmentresearch@gold.org.

Relative returns: alternatives offer good value for the money

Before we move on to our analysis of alternatives as a diversification tool, it is worth noting a relevant fact about gold: it has not only outperformed stocks, but also REITs and commodities on average since 1990 – and even more so since 2000.

Chart 2: Alternatives have generally provided better risk-adjusted returns than US stocks

Reference notes are listed at the end of this article.

Source: Bloomberg, Cambridge Associates, Dow Jones, HFR, The London Gold Market Fixing Ltd, World Gold Council

Gold stands out for its low correlations both to US and international stocks.

Chart 3: Hedge funds, private equity funds and REITs have high correlations to stocks

Correlations based on monthly returns (quarterly for private equity due to data availability) between January 1990 and March 2014

Source: Bloomberg, World Gold Council

We have carried out extensive original research that shows that gold is a valuable part of an alternative-asset portfolio strategy (see our 40-page report Gold: alternative investment, foundation asset).¹⁰

This section sets out relevant highlights from that research:

•       How gold can overcome specific alternative-investment portfolio issues (gold adds liquidity and reduces credit and counter-party risks)

•       Optimal gold holdings for portfolios that include alternative assets

Please note that the next section, A recap of gold’s portfolio attributes, describes the factors that make gold a valuable part of any portfolio. We emphasise that the ideas we draw on in this article are not ours alone. Well-respected organisations that have arrived at the same conclusion include New Frontier Advisors, Oxford Economics, J.P. Morgan, Mercer, and The University of Virginia Darden School of Business, among others.¹¹

Gold adds liquidity to an alternative-asset strategy

Gold is remarkably liquid. Investors can access it through exchange-traded funds (ETFs), exchange-traded derivative contracts and over-the-counter vehicles. Gold-backed ETFs collectively trade US$1 billion a day, rivalling single stocks and many equity-linked ETFs. Futures in COMEX alone trade a daily average of US$18 billion.¹³ What really stands out, though, is the over-the-counter (OTC) market. We estimate that, during 2013, gold contracts traded between US$60 billion and US$160 billion a day – most of them in the form of spot contracts. Further, during 2011 when liquidity was particularly high, daily volumes surpassed US$240bn, according to the London Bullion Market Association.¹⁴ In other words, gold’s liquidity in the OTC market rivals major currency pairs and surpasses all US stocks combined.

Gold helps reduce credit and counterparty risks

Given that gold is easily accessible in physically-backed securities and contracts, investors not only remove credit risk but can also minimise counterparty risk. For example, investors can take delivery of gold, keep it in allocated accounts, or hold ETFs that are backed by physical gold.

As we have shown in previous research studies, whether investors are based in the US, the UK, continental Europe or Japan, adding 2%-10% in gold provides benefits that may not be easily replicated by a combination of traditional assets and commodities.¹⁵

Chart 4: An allocation of 4% to gold for diversified portfolios that include alternatives can improve risk-adjusted returns and reduce losses during periods of systemic risk

Source: World Gold Council

We believe these particular benefits to holding gold apply to all portfolio types, and this section is a broader recap of gold’s portfolio benefits (see Why invest in gold? for more detail).¹⁷

Gold’s benefits are not solely driven by its price

•       Diversify a portfolio and consequently lower portfolio volatility

•       Reduce losses in periods of financial turmoil

•       Preserve purchasing power through its ready liquidity.

Table 1: Gold has outpaced inflation in the US and abroad, as well as short-term rates

Annualised average monthly returns

•       Low correlation with equities. Chart 3 (found in subsection Diversification: most alternatives significantly correlate to stocks) shows that gold has low correlations – lower than that of assets that are often seen as ‘diversifiers’ – to stocks over long periods of time.

•       Outperformance during crises. Gold tends to outperform other assets in periods of economic and financial turmoil (Chart 5). This gives investors a way to reduce risk when it is most needed.¹⁸

Reference notes are listed at the end of this article.

