Some nonprofits have looked to gold as an inflation hedge and a haven against weak currencies. The University of Texas Investment Management Company carved out a 2% allocation and Elizabethtown College recently invested in a gold fund. Nevertheless, not everyone is feeling the fever. Cambridge Associates, one of the largest consulting firms to endowments and foundations, is no fan. Contributing Reporter Joseph D'Allegro spoke to Robert Lang, Cambridge's hard assets research consultant, and Eric Winig, an investment and research consultant at the firm. He also queried Shelley Goldberg, Roubini Global Economics' director of global resources and commodities strategy; and Gus Arraya, a principal at Makena Capital Management and manager of its natural resources asset class, who see more potential in the asset class.
FEMM: Should endowments and foundations invest in gold?
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Robert Lang |
Lang: We have long believed that gold does not belong in most investor portfolios for a variety of reasons. Most notably, gold has an expected real return of zero and therefore should generally be expected to be a long-term drag on portfolios that seek to preserve purchasing power after meeting annual spending needs. However, gold is also one of the only ways to protect against a broad debasement of paper currencies by profligate central bankers. Given the degree to which the Federal Reserve has expanded its balance sheet since 2008 and continued expansion of the deficit, this may be a risk worth protecting against today. Indeed, in the event that current and planned government policies lead to sharply lower currency values in the future, gold would provide one of the few places to hide.
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Shelley Goldberg |
Goldberg: Gold as an investment vehicle trades more like a currency without a country and less like a commodity. Our core view is that gold serves to some extent as a portfolio hedge. Gold becomes most valuable in two opposite states of the world--deflation and a financial credit collapse, or high to hyper-inflation and a loss of faith in fiat currency and macro policy credibility. Hence, gold plays the lead role in today's profound macro anxiety. Major high-income countries--the issuers of the overwhelming bulk of global fiat reserve currencies--are candidates for debt deflation or monetization. The U.S., eurozone, U.K. and Japan all suffer from excessive public and/or private debt, so that failure would indeed be widespread.
FEMM: What are the advantages and risks?
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Gus Arraya |
Arraya: Gold as an asset offers some protection and diversification in an uncertain environment. During periods of inflation or deteriorating sovereign credit, gold may hold its value fairly well versus paper currencies. Most U.S. endowments and foundations worry about the dollar as it generally represents their largest exposure from an asset allocation perspective. Gold could potentially offer some hedge against dollar debasement, specifically in an environment in which foreign currencies also appear unattractive. In that scenario gold may be one of the few alternatives to the dollar. Over time gold may continue to benefit from a growing allocation from institutional and retail investors. In addition, certain central banks have switched from selling gold to buying gold as a way to further diversify their reserves, which may provide additional investment demand for gold.
Valuation is a risk that would concern me with this asset. The debate isn't about gold being undervalued or overvalued, but, rather, how is fair value determined? With other instruments, i.e. stocks and bonds, there are methodologies that can be used to make calculations and assume present and future value. For gold, there are some valuation methodologies but they are very inexact. The challenge when buying is to objectively decide if it is at a value that is reasonable given gold's role in a portfolio.
Goldberg: Gold's volatility is lower than that of almost all tradable commodities, so it can help mitigate the volatility of a portfolio of global assets arising from both currency and asset price volatility. This message applies equally to emerging market nations--historically in the eye of macro volatility storms--and now to the developed world, which has been at the center of repeated macro crises affecting currencies and the prices of all other domestic and foreign assets. Physical gold benefits a portfolio in severe economic downturns as there are few other assets that do not have a liability or counterparty attachment. From a portfolio sizing perspective, try to buy two-thirds of a Picasso painting, or half of an antique car.
