A wise Greek (Heraclitus) once stated “nothing endures but c hange.” On the other hand, and a few thousand years later, another learned man (Samuel Johnson) was quoted as saying: “He is no wise man that will quit a certainty for an uncertainty.” Most investment professionals, familiar with the need to balance risk and return, would probably agree with both and acknowledge change can be both a threat and an opportunity.
Change is, in itself, not necessarily a problem. Rather, the chal-lenge is understanding the nature and consequences of specific changes and having the resources and confidence to face them.
Uncertain times
The primary obstacle investors and the guardians of wealth cur-rently face in attempting to plan for and adapt to change is that of overwhelming uncertainty. The unprecedented economic turmoil of the past half-decade, chaotic market responses and the range of possible outcomes to current crises has severely weakened the ability of professional investors to identify trends and probabili-ties with any degree of constancy or commitment.
This has had a debilitating effect on strategic investment plan-ning and asset management. The recently published 16th annual Global Wealth Report (from Capgemini and RBC), indicates that while the number of HNW individuals in the world may have marginally grown over the past year, their collective wealth shrank in 2011. Significantly, traditional sources of growth and wealth accumulation have been most vulnerable to recent stresses. The aforementioned report estimates global equity market capitalisation plummeted by nearly 19% in 2011, ending the year at US$43.1 trillion, substantially below the high of US$61.5 trillion of five years earlier.
Concurrently, the state of pensions in the west suggests a deple-tion of assets that will impose a substantial financial burden on future generations. The OECD, in its Pensions Outlook 2012, recently reported that, in the UK, money invested by pen-sions companies fell every year between 2001 and 2010. Towers Watson’s annual Global Pension Assets Study (2012) also reported that while pension assets may have grown nominally in 2011, the asset-liability gap has widened further, with global pension fund balance sheets having lost 4.3% over the year. The credit crunch and its aftermath, the ongoing eurozone crisis and the continuing fall in stock markets have all set alarm bells ringing but institu-tional investors have found it difficult to define solutions and initiate restorative action. Unsure how to regain a sense of bal-ance in the face of current market dislocations, pension funds have struggled to identify effective safe haven assets while falling interest rates have forced them to buy ever more costly bonds to meet their future liabilities. This skews and distorts the whole investment environment.
There are other global structural shifts already occurring that will radically reshape the socio-economic landscape over the next decade or so. Investors would be wise to consider and pre-pare for them but, shrouded in the current fog of uncertainty, most have resorted to grasping at very short-term tactics. The consequent see-sawing of risk sentiment has only served to fur-ther amplify levels of market volatility.
Stable returns
While there is ample empirical evidence to remind us that the most significant component of an investment strategy in ensuring stable returns is strategic asset allocation, underpinned by adequate port-folio diversification, this lesson currently appears, in the case of many investors and advisers, to have been lost or obscured. Fortu-nately, however, there are glimmers of hope.
One of the potential benefits of the Financial Services Author-ity’s Retail Distribution Review (RDR), scheduled to come into force in 2013, should be a renewed focus on asset allocation and a more balanced and f lexible approach to asset selection. This is a trend investment strategists of all types might wish to embrace if they want to construct portfolios that are more robust and fit for future purpose.
It should be noted the impact and importance of asset alloca-tion is not universally accepted. Many commentators have recently argued portfolio diversification is fine in theory but unfeasible in reality due to globalised markets, crisis contagion and convergent asset responses. If this were true, investors might, justifiably, feel stranded, with no clear escape route through the current miasma. Fortunately, our research suggests this is far from the case and rein-forces arguments for greater diversification and the need to consider a broader set of assets in the allocation process in order to incorpo-rate better protection against downside and unexpected risks.
The benefits of including a more balanced set of assets in invest-ment strategies are illustrated very clearly in the latest research paper from the World Gold Council: Gold as a strategic asset for UK investors, which provides firm evidence gold offers investors a reliable source of diversification and a means to reduce cross-asset correlation and, by extension, portfolio risk.
The research explores portfolio performance between January 1987 and December 2011, thereby encompassing multiple market cycles and conditions, and focuses on UK benchmarks and sterling-denominated assets. Using the respected optimisation framework developed by specialists Richard and Robert Michaud (Efficient Asset Management: A Practical Guide to Stock Portfolio Optimisa-tion and Asset Allocation 1998), the paper analyses gold’s impact on different portfolio strategies, with varying allocations of cash, bonds, equities and real estate. The findings show that adding gold consistently increases risk-adjusted returns or reduces maximum expected (and observed) losses and suggest the average optimal strategic allocation to gold for UK investors with fairly balanced portfolios is approximately 6%, with an optimal range of 2.6% to 9.5% depending on other asset weightings and risk appetite.
Furthermore, in these uncertain and ever-changing times, it should be somewhat comforting to know the research also indi-cates gold provides measurable portfolio insurance benefits against excessive losses from extreme and unexpected (i.e. sta-tistically improbable) market declines. For example, during the 2008-2009 recession, investors having modest allocations to gold would have reduced their portfolio losses by 227 to 676 basis points (£22,700 to £67,600 on every £1mn of investment), depending on portfolio structure and risk profile.
While this paper is centred on UK-oriented portfolio analysis, its findings are broadly compatible with earlier research focusing on US- and EU-based asset classes. Taken as a whole, this research, supported by independent analysis from Oxford Eco-nomics and New Frontier Advisors, represents a consistent body of statistical evidence to bolster our suggestion that, rather than being perceived as purely a tactical hedge or a peripheral ‘alter-native’, gold should be recognised as a foundation asset – a core component in ensuring stable portfolio performance.
Gold’s potency as a diversifier is rooted in its strong funda-mentals and uniquely broad range of demand drivers; gold is many things to many people in many countries and demand in each sector and geography is shaped by a very diverse set of fac-tors. This differentiates gold from most mainstream assets and, indeed, from most commodities as its value is far less dependent on prevailing market conditions and consumption patterns in the developed world. Additionally, several of gold’s key growth markets are located in countries in which expanding economic activity, wealth creation and socio-economic change are shaping the global landscape and to which we may have to look to secure our own future prosperity and security.
Closer to home, we believe there is now a growing recognition of these issues. We were much encouraged recently, when hosting a debate on the future of wealth and risk management, to note that the majority of the audience (of senior investment professionals and advisors), while pessimistic on immediate prospects for the euro-zone, retained a degree of confidence that enhanced diversification might still offer a route to secure and stable investment returns. We hope our recent research findings reinforce that confidence.