Source: Bloomberg, World Gold Council

Gold’s unique supply-and-demand factors lower volatility and deliver returns

•       The drivers of demand for gold work at all stages of the business cycle. Gold’s unique demand and supply dynamics ensure its role as a true diversifier for investors. Gold demand is distributed between jewellery (49%), investment (34%), technology (10%) and central banks (8%).¹⁹ Broadly speaking, economic growth spurs demand for gold in the form of jewellery and technology, but in recessions investors tend to buy gold as a store of value. This creates the balanced demand that accounts for gold’s lack of correlation to other assets.

•       Gold demand is widely distributed. Demand from Asia (57%) and the Middle East (10%) reduces the usual commodity demand dominated by developed countries and influenced by their business cycles.²⁰ A balance between East and West allows different sectors of gold demand to flourish when conditions are unfavourable in other sectors or regions.

•       Gold supply is widely distributed. On the supply side, mine production accounts for approximately 65%, leaving another 35% to recycling. Given that gold mine production is spread around the globe, gold’s price performance tends to be less subject to geopolitical and other idiosyncratic risks (see Gold: metal by design, currency by nature). Further, recycled gold constantly re-enters the market, providing a balancing factor that can further absorb shocks to the supply chain.

References

Chart 1:     Only 5% of US$153 trillion financial assets are currently in alternatives

The chart values are as of December 2013. Estimates include the global market capitalisation of all publicly traded stocks and REITs, the total value of outstanding bonds and money market instruments, total open interest on major commodity futures plus above ground stocks of precious metals, the assets under management of private equity and hedge funds and private holdings of gold bullion. Central bank holdings of gold and bonds were excluded.

Chart 2:     Alternatives have generally provided better risk-adjusted returns than US stocks

Information ratio defined as the annualised return in excess of the MSCI US total return index divided by the corresponding volatility. HFRI used as a proxy for hedge funds. Cambridge Associate index represents private equity. US REITs stand for real estate, S&P Goldman Sachs Commodity Index for commodities and London PM fix for gold. All returns based in US dollars.

Chart 3:     Hedge funds, private equity funds and REITs have high correlations to stocks

Correlations based on monthly returns (quarterly for private equity due to data availability) between January 1990 and March 2014. US equity indices include MSCI US, Russell small cap, Russell mid cap, MSCI EAFE and MSCI emerging markets. HFRI used as a proxy for hedge funds. Cambridge Associate index represents private equity. US REITs stand for real estate, S&P Goldman Sachs Commodity Index for commodities and London PM fix for gold. All returns based in US dollars.

Chart 4:     An allocation of 4% to gold for diversified portfolios that include alternatives can improve risk-adjusted returns and reduce losses during periods of systemic risk

These results display the optimal portfolios that were found for the Gold: alternative investment, foundation asset report published by the World Gold Council in October 2011.

Table 1: Gold has outpaced inflation in the US and abroad, as well as short-term rates

Shows the annualised average monthly returns for gold between 1972 and 2013 adjusted by: 1) US CPI; 2) OECD global inflation; 3) 3-month T-bill; 4) 3-month global cash index.

Chart 5:     Gold has consistently outperformed stocks as well as other alternatives during tail-risk events

Returns during periods of systemic risk. For equities: MSCI US. HFRI used as a proxy for hedge funds. Cambridge Associates index represents private equity. US REITs stand for real estate, S&P Goldman Sachs Commodity Index for commodities and London PM fix for gold. All returns based in US dollars. Persian Gulf War I: Q3 1990, LTCM: Q3 1998, Dot-com meltdown: Q1 2001, 9/11: Q3 2001, 2002 recession: Q2/Q3 2002, US Credit Crisis: Q4 2008/Q1 2009, European sovereign debt crisis: Q2 2010.

