A growing concern for European pension schemes in the current environment of instability and insecurity is to ensure that, whilst they participate in the nascent market recovery and take advantage of growth opportunities, they are also sufficiently protecting their portfolios against
the ongoing volatility impacting the international economy. 2011 to date has been characterised by jittery markets and macro economic un-certainty. Issues such as the prospect of a further European sovereign debt default, continuing civil unrest in parts of the Middle East and Africa, the devastating catastrophe in Japan and the uncertainty of the long-term price of oil have certainly all had an unsettling impact on investors and market participants the world over.

However, the pensions industry is becoming more alert to this dynamic and the need to actively assess and manage the downside risk of investment strategies. This is reflected in a number of new initiatives which aim to better protect portfolios against unexpected events which may place extreme pressure on specific asset classes or wider global markets.

JP Morgan Asset Management, for example, has recently developed a portfolio risk modelling system enabling the firm to more accurately analyse Conditional Value at Risk (CVaR) through non-normal return distributions, for a series of asset classes(1). The new model has found that pension funds with more of an allocation to alternatives can reduce overall VaR – and thereby reduce severe losses in their portfolios – with only a minor reduction in returns. Indeed, industry sources(2) indicate that, after the turmoil of the financial crisis, pension fund investors are now seeking to smooth out return variability and secure more consistent returns through broader asset allocation strategies.

From our perspective at the World Gold Council, backed by significant research, we see greater portfolio diversification into alternative asset classes as clearly being a positive move. However, we believe that many pension funds have a somewhat one-dimensional view of gold, considering it primarily as a relatively 'peripheral' alternative asset, most typically as part of the wider commodities complex. In our view, while this perception may implicitly acknowledge gold's strengths as a diversifier in some regards, it may also neglect its benefits in others.

The failure to examine gold's unique range of attributes as an asset, underpinned by a diverse set of characteristics that elevate it well above most commodities, can result in the persistent undervaluation of gold's worth as a strategic buffer against market risk. For example, gold is more insulated from western market cycles than most other commodities as demand is geographically diverse and often strongest in more dynamic economies, such as China and India, which proved remarkably resilient to the recent financial downturn. This trend helps buffer gold from the impact of recession and also reduces its volatility.

Gold has traditionally been an asset class best known for its attributes as an inflation hedge and its capacity to act as a store of value. Yet gold's wealth preservation qualities are far deeper than this. Our research suggests that gold, as a stand-alone asset class (that is, beyond its inclusion in commodities baskets), can be statistically proven to be a highly effective and consistent portfolio diversifier not only helping increase expected risk-adjusted returns, but also considerably mitigating the potential for capital to be eroded by extreme events.

In a recent report entitled "Gold: Hedging against tail risk", we examined the impact that an allocation to gold would have on investors' portfolios in the event of a tail risk, or so called 'black swan' event. These are extreme occurrences, often hard to predict, which can have catastrophic effects on an investor's capital – and the wider economic system – if and when they do occur.

In the report, we analysed different portfolio compositions, including an allocation similar to a benchmark portfolio, to assess the behaviour of the long-term risk profile of an investment when gold was included and observed how, in various tail risk periods, value was adversely affected when gold was absent. The results provide some useful food for thought, indicating that portfolios that hold even a relatively small allocation to gold can consistently reduce portfolio VaR whilst maintaining a similar long-term return profile to equivalent portfolios which do not include gold.

The research found that for three quarters (18 out of 24) of the tail risk scenarios analysed (from a period between December 1987 and July 2010), portfolios which included gold consistently outperformed those which did not. Specifically, during the height of the global financial crisis, an institutional portfolio of US$100 million experienced an additional US$5 million financial loss simply by failing to include a modest (8.5%) allocation to gold. Thus, small allocations to gold (ranging from 2.5% to 9.0%, for example) can increase risk-adjusted returns and help reduce the weekly 1% and 2.5% VaR of a portfolio by up to 18.5%.

We found that a modest, consistent holding of gold mitigates the potential for significant value to be lost during extreme market events and, moreover, the downside protection on offer does not hinder potential upside. This research supports other World Gold Council analysis of optimal portfolio composition that shows that in multiple market conditions an allocation to gold can reduce the volatility of a diversified investment portfolio without sacrificing expected returns.

Much has been written on gold with some commentators questioning the longer-term performance of the asset class. Many of these arguments are based on a significant over-estimation of the level of institutional investment in gold, suggesting a crowded market, which is far from the case. However, to place the discussion on a more empirical basis, analysis(3) of the longer-term performance of gold shows that the current level is very much sustainable, well within statistically 'normal' growth trends and driven by strong market fundamentals, with considerable scope for additional development in key geographical and sectoral markets.

In short, we suggest there is certainly an enduring place for gold in institutional investment portfolios, particularly in such an unstable world. While investors understandably wish to exploit the opportunities presented by the global economic recovery and make up for the losses they have experienced over the previous few years, they also need some firm foundations on which to base their confidence to invest in riskier assets in a riskier world. We see an opportunity for pension funds to further acknow-ledge gold's role as a foundation asset, allowing them to then build more diversified and robust portfolios.

We have seen that market participants are becoming more attuned to the possibility of future tail risk events, which could send shock waves throughout the global markets, in turn having potentially far-reaching consequences for institutional portfolios. Through our latest research, we have drawn a direct link between inclusion of gold in an institutional portfolio and the ability to mitigate risk and protect wealth. For many pension fund professionals and trustees who have traditionally been unconvinced on the case for gold, we hope our recent findings may offer a broader perspective and a more useful set of options when facing difficult decisions on strategic asset allocation.

(1) Non-Normality of Market Returns: A Framework for Asset Allocation Decision Making, JP Morgan Asset Management, 2010
(2) Fifth bi-annual Pension Funds Asset Allocation Survey – bfinance 31 January 2011
(3) The Ten Year Gold Bull Market in Perspective, World Gold Council

Marcus Grubb is managing director, investment, World Gold Council

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