The case for gold as a financial asset divides investors and commentators like few other subjects. In one camp, you have those who see gold as the only unprintable currency and therefore an essential hedge against the debasement of fiat currencies. At the other end of the spectrum are those who view gold as just another volatile commodity offering no yield and reliant on the greater fool for price appreciation. In this article, we attempt to sketch out a moderate position in the sparsely populated middle ground between the gold bugs and gold bears.

A unique safe haven?

Gold has played a formal and an informal role in financial systems for millennia, with the first known coins containing gold having been struck in Lydia, Asia Minor, about 600 BC. Gold’s attractions as a currency include its durability, limited industrial use and relative stability of supply (in contrast to other precious metals). The most recent period in which gold had a widespread formal role in currency arrangements was in the post-war period from 1944 to 1971, under the Bretton Woods system, in which the world’s major currencies were pegged to the US dollar – which itself was convertible to gold at a fixed exchange rate. Although gold no longer has a formal role in currency arrangements, many central banks retain large holdings (the US being the most significant holder, with about 8000 tonnes).

A number of current factors arguably make the case for gold more interesting at the moment. Highly indebted governments (particularly in the developed world), the rise of populism and signs of increasing social conflict all point to an environment of heightened political uncertainty and risk. At the same time, financial assets have been inflated by almost a decade of ultra-stimulative monetary policy, leaving investors with few safe havens that are not exposed to the risk of a faster-than-expected unwind of monetary support.

Gold has exhibited attractive diversifying characteristics from both equities and bonds, especially in periods of rising inflation. In particular, in the stagflationary 1970s, gold provided strongly positive real returns; whereas equities and government bonds exhibited negative real returns. In addition, gold has tended to exhibit a negative correlation with equities during market crises; for example, during the financial crisis, the gold price rose by 28 per cent while, over the same period, developed equity markets fell by more than 50 per cent from peak to trough, Thomson Reuters data shows. Furthermore, the correlation between gold and equities tends to move further into negative territory the more extreme the downward move in equities. Therefore, gold is considered by some to be a valuable hedge against tail events and risk-off periods in general.

Or just a volatile commodity?

The primary challenge to gold as a financial asset comes from the absence of any yield or risk premium, making it difficult for many institutional investors to justify a long-term strategic holding. As noted in the 2012 Credit Suisse Global Investment Returns Yearbook, gold has produced low real returns over the very long term (about 1 per cent annually, in sterling terms, from 1900 to 2011).

The gold price is also highly volatile, more so than developed market equities. Further, during periods of low or falling inflation, with decent levels of economic growth, gold has tended to struggle. For example, during the Great Moderation, in which business-cycle volatility and inflation both reduced, the gold price fell by more than 80 per cent in real US dollar terms, Credit Suisse found.

 

These characteristics – a highly uncertain future return and high volatility – make sizing any allocation to gold challenging. If the allocation is too small, it will have a limited impact on overall risk-return. If the allocation is too large, it may act as a painful drag on returns during periods when the gold price falls. This perhaps supports a case for a tactical approach to gold. However, timing gold poses at least as many challenges as timing other market exposures and perhaps more, given the lack of any fundamental basis for making an assessment of fair value. Few institutional investors are set up to make tactical asset allocation decisions; therefore, we believe such activity is best left to macro and trend-following hedge funds.

Finally, there can be no guarantee that gold will exhibit the same risk-return characteristics it has in the past. The idea that it will relies on a belief that gold will continue to be perceived by a sufficient number of investors as an alternative currency of sorts. A few thousand years of being treated as such clearly provides some comfort, but at a time when digital cryptocurrencies are gaining attention, there can be no certainty that investors will always treat gold as the only unprintable currency.

Finding a role for gold

The investment case for gold will continue to polarise, and it is difficult to make sweeping generalisations about the types of investors for whom a strategic allocation might make sense. However, it is possible to suggest some of the characteristics of investors who are more likely to be open to the merits of gold. These include:

  • Investors highly sensitive to inflationary scenarios, while not being able to access other forms of inflation hedge, such as inflation swaps
  • Investors with a willingness to accept a potential drag on returns in normal scenarios, in order to access some protection against extreme scenarios; for example, one in which investors lose faith in the fiat money system
  • Investors with a willingness to view gold as a risk-management tool in a portfolio context, as opposed to an isolated exposure that is expected to deliver a consistent contribution to the total return.