Commodities are also volatile. So far this year a number of events have highlighted the uncertain nature of investing in commodities. In January, Indonesia’s ban on nickel-ore exports triggered a 50% rise in price to May. In the first quarter of 2014, approximately 40% of global platinum production came under threat by striking miners in South Africa.³ Elsewhere, cocoa has been affected by political events in the Ivory Coast, the largest producer, and severe droughts in Brazil have had a material impact on coffee prices. Volatility is a boon for speculators but presents a real problem for firms involved in the physical supply or consumption of the resource.

…but there are signs that the rout may be drawing to a close.

But not all commentators are despondent. Among the optimists, investment bank Goldman Sachs argues that commodity performance has played to expectations given the stage of the business cycle and that the commodity complex is now poised to benefit from a global economic recovery. And some fund managers who are concerned about the outlook for equities (a view we detailed in Can gold replace bonds in balancing equity risk?⁴) are actively considering redeploying commodities as a portfolio diversifier.

To us, the commodity story serves as context. It is useful to understand the commodity complex because there are some similarities between its constituents and gold. It is also useful to understand the portfolio benefits of commodities and their impact on inflation. However, what we highlight in this paper is how distinct gold is from the group, why this is the case, and what the implications are for investors.

Gold is often lumped together with the commodity complex by investors and investment practitioners alike. Whether as a component in a commodity index (S&P Goldman Sachs Commodity Index, Dow Jones UBS Commodity Index), one of the securities in an ETF, or as a future trading on a commodity exchange, gold is viewed as a part of this complex. Before setting out to show how different gold is from its nearest ‘commodity’ cousins and by extension the rest of the complex, we detail the similarities.

Zooming in to the tradable commodities we are familiar with, gold shares characteristics with other commodities in that it:

•       Is extracted, and shares other commonalities with commodities including scarcity, consumption and fungibility.

•       Forms part of commodity structured products. Gold is a component of many well known indices, and this inclusion will invariably align some of the price movements of the constituent commodities. These influences include both end-of-year rebalancing where futures are bought/sold to realign commodity weightings in these indices, and the effect of exchange-traded products that track such indices.

Gold undoubtedly shares some similarities with other commodities. But a detailed look at the make-up of supply and demand highlights that the differences outnumber the similarities.

Reference notes are listed at the end of this article.

Source: Bloomberg, GFMS, Thomson Reuters, World Gold Council

The prominence of the Asia and Oceania region in the production of base metals, excepting copper, is striking. Nickel’s dominant producer is Indonesia, with a 30% share. Although Chinese copper mine production did not exceed 10% in 2013, its share of refined copper production is above 30%. Equally striking is the production concentration of platinum and palladium in Africa and Eurasia (South Africa and Russia dominate with almost 80% of production).

Geographic spread of production is considerably higher for silver, with no region producing more than 30% of annual mine supply, but Mexico is the largest single producer, with 21% of 2013 production.

Gold production concentration stands out as the most balanced. In 2013, the largest producer of gold was China, with 15% of global mine supply. Eighteen countries represent a cumulative 80% of production, while only eight countries reach the same cumulative total in silver production.

Given the propensity for supply disruptions in commodity markets, if stock levels – the supply-chain buffer – are low, supply concentration is likely to have a material impact on price volatility and uncertainty.

One of the most remarkable features of the gold market, and one that often confounds investors who try to use it to assess the gold market’s imbalance, is the size of the stock of gold. The hypothetical ‘cube’, measuring approximately over 21 meters (67 feet) on each side and containing all the gold ever mined, serves as a potent reminder of how precious gold is (see Focus 1 in A perspective on gold as a hedge in an expanding financial system).⁶ However, it also highlights how much gold currently exists above ground, ready to be mobilised should the need arise, and also emphasises the critical difference that gold is held as a store of value, not consumed.⁷

Chart 1 lists the current ‘forward cover’ of metal stock piles. The lead market currently has 2.8 weeks’ worth of supply on hand at the current rate of demand. The base metals numbers and even the PGM figures are in stark contrast to gold stocks, which would cover 2,260 weeks (about 43 years) of demand at current levels. The stock of private investment gold would cover total demand for 8.9 years.

