Gold: Risk or Rescue?

For those of you who are still doubting...we live in a crazy world....

The Dutch Central Bank (DNB) has ordered (by court !) the glass-workers pension fund (SPVG) to decrease its 13% Gold allocation to less than 3% within two months.

DNB and Court arguments in short:

1. An investment of 13% is not in line with the Prudent Person Rule, which includes the principle that: assets must be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole.
   
   
2. Gold is a commodity and holding 13%  is classified as 'overweight' in comparison to the 2.7% average that Dutch pension funds have invested in commodities.
   
   
3. 15% allocation in Gold is a 'concentration risk' that could lead to a coverage shortage if the gold price imploded (volatility of Gold is relatively large).

At first, it seems unbelievable that important decisions, with substantial financial impact  - even in Court - are not based on financial facts, but on 'general principles' and the way the market 'used to do it'.

A decision based on an argument that refers to 'the average pension fund,' would more or less imply that pension funds would not be allowed to base their investment strategy on their own specific situation or a changing market outlook. Pension Fund Boards appear to be  'captured' by the market and a Supervisor who obviously has a hard time to develop 'own standards'....

Secondly, DNB actually takes over the investment responsibility of the pension Board. One could wander if DNB is (sufficiently) aware of the possibility that it can be hold financially responsible for the effect of a negative outcome if it turns out in the near future that SPVG has suffered a substantial financial loss, caused by this DNB-designation.

Is Gold really a risk?....  or a rescue?

Checking the facts.... 
Let's just check if DNB's and Court's arguments are valid.....

Yearly Return
We start by comparing the yearly returns of Gold, the S&P-500 Index and '10-Y Treasury Bonds' over the period 1971-2010.

To make Bonds risk-comparable with Gold and the S&P-500 Index, the yearly average Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in a specific year are valued, and sold at the average interest rate one year later (approximation).


Here is the result:

To bring some sense and order into this chart, we calculate the 'Moving Compound Annual Growth Rate' (MCAGR).
We start in 2010 and calculate the  compound average yearly return backwards moving up (year by year) to 1971. This is the result:

Now, this looks better... and a bit surprising as well!!! On the long term Gold (μ=9.2%) and the S&P-500 (μ=10.2%) are tending to a rough 9-10% yearly return......  A little bit Surprising is that Bonds (μ=7.6%) get along very well with their big risky brothers...
Take your time to 'absorb' the impact of this chart.....

Risk
Next, we take a look at Risk. We define Risk at first as the Standard Deviation (SD). We directly cut trough to the 'Moving Risk' (Moving SD).

We might conclude here that during recent years there was an increase of risk with regard to the S&P-500 (the 'red' crisis 'Mount K2' is clearly visible). Note that also for a longer period, i.c. the last 30 years, the S&P-500 Risk is substantial higher than the Risk of Gold and much higher than the Risk of Bonds. Only looking at a period of 40 years, Gold shows 'optical' up as more risky (SD=σ=25.8%) than the two other asset categories, Bonds (SD=σ=6.9%) and S&P-500 (SD=σ=18.1%).

However this way of presenting Risk is strongly discussable. Another view of Risk that comes closer to what we naturally 'perceive' as Risk, is to define Risk as only as the Downside Standard Deviation (look up : Sortino ratio ), where all positive yearly returns are eliminated (DSD) or set to zero (DSDZ).....
Let's have a look:

Now, these charts give us a quite a different sight on Risk-reality....
It shows that -on the long term -  not Gold (DSD=Dσ=7.5%) is the riskiest asset, but the S&P-500 (DSD=Dσ=10.6%). Bonds (DSD=Dσ=0.5%), as aspected, have the least volatility and are therefore less risky.

Perhaps the Risk of Bonds is a bit underestimated (very few observations) by the DSD-method (excluding positive yearly returns). In this case the downside deviation of yearly Bond-returns, replacing positive returns by zero, which generates a standard deviation of 3.2%, gives a better indication of a more likely standard deviation on the long run.


