Rozanna Wozniak, investment research manager at the World Gold Council, looks at how gold offers a secure foundation for recovery strategies in the wake of the economic crisis
The recent struggles of iconic publisher Reader's Digest, apparently tipped into bankruptcy by the weight of its debts, not least the liabilities represented by its defined benefit (DB) fund, and the delicate and extremely difficult negotiations attempting to deal with the aftermath, illustrate all too well the stark predicament of legacy pension arrangements. Reduced funding positions, significantly weakened sponsors' covenants and wider financial market volatility have exacerbated the already difficult position in which many asset owners find themselves.
A recent US survey by Mercer showed that required cash contributions in 2010 of surveyed DB plans are estimated to be 400% higher than in 20091. The last major market correction in 2000 caused many plan sponsors to stumble, but the current economic environment and the limited availability of credit could well place them in an even more difficult position. The same survey recorded that, as at December 31, 2009, 36%of the 874 US private-sector plans surveyed had funded ratios below 80%.
Taking a global viewpoint
US schemes are clearly not alone in this. For pension schemes globally, asset performance will be central to any progress on funding. Even with the low volume equity market rallies we have seen of late, pension funds still face significantly depressed asset values.
Mounting pressure to quickly improve funding levels while minimising the variability of returns makes asset allocation an urgent priority. It is asset allocation and not manager selection that is widely recognised as the foundation of long run performance. At the heart of any progress on funding must be a robust, yet flexible, framework for asset allocation strategies. This framework must control risk exposures while affording the freedom to invest in risky assets. Of course, investment strategies must seek to capitalise on opportunities, but they must also be vigilant to mitigate unrewarded risk.
In the UK, US and Europe, approximately 45% of schemes have, over the last few years, extended their investment policy to include alternatives such as hedge funds, commodities or infrastructure2. However, the scale of these moves has been fairly small, the motivations behind them varied, and the results decidedly mixed. ‘Alternatives' do not always function as diversifiers. The search for effective diversifying assets has gained in intensity recently, largely reflecting the unexpected global asset convergence during the credit crisis and growing awareness of tail risk, i.e. the possibility that an asset will move beyond the bounds of ‘normality' (three standard deviations from the mean).
A balanced portfolio should be robust and stable enough to cope with a range of market conditions. The seemingly increased frequency of extreme market events makes this even more pressing a consideration.
True portfolio diversification relies upon an investment in a range of assets that have a fundamentally low to negative correlation with one another. However, to date, investment in alternatives has largely consisted of hedge funds, private equity and real estate, all of which have been highly correlated in the downturn because of the close relationship of their drivers to macro-economic factors.
One asset that has been shown, both historically and statistically, to consistently stabilise portfolio returns and mitigate risk is gold.
Gold fundamentals are much more geographically and sectorally diverse than the bulk of both foundation and alternative assets. Gold is many things to many people - a luxury good, a commodity and a monetary asset - and, as a consequence, its price is driven by a more diverse range of factors than those influencing other assets. Consequently, gold has the ability to distance itself from the tendencies of other investments and prevailing economic indicators and can therefore be used to add diversification and balance to an investment strategy.
Portfolios that contain even a small allocation to gold are proven to be generally more robust and better able to cope with market uncertainties than those that do not, showing improved stability and predictability of returns. Recent empirical research for the UK market suggests that the optimum investment in gold for any long term institutional investment portfolio ranges from 4% to 10%, depending on the risk appetite of the institution. Furthermore, contrary to popular opinion, the unique qualities that gold adds to an investment portfolio cannot be duplicated through a broader commodity exposure3.
Pension funds and other long-term investors face some tough choices in coming months. When reorganising asset allocation, trustees must be reassured that they can harvest upside potential, while ensuring that the scheme is protected on the downside. This will be challenging, even for those with deep resources and adaptive strategies.
So, with recovery now on the horizon, will risk management once again become the poor cousin of a market geared heavily towards return dynamics? What the events of recent past should have taught us is that we must always be prepared for the unexpected. Gold shines brightest during periods of crisis and extreme, unexpected events. The real value of gold will not be found in its return profile but in its capacity to provide a sure and steady means of enhancing the consistency of returns whilst reducing risk. For without such an anchor, opportunism may once again cause pension funds and their sponsors to drift into risky waters and threaten to capsize desperately needed asset recovery.
1A Mercer analysis of 874 private-sector plans subject to the Pension Protection Act - 3 Feb 2010
2Hewitt Associates: Global Pension Risk Survey 2008 (published November 2009)
3Gold as a Strategic Asset for UK Investors, World Gold Council, 2009
Rozanna Wozniak is investment research manager at the World Gold Council.