Nickel stocks are ‘visible’. According to Roskill, invisible stocks could amount to 27 weeks. Additional reference notes are listed at the end of this article.

Source: Bloomberg, Roskill Nickel Market Outlook, GFMS, Thomson Reuters, World Gold Council

Equally important, however is the structure on the demand side. Chart 2 divides demand into broad types. Here we assume that various sources of industrial and technological demand will ‘broadly’ be driven by the same macro-economic factors.

Chart 2: Gold enjoys sources of demand that de-link it from the global business cycle

Copper has small proportions in consumer and investment categories but these are negligible. Additional reference notes are listed at the end of this article.

Source: Bloomberg, GFMS, Thomson Reuters, World Gold Council

Base metals are almost uniformly used within industrial applications. Copper is often referred to as ‘Dr Copper’ by economic commentators, due to its integral role in sectors of the economy that are good bellwethers of economic growth. Industrial and technological demand is undoubtedly the predominant source of demand for these metals.

Platinum, palladium and silver also feature in the jewellery segment, but none of the precious metals has the geographic spread of demand that gold has, across each segment (Chart 3). Gold’s demand is certainly more centred in Asia and Oceania than platinum and palladium, but their concentration within the automotive industry mitigates the effects of a reasonably broad geographic spread. In addition, gold demand features more heavily in the regions of Latin America, Eurasia and the Middle East (14.5%) than the other metals.

Chart 3: Although Asia figures prominently in gold demand, categories are well spread

Gold has lower counterparty risk than other commodities

Finally, while most commodities tend not to be subject to credit risk in the same way that fixed income and equity securities are, they may still be subject to counterparty risk (the risk that the short investor cannot fulfil the contract) especially when accessed via futures markets.

Given that gold is heavily traded on the spot market, investors can minimise counterparty risk by taking delivery of gold, or by keeping gold in allocated accounts or products that are held primarily in allocated accounts (eg, various gold-backed ETFs).

The fundamental make-up of gold is different from that of other commodities. They may share some attributes, but gold’s qualities make it behave differently.

Base metals and energy are more closely related to the global cycle than other commodities as shown by the dark green bars and the left y-axis. Least closely tracked are agricultural commodities, silver and gold – possibly driven by gold’s (and silver’s) negative relationship to the dollar. After all, higher growth should coincide with higher interest rates and consequently a stronger currency.

Accounting for changes in the broad US dollar index still leaves gold as the least sensitive commodity to changes in global industrial production (light green squares and right y-axis). A further examination substituting real GDP growth for IP growth raises gold’s sensitivity ranking somewhat. But this is intuitive, as the income effect (a driver of gold demand) is much more reflected in a broad measure like GDP than a concentrated manufacturing-related factor such as IP.

This lower cyclical sensitivity in gold’s price behaviour is a factor that separates it from other commodities, including the other precious metals. This also makes gold a better diversification asset for equities, as equities also correlate well with industrial production (correlation of 0.56 using year-on-year changes of global IP and MSCI world equities).

While gold is considered a commodity by many, its currency attributes stand out. Its track record as a part of the economic architecture and backer of currencies is unparalleled. It remains the third largest reserve asset, after the US dollar and the euro, accounting for c. 13% of global reserves.

It also satisfies the characteristics that define a currency, including:

•       A unit of account. Gold is traded 24/7 globally, and is one of the most convertible assets to local cash.

•       A store of value. It is virtually indestructible and has constrained supply not dominated by a single entity.

•       A medium of exchange. While gold does not serve as an official currency, it has served as a medium of exchange throughout history. It is used in transactions from houses to chickens and has gained interest as an alternative currency in countries such as Switzerland and Mexico.⁸ Component of foreign reserves. Central banks hold gold; indeed, the Bank for International Settlements (BIS) stated in its 2013 annual report that ‘gold is to be dealt with as a foreign exchange position rather than a commodity because its volatility (which is almost consistently lower than commodities) is more in line with foreign currencies, and banks manage it in a similar manner to foreign currencies’.