Investors for whom an allocation to gold is less likely to be suitable include:

  • Investors with nominal liabilities or an alternative approach to hedging inflation risk
  • Investors with an alternative way of plugging any gap that arises from disappointing real returns; for example, a strong sponsor covenant for a pension scheme or other sources of income/support for an individual
  • Investors able to adopt a multi-decade time horizon with flexibility in their long-term liabilities, such that experiencing a decade of disappointing real returns from equities is not catastrophic; for example, a young defined-contribution investor.

Ultimately, consideration of gold will necessarily be an investor-specific decision. However, we believe some investors will find the diversifying characteristics of gold attractive in mitigating the impact of certain extreme scenarios. The views of gold bugs and gold bears will remain entrenched, but investors should aspire to achieve a rational and well-reasoned view on the merits and challenges of this precious metal, in the context of their own circumstances.

Hedge funds need to be more flexible with fee arrangements and respond to investor demands for fee alignment, says Albourne chief executive John Claisse, who pointed to the ‘1 or 30’ fee structure the consultant helped develop with Teacher Retirement System of Texas (TRS) as an example.

“When it is working, there is an elegance,” Claisse says. “You are tapping entirely into your share of alpha, and paying for skill.”

As Jonathan Koerner explains in the case study on the $140 billion Texas Teachers, the 1 or 30 structure always pays a 1 per cent management fee or a performance fee of 30 per cent of alpha, whichever is greater. However, following periods when the 1 per cent management fee exceeded 30 per cent of alpha, an investor pays less to bring its share of alpha back to 70 per cent.

Essentially, when alpha is not sufficient to cover the 1 per cent management fee, that fee is paid as an advance on future performance fees.

“What we’re hearing from asset owners is that 1 or 30 revolutionises the conversation,” Claisse says. “It simplifies the focus to [put it] on alpha, and there is an elegance to that. Credit to TRS, they are not just doing it for their own benefit. Ultimately, it stabilises the business model of the manager, which is good for every investor.”

He says some large sovereign wealth funds are asking all their managers to consider these structures.

Furthering this, Albourne has conducted a survey, which 350 funds have completed. It found that more than 40 per cent have adopted a 1 or 30-style fee structure or are considering it.

Claisse says the beta hurdle and performance fee share are negotiable.

“This is not a one-size-fits-all,” he explains. “There are a lot of different types of fee structures for different strategies, but the important thing is they are all focused on the alignment of fees. It’s not the level but the shape of fees that’s most important.”

Fees are fraught

There has been increasing pressure on fee structures from investors, partly because of the sheer volume of fees they pay, but also because there are now genuine alternatives.

Claisse explains that in 2015, (based on a review of more than 600 funds managing more than $1 trillion in assets), hedge funds generated $51 billion in revenue. The investor share of this was only $23 billion, or about 45 per cent, while $16 billion, 31 per cent, went to management fees, and $12 billion went to performance fees.

“That just doesn’t work,” he says.

Claisse, who has been at Albourne for 20 years and, along with its two founders, makes up the executive committee, says the most important trend in the hedge fund space is the activist investor, which is moving the industry forward.

“End investors have the ability to make the hedge fund industry a pool of investable assets that’s attractive as they can be,” he says. “Hedge funds are an efficient business model for deploying risk capital, but they need to evolve to adapt to the current environment and survive. Hedge funds need to change and investors have the opportunity to effect change.”

There has been meaningful progress in fees, he says, but investors can still have a greater impact.

Albourne has been an advocate for fee transparency. In 2013, it launched the feemometer tool for investors. It has also helped managers produce Open Protocol, an industry standard for reporting risk exposures, in effort to empower investors in their negotiations with managers.

Claisse wants to eliminate the ‘angry dollar’ – investors who are unhappy because they are paying for beta or a manager kept a performance fee following a drawdown. The consultant continues to work on fee structure and has an initiative focused on fee disclosure called The Matrix, which includes the scoring of a manager’s fee transparency and flexibility.

“This allows investors to get a more accurate understanding of what they are paying, relative to the alternatives,” he says. “This information can be complex and challenging to obtain.”

Claisse says investors should be asking where they stand relative to other clients.

“Do [the managers] charge 2 and 20 to everyone and have no flexibility, or do other clients get better deals?” he asks.

Standard methods of risk management don’t work in a crisis but a revolutionary approach called agent-based modelling, which the University of California uses, is appropriate for investors, says chief risk officer for the university’s $110 billion pension and endowment, Rick Bookstaber.