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Eric Winig |
Winig: While many investors think of gold as an inflation hedge, it is arguably a better hedge against deflation. This is particularly true today given the low level of longer-term U.S. Treasury yields, which limit the ability of Treasuries to provide the same level of protection against deflation as they have in the past. Put a different way, as the cost of Treasuries has moved higher, potential returns have shifted lower, thus increasing gold's relative appeal. While unhedged foreign sovereign bonds can provide a substitute deflation hedge, meanwhile, the lack of attractive currency options at the moment may make gold a more appealing option for some. All that said, gold can carry a significant opportunity cost, particularly during disinflationary periods such as the 1980s and 90s, and/or during bull markets in financial assets. In addition, unlike stocks and bonds, gold is speculative by definition, as it lacks financial characteristics--gold pays no dividends and has no earnings or maturity date.
FEMM: How should a nonprofit invest in gold?
Lang: It depends on the rationale for investment. Investors worried about currency debasement and/or disaster protection should invest in gold bullion or a gold ETF backed by the physical metal (e.g., GLD), as gold-related equities would likely underperform in such an environment as they did in 2008. A stagflationary environment could also squeeze profit margins if the increase in the cost of production outweighed the benefit of rising gold prices. In terms of ETFs versus bullion, ETFs offer better terms of liquidity and ease of investment. Vaulting is cheaper, but not as investor friendly, largely because the investor must arrange for delivery and eventual sale. For those looking to profit from higher-than-expected inflation, gold mining companies are likely to offer more upside potential in such a scenario, due in part to leverage at the corporate level.
Goldberg: Investing in gold as a portfolio hedge against fat-tail risks requires an analysis of trading and execution costs as well as risks. The various gold investment vehicles entail differing risk/reward characteristics and direct and embedded costs. This in turn means that the best choice of gold vehicle is critically dependent on where on the distribution of macro outcomes we actually find ourselves--severe deflation/financial collapse, inflation or reasonably normal world. Indeed, macro factors could be as or more important than micro-trends in gold supply/demand.
Arraya: Before making an investment, an endowment or foundation should consider how to own gold and for what purpose. It can be considered a real asset, or a currency, or a hedging tool. Depending on what role it is intended to play, investors may consider owning physical gold, owning shares of companies that mine and produce gold, or owning futures and options that help protect a portfolio against certain outcomes. Another option is to invest in hedge funds that take position in gold and related equities. This may offer a more tactical approach to owning gold.
FEMM: What percentage of a portfolio should be in gold?
Goldberg: We advise a neutral gold weight--under 5% of global, cross-asset portfolios, tilted to bullion over paper and equity. We expect demand for physical gold to continue to rise faster than paper, though we also expect monetary authorities to retain credibility by preserving price stability and modest growth, with eventual fiscal adjustment amid global uncertainty. We expect global price stability to prevail with ongoing upsets, rather than extreme fat-tail scenarios of severe deflation or extreme inflation. Despite this, global uncertainty will remain extraordinarily high in both high-income and emerging-market countries.
Winig: How strong is the institution's conviction that currencies will be debased and inflationary pressures will grow? What is the organization's ability to tolerate gold's high opportunity cost and what kind of insurance has the institution already put into place? An investor with a real assets basket dominated by illiquid investments, for example, might require a larger gold position to support spending than an institution with more liquid hedges. All that said, a gold allocation of less than 5% is unlikely to provide sufficient resources to cover spending during an inflationary and/or deflationary bust.
FEMM: What is the outlook for gold one- and three-years down the road?
Lang: Short-term, while we would not be surprised to see prices correct further given the steep run-up and excessive optimism that prevailed in late 2010, it is noteworthy that sentiment measures for gold have plunged along with prices and are now at levels indicating extreme pessimism. Longer-term, we continue to believe current and stated government policies that lean hard against deflation are supportive of gold prices, although a significant move toward fiscal restraint by the U.S. government and/or a scaling back of central bank quantitative easing policies would likely pressure prices.
Goldberg: We forecast low to modest gold price appreciation in the coming years, in line with our views on inflation. Emerging market inflationary pressures along with their physical buying should soften after 2011. Barring the fruition of either fat tail event, we expect a flat to low (single-digit percent) growth in the next three years.