In Gold and currencies: the evolving relationship with the US dollar,⁹ we looked at the relationship between gold and the US dollar and described how gold is influenced by three currency-related themes: the value of the US dollar vis-à-vis other currencies, global money supply and gold’s role in foreign reserves.

If these are themes that influence gold, and gold behaves differently from the commodities complex, one would expect to see a difference in the relationship between the price of a given commodity and measures of these characteristics.

Chart 5 and Chart 6 show precisely this difference. Gold has a stronger correlation to year-on-year changes in global broad money supply than the other commodities. Gold is the only commodity that has a positive correlation to excess money supply,¹⁰ a marker of potential inflation and currency debasement. And gold has the strongest negative relationship to the US dollar (see footnote 7).

Finally, gold has the strongest relationship to global foreign-exchange (FX) reserves. This is partly a function of efforts by central banks to maintain a constant ratio of gold to growing reserves, and it is also partly due to gold’s reaction to the growing influence of emerging markets whose reserve building has been concurrent with wealth creation and the increased desire for gold.

Armed with the information set out above, how can investors benefit from gold’s unique attributes? We maintain that commodities, despite their volatility, should form part of a prudent asset allocation strategy. But many investors might view gold as simply part of the commodity complex and invest in one of the broader commodity indices. This we have shown is suboptimal from a risk-return perspective.

Gold’s unique attributes set it apart from the commodity complex in that it deserves a separate allocation. It should be viewed as a hybrid of commodities and currencies rather than being firmly entrenched in either camp.

In the paper Gold: a commodity like no other,¹¹ we showed that gold can enhance a portfolio that already has exposure to commodities via a broad index (S&P Goldman Sachs Energy Light Index or GSEL). The results are reproduced in Table 2. Using long-term strategic returns, 20-year volatilities and correlations, an allocation to gold was shown to be beneficial right across the risk spectrum, even with an existing commodity allocation.

Overall, the addition of gold increased risk-adjusted portfolio returns and reduced portfolio Value-at-Risk (VaR), or the probability of large portfolio losses.

1)    Calculations are based on weekly total returns and converted to annualised return and volatility when applicable

2)    Portfolio using a 30% allocation to US equities, 20% to international equities, 39% to fixed income, 1% to cash and various allocations to gold and commodity indices. A 0% gold is equivalent to a 10% on the S&P GSEL; 5% on gold implies 5% on S&P GSEL; and a 10% gold weight implies a 0% allocation to S&P GSEL.

Source: Barclays, JP Morgan, MSCI, Standard and Poor’s, World Gold Council

References

Table 1:     Gold production is geographically widely distributed

All values calculated as 3-year averages. Regions have been constructed from country-level data to ensure consistency among constituents. Major country designations: Turkey=Eurasia, Russia=Eurasia, Iran=Middle East, All former CIS countries = Eurasia, Mexico = North America.

Chart 1:     Total above-ground gold stocks could cover 43 years of demand

Stocks calculated as of 2013. As not a flow variable, a single year is deemed representative. Forward weekly cover calculated as available above-ground stocks / weekly demand. Data sourced from Barclays, Bloomberg (Industries), Roskill Nickel Market Outlook 2014, GFMS, Thomson Reuters

Chart 2:     Distribution of demand by category

All values calculated as 3-year averages. Although small amounts of copper will be reflected in both consumer demand (ornamental / functional) and investment (ETFs), these amounts are negligible and unlikely to have any effect on prices at current levels of flow.

Regions have been constructed from country-level data to ensure consistency among constituents. Major country designations: Turkey=Eurasia, Russia=Eurasia, Iran=Middle East, All former CIS countries = Eurasia, Mexico = North America.