The failings of standard methods of risk management, which use historical data and stress testing, are rooted in the fact that they deal with static portfolios. But crises stem from a series of events, not just one, with many agents interacting and changing the environment constantly, Bookstaber said.

“Why do we need an agent-based model for risk management? Because we are human, not automatons, and we interact with our environment,” he argued. “A lot of economics assumes there’s only one agent, and everyone behaves the same. But there are a set of agents with heterogeneous heuristics, and they interact and that changes the environment and you get a cascade period by period.”

“Because we are human, we create and innovate, so the world is always filled with surprises and things we couldn’t anticipate. This leads to radical uncertainty, but this is not central to economics. Not only does the future not look like the past but the future crises won’t look like past crises.”

Bookstaber, who was speaking at the Fiduciary Investors Symposium at the Massachusetts Institute of Technology, said the financial system consists of “computational irreducibility”; in other words, it’s a system that can’t be reduced to a set of equations. Yet most of the economic theories the industry practices are based on trying to solve problems with equations.

“Interactions create dynamic complexity and we can’t solve it, we have to live with it,” he said. “The world is not ergodic.”

The agent-based model uses heuristics instead of optimisation, and an open, simulated environment where many paths can emerge.

“In standard economics, you have an atomistic equilibrium world – whatever you do, or others do, doesn’t change the environment. That doesn’t make sense. In an agent-based model, you have an interactive, changing world that evolves over time.”

In a financial crisis, liquidity, leverage and concentration are the key areas that need to be dealt with, he said. In practice at the University of California, this plays out by logging different levels of liquidity and leverage on a heat map and determining where the fund’s holdings are at any point in time.

“Then we can see how bad things could be with a stress scenario,” he said. “Each square shows the distribution of assets and thus a portfolio over time. This is not symmetric, movement into the tails is not smooth, risk doesn’t resolve at a constant rate.

“Value at Risk [VaR] doesn’t deal with a crisis. A tail event or a regime change is not a bad draw from the urn, it’s a different urn. To say it’s a tail event or a black swan is a cop out. It’s saying something bad happened, but not looking at which market dynamics led to that and being prepared to deal with that.”

The objectives of the agent-based approach are not only managing risk better but taking advantage of opportunities that might arise because of crises.

“It’s to manage risk better, and to understand any market dislocation and how it could affect me and the narrative for how it might cascade out,” Bookstaber said. “Then, seeing the crisis, and knowing it and how it works through the narrative, you can buy in and generate returns. [If] someone else is screaming for liquidity and you can provide that, it’s a social value to the market. If enough people with enough capital are involved, the liquidity can dampen the crisis. You can’t solve for life, you have to live it.”

Bookstaber’s book on this subject is called The End of Theory.

Future leaders of the investment industry will have to embrace diversity, a panel at the Fiduciary Investors Symposium has said.

The panel, chaired by CFA Institute managing director, Americas, John Bowman, discussed the next five years in the investment industry, a conversation prompted by the CFA’s paper Future State of the Investment Profession.

“Leaders need to change for the future of the investment industry,” Bowman said. “Leadership is becoming more important to transform the industry.”

Roger Urwin, global head of investment content at Willis Towers Watson, who co-wrote the paper, said one of the motivations for the study was that too many people in the industry are specialists who don’t look at the entire ecosystem.

“Finance has to get out there more and think about the big picture, [about how] behaviours matter and about how it is doing something for society,” Urwin said. “The research confronted the industry and found the status quo is not an option. Leadership needs to change.”

The chief investment officer of the California State Teachers’ Retirement System (CalSTRS), Chris Ailman, said he was shocked by the CFA study’s finding that only 11 per cent of the 1100 investment professionals surveyed said the industry added considerable value to society.

“That ethical question will be huge in the next 10 years,” Ailman said. “I wish I could be optimistic. We need to really be thinking it through – what’s our value add to society? We have to prove we add value to society.”

He added that in the next five years, Baby Boomers will retire and Generation X and the Millennials, who care about environmental, social and governance issues will become the new industry leaders.

Skills for the future

Bowman said the skills and competencies needed in the industry will be fundamentally different in the future.

Lori Heinel, executive vice-president and deputy global CIO of State Street Global Advisors (SSgA), pointed out that investment leaders of the future will need to understand mathematics and data but also have the skills to communicate with many different stakeholders.

