Pensions World

Gold stands out from the wider commodities basket says Juan Carlos Artigas, World Gold Council

2011 has proven to be a volatile year for most commodities, due in part to heightened geopolitical risk, severe weather conditions, tighter margin requirements for silver futures, concerns about the changing regulatory landscape and uncertainty over global economic growth all contributing to swings and price pullbacks.

While the major sell-off witnessed in commodity markets in the first week of May raised concerns from some quarters about the longer term diversification and hedging benefits of commodities, it also highlighted that gold does not behave in the same way commodities do, both in terms of volatility and crucially, price recovery.

When most commodities suffered some of the largest price drops during the first week in May, the gold price fell by only 4.4%. By comparison, the Dow Jones UBS Commodity Index™ (DJ-UBSCI) and the S&P Goldman Sachs Commodity Index™ (S&P GSCI) index fell by 9.1% and 11.2%, respectively. Further, individual commodities such as oil fell by almost 13.0% while silver prices dropped by a whopping 25.6%. The gold price recovery has also been one of the strongest among all commodities, with the price by the end of May standing only 1.8% lower than at the end of April. Moreover, gold’s annualised volatility during the month at 16.8% was just slightly higher than its 20 year historical average. In stark contrast, silver’s annualised volatility at 75.8% during the same period was twice as high as its average and even the DJ-UBSCI and S&P GSCI realised volatilities were more than 1.5 times higher.

Like no other

In a recent study, Gold: a commodity like no other, analysis performed by the World Gold Council showed that a modest, consistent holding of gold increases long term, risk-adjusted returns in a way that a commodities basket alone does not.

Within indices such as the S&P GSCI or the DJ-UBSCI, gold’s weighting typically ranges between just 3 and 7%. Thus, while investors typically get some exposure to gold when using one of these indices as a benchmark, its total weighting is small. For example, for an investor with a 10% overall allocation to commodities, the effective exposure to gold is as low as 0.3% using the S&P GSCI and only as high as 0.7% when using the DJ-UBSCI. Therefore, to achieve true diversification an allocation to an outright position in gold provides benefits that cannot be replicated simply by investing in a wider commodities basket. This supports the premise that gold should be viewed as a distinct asset class.

True diversification

The reason that gold can consistently act as a highly effective portfolio diversifier and risk management tool is rooted in its supply and demand dynamics. These characteristics combine to produce a very different reaction to economic and financial variables than other commodities.

Gold’s correlation to the wider commodity complex tends to be low; it is less exposed to swings in business cycles, typically exhibits lower volatility and tends to be significantly more robust at times of financial uncertainty. This gives investors who hold gold the confidence to invest in other assets irrespective of wider market or macro-economic conditions.

Gold is not only different from commodities with respect to its performance, volatility, correlation and its composition of demand and supply, the gold market is also very large and liquid. Financial gold holdings, which include gold in public and private hands, are equivalent to US$2.9 trillion, based on the average price of gold in Q2 2011. To put that into context, the gold market is larger than any single European sovereign debt market, yet it is no-one’s liability.

Commodity allocations have become more common among investors seeking diversification and market sources indicate that further room for growth exists1. An allocation to gold provides benefits that cannot be replicated simply by investing in a wider commodities basket. This supports the premise that gold should be viewed as a separate asset class and a foundation for a diversified investment portfolio.

1 Barclays Capital, Commodity Cross Currents, March 2011