Chart 3:     Distribution of demand by geography

All values calculated as 3-year averages. Regions have been constructed from country-level data to ensure consistency among constituents. Major country designations: Turkey=Eurasia, Russia=Eurasia, Iran=Middle East, All former CIS countries = Eurasia, Mexico = North America

Chart 4:     Sensitivity to the global business cycle

The chart shows the unweighted average correlation of commodities prices to industrial production (IP) in the G20 countries. Please note that the EU is represented by Germany France, UK, and Italy. We exclude Saudi Arabia due to data availability. Correlation run on QoQ changes in variables. The results were robust to changes in year-on-year changes in IP growth, and to a GDP weighted average of global IP. The unweighted average was used to capture emerging market growth better. To control for changes in the dollar index, a simple OLS on changes in variables was run as per above, with commodity prices as the dependent variables, IP growth and changes in a broad trade-weighted dollar index as the independent variables. The coefficients were then averaged as per the correlations above. Results were robust to the weighted average. The same procedure was repeated for GDP growth. Seasonally adjusted indexes were used where available. Quarterly data spanning Q4 1990 to Q1 2014 was used across all series.

Chart 5:     Correlation to global broad money supply growth and excess money supply growth

Data spans Q1 1995 to Q1 2014, quarterly frequency. Correlation of year-on-year percentage changes in commodity prices with year-on-year growth in global broad money supply and global excess money supply (Broad Money supply growth less Nominal GDP growth). Global aggregate comprises US dollar value of broadest available measure of money supply in the US, UK, China, Japan, Switzerland, Russia, India, Brazil, Germany and France (contribution to Euro Area money supply respectively).

Chart 6:     Correlation to the US dollar and global FX reserves growth

Data spans Q1 1995 to Q1 2014, quarterly frequency. Correlation of year-on-year % changes in commodity prices with year-on-year percentage change in broad US dollar trade-weighted index and global FX reserves (IMF composite from Q1 1999, aggregated total from Q4 1990).

Chart 7:     Gold is far less volatile than the commodity complex constituents

Based on weekly log returns. Data spans Dec 1987 to May 2014 except for Natural Gas, (Apr 1990) and Zinc (Jan 1989). Base metals prices are LME 3-month futures, all others US-listed futures except precious metals which are spot prices in US$/oz.

•       Strategies that go beyond long-only investing in equities or debt instruments

•       Higher liquidity than other alternatives through daily pricing and daily subscription/redemption mechanisms

•       Transparency via periodic and regulated disclosures.

•       An increased flow into active equity funds that spurred demand for a way to manage directional equity risks

•       The end of a 30-year credit bull market that forced investors to seek yield from non-traditional sources

•       Investors’ concerns about future liquidity crises.

In addition, recent regulatory and advisor-compensation shifts, sparked by the global financial crisis, have added supply and demand for liquid alts.

Regulations on the back of the Dodd-Frank Act have resulted in making mutual fund and ETF structures more attractive for alternative strategies.¹ These regulations require private funds to have levels of transparency that are closer to those of public funds. Similar regulatory rules and pressures in the European Union are likely to boost investment in liquid-alt assets.²

The recent shift in advisor compensation models towards a combined fee-and-commission structure has also added to demand for liquid alts. This incentivises advisors to use volatility-reducing strategies to keep their asset base – and the fees collected on it – as stable as possible.³

Global demand for liquid-alts could reach US$1.3 trillion by 2017

As we see it, the outlook for liquid alts looks positive (Chart 1). There is growing, global interest and an increasing number of qualified investors. According to a 2012 Cogent Research survey, almost 75% of US financial advisors used some form of alternative assets, and they have increased their usage in recent years.⁴

A recent Citigroup study suggests overall demand for liquid alts will reach US$1.3 trillion by 2017; a level equal to total assets invested in all hedge funds in 2008.⁵ They expect that US demand from retail and institutional sources will push assets in liquid-alt vehicles to US$908 billion, and new demand for liquid UCITS⁶-structured products in Europe is expected to reach US$417 billion. Similar figures are estimated by Barclays, which sees demand ranging from US$650 to US$950 billion in US alternative mutual funds alone by 2018.⁷

Reference notes are listed at the end of this article.