“I also think we need more vision, and these skills classically come from the liberal arts,” she said. “We see too few young people who really value that [ability] to synthesise information and create a vision.”

Another necessary quality will be diversity, Urwin said.

“It used to be more individualistic, but now so much more of our output is in team settings,” he explained. “Diversity comes up and bites you on that. How we achieve cognitive diversity is critical, and we have to face facts, the diversity in our industry is pretty poor.”

CalSTRS is one of the few organisations in the industry, on the sell side or buy side, that has implemented true diversity, and 50 per cent of Ailman’s team is women.

‘Diversity of thought’

“I’m biased, I think women make better investment officers than men do,” he said. “But it’s not politically correct to say the outcome would have been different if instead of Lehman Brothers it was Lehman Sisters or, even better, Lehman Family. Diversity of thought is essential.

“There is a narrow group thought that comes from the Ivy League and then goes to Wall Street. We are lucky on the West Coast. Gen X and other generations that look at the world and this industry differently will be our future leaders and we have to get them interested.”

Heinel, who was a spokesperson for SSgA’s Fearless Girl statue on Wall Street, said the organisation “cares deeply about diversity”. The firm runs all its advertised job descriptions through software to gender-neutralise them, and conducts job interviews based on competency not experience.

Inspired by CalSTRS, SSgA has also launched a Gender Diversity Index, which is made up of the listed US large-cap stocks with the highest levels in their sector of gender diversity on their boards and senior leadership. SSgA also has a Gender Diversity Index ETF, called SHE.

The panel also considered the lack of trust in the industry and the need for the industry as a whole, not just individual service providers, to be trustworthy.

The ESG industry needs to make more progress on the ‘S’ to provide investors with reliable data on human rights issues, said Kerry Kennedy, president of the Robert F. Kennedy Human Rights organisation, who spoke at the Fiduciary Investors Symposium.

Kennedy said investors should be able to rely on data from the environmental, social and governance industry to assess risk, and while much has been done on the environment and governance, there is still much more work to be done providing reliable data on the social aspects.

“Analysis of 12 leading ESG frameworks show the industry is still failing on its objectives when it comes to ‘S’,” she said.

Kennedy, who is the daughter of Robert F. Kennedy and has been a human rights advocate since 1981, said the industry is failing in four ways:

  • Social measurement evaluates what is most convenient, not what’s most meaningful
  • Approaches to disclosure don’t yield information on social leaders
  • There is a lack of consistent standards underpinning social measurement
  • Existing measurements don’t equip investors for the growing demand for information on human rights issues.

“In short, the ESG industry must improve measurement of S. Investors are too willing to accept data that is not adequate,” she said. “S is not a tick-the-box exercise.

“Most investors view themselves as good actors who will deploy capital that benefits society if they can do so by meeting their fiduciary duty to beneficiaries. This is an important moment to seek better rigour on the S in the ESG industry.”

Further, she said there were a number of things that were necessary to improve the measurement of social factors:

  • Companies’ real-world effects should be measured, not just their efforts. Rather than asking for safety guidelines, ask how many people were harmed on the floor
  • Diversify the data
  • Establish and rely on clear standards
  • Target investors as the primary audience.

“Companies should redirect away from reporting on commitments and process, towards gathering and disclosing information on the effectiveness of these efforts on the ground,” Kennedy said. “Investors and consumers should demand accurate, performance-based social measures, and asset owners and managers, particularly large institutional investors, should examine and articulate the systemic social risks they see in their investments.

“We believe investors, if equipped with reliable data, are in a unique position to reward companies with strong social performance.”

Anna Pot, manager of responsible investment at Dutch pension provider APG, which manages €451 billion ($530 billion), also spoke at the conference, which is taking place at the Massachusetts Institute of Technology in Cambridge.

She said that as a long-term investor, taking into account social considerations, including human rights, is the right thing to do.

“We see more evidence from companies that human rights matters,” Pot said. “To be successful, they need a social licence to operate. Engaged workers are more productive, and there is less worker turnover and better company performance.”

APG has an inclusion approach to investing and has proprietary methodology to identify leaders and laggards.

“If the investment team wants to invest in the laggards, that’s OK but they need to allocate assets and engage with these companies to improve them,” Pot said. “This automatically means our portfolio managers will be more selective in their process, because investing in laggards means more time and capacity.”

