Gold: A Solution for Zero-Beta Satellites

In a previous piece, I illustrated a more active approach to core-satellite portfolio construction. While managing the core in a pro-active way mostly deals with fine tuning a multi-beta exposure and then applying active risk management, more creativity can be utilized for the satellite.

In this regard, there are probably two main approaches: active alpha or crisis alpha.  The first would require a strategy geared toward exploiting market anomalies that may lead to superior performance; such outperformance may realize itself via concentrated and targeted bets or via uncorrelated performance when measured over a certain timeframe. On the other hand, the latter would implement a strategy not only generally uncorrelated to the traditional core but that would be able to produce superior performance especially during times of great stress for traditional asset classes. 

This is an important distinction often overlooked: alternative investments which are usually generalized as a solution for alpha exposure may provide superior performance (especially over longer time frames) but not necessarily at times of significant liquidity and credit breakdowns for traditional asset classes.  A detailed factor analysis may uncover superior returns for many alternative strategies; however, it may also reveal a degree of sensitivity to fundamental price drivers common to traditional assets which may be much higher than desired.  Only a few strategies seem to be providers of crisis alpha or outperformance in time of significant stress in traditional betas: gold seem to fit that definition.

The successful run of the precious metal in the last ten years has been sparked by a confluence of positive factors such as extremely easy global monetary policy and a socio-economic transition from an age of optimism to a zero-sum era.  These elements reversed a downward trend in gold entrenched since the famous top in the early 1980s.  Central banks have been reversing their selling course as well as they relaxed their monetary policy.

This new dynamic rendered gold a stronger candidate for portfolio allocation.  Gold ability to provide crisis alpha makes it a perfect asset for inclusion in a zero-beta satellite.

Gold does not produce a stream of cash-flows which makes it difficult to analyze it based on classic valuation metrics such as DCF models, leaving most of the analytical work reliant on the study of supply and demand.  However, as the metal increases its magnetism for investment flows, its continued lack of correlation to traditional asset classes becomes the ultimate analytical input.

The World Gold Council ran a number of interesting statistics and scenarios in a recent working paper[1] showing how gold has been a consistent risk diversifier in addition to its traditional role as a store of wealth.

Their analysis showed that a 3.3% to a 7.5% allocation to gold (depending on the composition of the portfolio and the investor currency of reference) can improve the risk adjusted profile of the allocation even when other alternative assets are included.

In one of the tables produced by the study, we can see two different portfolios, a standard one allocated 55% equities, 25% fixed income, 5% cash and 15% alternative investments, and a conservative version allocated 30% equities, 50% fixed income, 10% cash and 10% alternative assets.  The portfolios were tested for the trading period from January 1987 to June 2011 utilizing US Dollar denominated assets.  In all cases portfolios with gold included scored higher Information Ratios with an optimal allocation to gold between 3.3% and 4.4%.

In this new turbulent investing environment, it is my belief that the old approach of trading around the mean hoping that investment returns will conform to an unrealistic bell curve will continue to disappoint and a more aggressive approach toward hedging and/or exploiting tail risk will continue to be key for some time.

Got gold?

Disclaimer: PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THEREFORE, NO CURRENT OR PROSPECTIVE CLIENT SHOULD ASSUME THAT FUTURE PERFORMANCE OF ANY SPECIFIC INVESTMENT AND/OR INVESTMENT STRATEGIES MADE REFERENCE TO ABOVE AND RECOMMENDED OR UNDERTAKEN BY CERVINO CAPITAL MANAGEMENT, WILL BE PROFITABLE OR EQUAL THE CORRESPONDING INDICATED PERFORMANCE LEVELS. DIFFERENT TYPES OF INVESTMENTS INVOLVE VARYING DEGREES OF RISK, AND THERE CAN BE NO ASSURANCE THAT ANY SPECIFIC INVESTMENT WILL EITHER BE SUITABLE OR PROFITABLE FOR A CLIENT OR PROSPECTIVE CLIENT'S INVESTMENT PORTFOLIO. HISTORICAL PERFORMANCE RESULTS FOR INVESTMENT INDICES AND/OR PORTFOLIO BENCHMARKS DO NOT REFLECT THE DEDUCTION OF TRANSACTION AND/OR CUSTODIAL CHARGES, THE DEDUCTION OF ADVISORY MANAGEMENT FEES, NOR THE IMPACT OF TAXES, THE INCURRENCE OF WHICH WOULD HAVE THE EFFECT OF DECREASING HISTORICAL PERFORMANCE RESULTS.

HYPOTHETICAL RISK DISCLOSURE: HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN, IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

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[1] World Gold Council, Gold: Alternative Investment, Foundation Asset, October 2011