Source: Morningstar, Citi Prime Finance, World Gold Council

•       Liquidity: Most offer daily pricing that would be highly unusual in traditional hedge funds or private-equity funds. In general, liquid-alt funds must meet daily investor redemption requests and publish daily net asset values (NAVs). In contrast, traditional hedge funds, private equity, and direct real estate investments often inhibit redemptions through gate and lock-up mechanisms and offer less frequent valuations.

•       Transparency: Liquid alts are more transparent because they have set investment mandates. These require them to clearly outline the intended investment strategy and, if applicable, state a benchmark for performance comparison. Changes require shareholder approval. Traditional alternatives can be more opportunistic and change their strategy as they see fit – often without shareholder approval. Liquid-alt funds must also file regular portfolio holdings and produce standard public documents (eg, annual reports, prospectuses, statements of additional information).

•       Lower fees: Liquid alts offer investors lower total investment costs compared to many alternatives whose differentiated strategies and strong performance come at a high price. This can be the risk premium associated with illiquidity in private equity investments, hedge funds’ performance fees, or the extra research costs of direct real estate investments. Liquid alts give investors a way to invest in non-traditional assets at a lower initial cost. They are available to non-accredited investors, require a low minimum investment, and their conventional investment structure usually creates an efficient tax structure and reduces initial costs.

•       Short track records. Liquid-alt funds usually have shorter track records than traditional alternative-asset funds. This makes it harder for investors to analyse and evaluate investments, and increases pre-investment research costs.

•       Performance drag. Liquid-alt funds tend to keep cash on hand to meet investors’ redemption requests, and this can create a drag on performance. There also appears to be a structural liquidity discount across liquid alts: a study by Cliffwater found an average annual discount of 100bps in their performance relative to non-liquid alternatives.¹⁰ They found that it was persistent across time but inversely related in times of market stress (markets tend to value liquidity more highly during a crisis).

•       Limited liquidity. There can be limits to the liquidity of liquid-alts. Some markets (eg, particular credit and derivative markets) that liquid-alt funds access can be less liquid than basic equity and bond markets. In times of stress this could mean that underlying positions have to be sold at a discount.

•       Limited transparency. Transparency is limited between reporting periods, and some funds do not specify a performance benchmark. This could create risk-management problems for investors who want to understand their risk position on a more frequent basis.

•       Limited capacity. Liquid-alts can also suffer from limited capacity: a liquid-alt manager may not want to take on new capital because a larger fund would not be able to implement a particular strategy.

•       Wide range of fees. Liquid alternatives have lower fee structures, but there still is a wide range of fee levels across the asset class. According to Morningstar data, an average net-expense ratio for US mutual fund liquid-alts is 1.9% but can go as high as 4.6% – compared to annual fees of less than 1% common in many traditional mutual funds and ETFs.¹¹

Many hedge funds, private equity funds, real estate-based investments (the catalyst of the 2008-2009 financial crisis), and commodity-based investments experienced steep increases in correlation during the 2008 crisis (Chart 2) and have not dropped to pre-crisis correlation levels. As the chart shows, gold’s correlation with stocks – typically low in normal market conditions – is the only asset whose correlation has fallen below pre-crisis levels.

Chart 2: Most assets’ correlation to global equities spiked in 2008 and has remained elevated; only gold has dropped below pre-crisis levels

Correlations to equities based on monthly returns (quarterly for private equity due to data availability) between Jan 2000 – Dec 2007, Jan 2008 – Dec 2008, Jan 2009 – Apr 2014

Reference notes are listed at the end of this article.

