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Reassessing ‘Risk Free' Assets

Reassessing 'Risk Free' Assets

In the current environment of increased uncertainty, the search for so-called 'risk-free' assets to hedge portfolios against negative outcomes has understandably gained momentum. However, the recent wealth erosion experienced by investors worldwide coupled with the depth and breadth of the problems facing global economies calls into the question the reliability of traditional 'risk-free' assets. Juan Carlos Artigas, Global Head of Investment Research at the World Gold Council, examines the recent performance and outlook for traditional 'safe' assets and explores gold's credentials as an asset which can provide investors with a long-term trusted alternative to manage the risks their assets face more effectively.

Investors and asset managers have historically considered government bond yields as the benchmark risk-free interest rate, against which other asset classes were to be measured. True to form, over the past year, national bond markets haves provided shelter from turbulence in global risk assets: U.S. Treasuries enabled investors to preserve capital while riskier assets have floundered. Certain hard currencies have also historically been seen as a reliable and stable store of value due to the long-term stability of their purchasing power. And in 2012, we have seen behavior supportive of this with the U.S. dollar, the Japanese yen and the Swiss franc benefiting from de-risking inflows.

However, being an asset of last resort is not without consequences. In particular, investors seeking 'safer' assets must also recognize that the ever-increasing supply of both currency and debt deplete the value of these assets. Furthermore, as declining yields approach zero, bond holders will at best get their capital back in nominal terms if they hold the bond to maturity. And in fact, they will more likely be negatively impacted by two factors: first, a loss of purchasing power in real terms as inflation erodes capital; and second, a fall in price for the bonds they hold when conditions normalize and yields start to rise.

Like main currencies and bonds, gold is a highly liquid asset; however, gold is also an alternative monetary asset with no default risk. A strong signal of the market's growing recognition of gold's ability to protect capital is the move by central banks over the past two years to become net buyers of gold, diversifying their reserves in response to concerns regarding the credit-worthiness of other assets, most notably government bonds. Record levels of government indebtedness and quantitative easing programs have heightened investors' fears about future inflation and holding fiat currencies. They have increasingly been turning to gold due, amongst other things, to its long history as an inflation and dollar hedge. This trend is expected to continue, as the sovereign debt situation around the world is moving from bad to worse. U.S. Treasuries, which has provided investors with consistent returns so far this year, is also a market facing significant risks. While Congress has found a temporary solution to the debt ceiling debate, pushing it to Q1 2013, the outcome of the presidential elections this November and the need to find a sustainable, long-term solution to the $1.3trn budget deficit loom large. In addition, the tepid job market's potential drag to economic recovery has given the Federal Reserve (the Fed) ammunition to introduce a third round of quantitative easing (QE3). In particular, the Fed signaled a clear intention to purchase mortgage-back securities "at a pace of US$40 billion a month" for as long as necessary. These factors combined mean a higher likelihood of debasement to the U.S. dollar alongside concerns of higher inflation over the long run.

Gold has historically exhibited a strong inverse relationship to the U.S. dollar. Over the past ten years, the correlation of weekly returns between gold and the trade-weighted dollar has ranged from -0.32 to -0.73. This relationship makes gold an effective hedge against dollar weakness and has been a key influence in driving up the gold price in recent years, which have been characterized by depreciation in the dollar and expectations of further dollar weakness due to the record U.S. budget deficit and scale of public debt. While the dollar experienced a sustained appreciation against most currencies from Q2 2011 to August 2012, the longer term outlook is still very uncertain and supportive of continued hedging-related demand for gold.

In light of this, a more comprehensive view of effective portfolio risk management is required and U.S. investors should consider the range of ways to harness gold's unique properties to protect wealth as it is accumulated. Whichever the investment vehicle, over the long run, gold competes on the basis of its diversification qualities and ability to offer downside protection during extreme market events, while reducing the volatility of a portfolio without sacrificing expected returns in more positive times.1 Research has shown that modest allocations to gold ranging between 2% and 10% over the past 25 years have not only generally improved risk-adjusted returns, but reduce potential losses. For example, during the height of the global financial meltdown, investors holding gold within that range would have reduced total losses by 5% relative to an equivalent portfolio without gold.2 In fact, despite higher than average short-term correlations between gold, equities and other risk assets during early 2012, correlations have since fallen to their more normal low and negative levels. Over the long-term, correlation of gold to equities is statistically insignificant and gold's performance remains independent of risk asset performance.

This behavior is a direct consequence of the dynamics of the gold market: a market where the sources of demand and supply are diverse and complementary; where a ready, deep and liquid global market exists; and where gold is often viewed as an alternative monetary asset with no default risk. Indeed, gold's physical attributes and functional characteristics set it apart from the rest of the commodity complex. For example, most other metals - including silver and platinum - rely heavily on industrial-based demand and are therefore linked to business cycles. Gold, on the other hand, is less exposed to these swings, typically exhibits lower volatility and tends to be significantly more robust at times of financial duress. In turn, this causes gold's correlation to other commodities and other asset classes to be low.

In the face of the depletion of traditional 'risk free' assets, investors are increasingly looking for alternative sources of wealth preservation.

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 wealth and should form a foundation of any long-term investment portfolio.

1 World Gold Council, Gold as a strategic asset for UK investors, June 2012.

2 World Gold Council, Gold: hedging against tail risk, October 2010.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Juan Carlos Artigas is Global Head of Investment Research for the World Gold Council.

This article is tagged with: Gold & Precious Metals

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Juan Carlos Artigas is Global Head of Investment Research for the World Gold Council.

Additional disclosure: Disclaimer: This communication is provided for informational purposes only; does not purport to provide any investment or other advice; and is not and should not be construed as an offer to buy or sell, or a solicitation of an offer to buy or sell, gold or any product, security or investment.