Why Gold? 
Although these simple calculations already put the DNB conclusions in a different light, let's get to the main point that should be addressed in defending why Gold should be a substantial part of any Pension Fund portfolio:
 

 Gold Reduces VaR

In a 2010 (october) publication the World Gold Council published a document called Gold: Hedging Against Tail Risk. This interesting report concludes:

1. Gold is first and foremost a consistent portfolio diversifier
2. Gold effectively helps to manage risk in a portfolio, not only by means of increasing risk-adjusted returns, but also by reducing expected losses incurred in extreme circumstances such tail-risk events (VaR).

Following this excellent WGC report, let's test the balancing and risk-reducing  power of Gold by analyzing (classical) Risk (SD) in combining Gold with different allocations (0% up to 100%)  in an asset mix with Bonds, respectively investments in S&P-500 stocks.

This chart clearly shows that Gold has the power to reduce the S&P-500 Risk (SD) from18.1% to 13,3% with an optimal asset location mix of  approximately 60% S&P-500 and 40% Gold. 

In case of Bonds the Risk (SD) is reduced from 6.9%  to 4.8% with an optimal mix of 80% Bonds and 20% Gold.

Asset Liability Model (ALM)
In practice it is necessary to optimize, by means of an adequate ALM study, the  allocation mix of stocks, Bonds and Gold. Just as a 'quick & dirty' excercise, let's take a look at the next asset-combination scenarios, based on data over the period 1971-2010:

Just some head line observations:

• From scenario M1 it becomes clear that even a 100% Bond scenario is't free from Risk. So diversification with other assets is a must.
  
• Looking at M2-M5 we find that the optimal mix, defined as the mix that best maximizes Return (Compound Annual Growth Rate)  and Sharpe Ratio (at a Risk free rate of 3% or 4%) and minimizes Risk (Standard deviation), is something something in the order of: 70% Bonds, 15% stock and 15% Gold.
  
• Scenarios M6-M8 and M9-M11 take todays most common (but strongly discussable!) practice as a starting point. Most pension funds have allocated around 50% or 40% to Bonds and 50% or 60% in more risky asset categories (stocks, etc.). It's clear that even in this situation Risk can be reduced and Return can be optimized, if Stocks are exchanged to Gold with a maximum allocation of 20% or 30%.

Notifier

Although this 'rule of thumb exercise' on this website provides some basic insights, please keep in mind that finding the optimal mix is work for professionals (actuaries).

A serious ALM Study is always necessary and should not only take into account a broad range of diversified asset categories, but should also focus and optimize on:

• The impact of the liabilities (duration) and coverage ratio volatility
• The Timing: Mean values and Standard Deviations are great, but the expected return highly depends on the actual moment of  investment or divestment in the market.
• Future expectations. In the current market situation (2011) the risk of interest rates going up and therefore Bond market value going strongly down, isn't hypothetical. Secondly, the stock market has been pumped up by trillions of 'investments' (?) in the US economy. Once this crisis-aid definitely stops, the question is if these 'cement investments' will be strong enough to keep stocks up. Personally I fear the worst...
  Not to mention a scenario with declining stock rates in combination with increasing interest rates and inflation......
  Who said the life of an actuary was easy???

Conclusion
We may conclude that:

• Investing in Gold up to a 10% to 15% allocation, reduces the Risk of a portfolio consisting of Bonds and S&P-500 Stocks substantially. 
• Gold is less Risky than investing in S&P-500 Stocks

Therefore the 'not with facts' underpinned intervention of DNB looks - to put it euphemistically -  at least strongly discussable....

A wise and modest underpinned allocation of Gold is no Risk, it's a Rescue!

Related Links:
- Spreadsheet with Data used in this Blog
- Prudent person Rule
- IPE: Dutch regulator orders pension scheme to dump gold
- GOLD: HEDGING AGAINST TAIL RISK
- Downside Risk:Sortino ratio
- Dutch Central Bank Orders Pension Fund To Sell Its Gold
- Pension Fund Benchmarking 
- Strategic Risk Managment and Risk Monitoring for Pension Funds

Bonus: Gold, Hedging against Tail Risk Video