Source: Bloomberg, Cambridge Associates, Dow Jones, HFR, The London Gold Market Fixing Ltd, World Gold Council

Gold is one of the most liquid assets in global markets

When it comes to liquidity – a key characteristic of liquid alts – Chart 3 shows that gold is well placed. The gold market is very deep and very liquid:

•       Average daily gold volumes are significant. Gold daily volumes have historically only been surpassed by three major currency pairs (involving the US dollar) and two other financial assets: US treasuries and Japanese government bonds.

•       The gold market is deep. It can be accessed by investors big and small. The above-ground gold stock in the form of bars and coins accounts for one fifth of stocks, worth approximately US$1.5 trillion.¹² In addition, the notional amount in gold derivatives (over-the-counter and exchange-traded contracts) is estimated at US$740 billion.¹³ This has allowed investors to buy and sell in periods of crisis without apparent price distortions.

•       Gold prices are available 24/7. Gold is traded intraday worldwide. This allows continuous pricing through products such as physical bullion exchanges, exchange-traded products and over-the-counter (OTC) contracts. A robust spot and forward market along with a large and active swap market further augments available liquidity and allows investors to lend and borrow gold. In addition, gold-backed ETFs have given a wide range of investors a way to invest in gold.¹⁴

Chart 3: Gold is one of the most liquid of all assets

Average daily volume in US$ billions for various assets and currency pairs

Reference notes are listed at the end of this article.

Source: German Finance Agency, Japanese MOF, SIFMA, CPM Group, UK DMO, LBMA, World Gold Council

Gold does not suffer from other disadvantages of liquid-alts

Earlier in this article we outlined other disadvantages and limitations that liquid-alts have, whether in general or compared to other alternative assets. In addition to gold’s high liquidity, we note that it does not suffer from the many of their disadvantages:

•       Extensive capacity. Gold’s deep and liquid global market means that investors do not face the capacity issues that can arise with other liquid-alts.

•       Transparency. Lack of transparency between reporting periods is not an issue for gold. An investment in gold bullion and many of the currently available gold-backed ETFs is solely that. In contrast, the underlying assets in many liquid alts may be less apparent or readily available to investors.

•       A long track record. There are no concerns around limited track records for gold. The benefits of adding gold to an investment portfolio have been studied and reported extensively, and gold has been freely traded since the 1970s.

•       Low cost. As has been noted in our previous article Hedging EM risks? Think gold,¹⁵ investments in gold can be relatively inexpensive to implement. Investors can store physical bullion and coins, or invest in exchange-traded products or OTC products such as futures and options. For example, the cost of vaulting allocated physical gold or owning gold through an ETF is typically less than 50 basis points per year. Compared to the average cost of other mutual fund liquid alts (190bps), gold can achieve the same desired investment characteristics at a fraction of the cost.¹⁶

References

Chart 1: Global liquid-alternative assets have grown substantially since 2008

Asset values for years 2007 through 2011 were based on data from Citi Prime Finance. For the years of 2012 and 2013, asset values were determined from Morningstar’s Global Flows report. The Alternative and Commodities asset classes were aggregated to represent the net assets for liquid alternatives globally.

Chart 2: Most assets’ correlation to global equities spiked in 2008 and has remained elevated; only gold has dropped below pre-crisis levels

Correlations of global equities and other assets based on monthly returns (quarterly for private equity due to data availability) between Jan 2000 – Dec 2007, Jan 2008 – Dec 2008, Jan 2009 – Apr 2014. Global equities represented by the MSCI All Country Index. HFRI used as a proxy for hedge funds. Cambridge Associate index represents private equity. US REITs stand for real estate, Dow Jones UBS Commodity Total Return Index for commodities, and London PM fix for gold. All returns based in US dollars.

Chart 3: Gold is one of the most liquid of all assets

Foreign exchange liquidity is based on statistics by the Bank for International Settlements. Government bond liquidity is based on statistics published by country’s respective debt offices. Daily trading value of gold is based on the loco London survey conducted by the London Bullion Market Association and the Bank of England in Q1 2011 for the OTC market, as well as daily volume from futures and ETF markets. OTC gold volumes make up more than 80% of daily gold liquidity.

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