Asset owners are agents of change but are not acting that way, a panel at the Fiduciary Investors Symposium determined.

The director of policy and research at the Principles for Responsible Investment, Nathan Fabian, said asset owners were prime movers in the financial system.

“Asset owners are very influential actors and are active participants and they should be trying to align the financial system and the interests of beneficiaries over the long term,” Fabian said. “Traditionally, that’s been done through asset allocation and that’s it, but there is more going on than just that role.

“There are failures in the financial system that can impact on society, the environment and ultimately your portfolios. These shortcomings stem from certain facets, such as the supply chain, the misalignments in public policy and the lack of reliable market indicators [for the] long term…Asset owners should do something about this,” he told symposium delegates at the Massachusetts Institute of Technology in Cambridge.

Also sitting in on the session, which was chaired by David Wood, an adjunct lecturer in public policy at the Initiative for Responsible Investment within Harvard’s Kennedy School, were Cbus Super chief investment officer Kristian Fok, CalPERS trustee Priya Mathur, and MIT Sloan School of Management senior lecturer Robert Pozen.

Decisions beyond price alone

Fok gave the audience an insight into ways asset owners can think outside the current system and behaviours to effect change.

Cbus has a fully owned property development subsidiary that manages $2.5 billion of its property assets.

“We were determined to avoid competing on price, so were very early adopters of wanting to build energy-efficient buildings. If you think about business as your reputation and your right to do business, then you think about things, and do things, very differently,” he said. “If you can’t assess societal issues, you don’t have a right to play.”

Fok gave the examples of a residential project in suburban Sydney that Cbus Property bought the rights to develop.

“We had to illustrate the quality of the building, but also the community and amenities we put into the package,” he explained. “We agreed to allocate a portion of the development to affordable housing, and donated a historic stable back to government. If we had to make decisions on these individual aspects on price alone we wouldn’t have done them.”

CalPERS’ Mathur said the fund considers its 1.8 million current members but also its future stakeholders.

“We expect the state of California to be operating for a long time to come, so our future members are also on our mind,” she said.

CalPERS has $330 billion in assets under management and pays about $20 billion every year in retirement benefits.

“We think about the long term [for] our beneficiaries but also in terms of ensuring that our fund is sustainable and able to pay those benefits, and maintain a licence to operate,” Mathur explained.

She said CalPERS lost 24 per cent of its assets in the financial crisis and that was a wake-up call to the impact investments had on the future.

“That was nearly a quarter of our assets in a single year,” she recalled. “Going into it, we were overfunded and we’ve been trying to recover ever since. This drew our attention to the fact we can’t be focused just on our returns today. [We also must consider] how our investments [today] affect markets and our investments in the future.

“For example, in securities lending, we need to look at who is borrowing the securities; generally, its hedge funds, which may be short-term focused and not aligned with our long-term interests. Now we retain all of our proxy votes, even if we do lend securities.”

CalPERS spent nearly two years revamping its investment beliefs, putting environmental, social and governance principles at their core.

“This was hard to grapple with because these types of issues – climate change and labour rights – have often been thought of as non-financial factors; the materiality of them had not been explicitly linked in many investors’ minds,” Mathur said. “There’s been a huge evolution in that.”

Realistic ways to make change

Speaking about the role of service providers, MIT Sloan’s Pozen, who was formerly chief executive of Fidelity and chair of MFS, said managers should be thinking more long term but asset owners need to have realistic expectations.

“I have come to the conclusion if we could get asset managers to think three to five years out we’d be doing really well; 10 and 20 years is unrealistic, considering all the pressures we are all under,” he said.

PRI’s Fabian said the industry was looking the wrong way in terms of how to solve short-termism.

“People are talking about refining how the supply chain works,” he said. “But we should be thinking about how [individually managed accounts affect] the beneficiary over the life of the beneficiary, including the kind of world the beneficiary will live in. They should then be setting the chain to reflect those drivers,” he said.

Pozen agreed it would be optimal to “get off the current system”, but that was not easy to do.

“Investors should be pushing for longer-term criteria and better and broader definitions than earnings per share,” Pozen said.

Fabian liked the idea of service-level agreements in financial services based on competency and the service provided.

“Imagine if a funds manager said, ‘What is the time horizon of the beneficiaries of the investors in this fund? How can I set up the portfolio to account for that?’ There would be trade-offs for that, but if you had that type of conversation and understanding, then there would also be a better understanding of how to set remuneration,” he said.