WGC Asset Allocation RT

7/28/2019 WGC Asset Allocation RT

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BROADENING HORIZONS IN

THE QUEST FOR RETURNS

ASSET ALLOCATION ROUNDTABLE

Photograph Jason Leader / Dreamstime.com, supplied September 2011.

ParticipantsROBERT BROWN, chairman of Towers Watsons Global Investment Committee

MARCUS GRUBB, managing director of investment, World Gold Council

FREDRIK NERBRAND, global head of asset allocation, HSBC Bank

NEILL NUTTALL, managing director, chief investment officer and head of the Global Multi-Asset Group (GMAG), JP Morgan

COLIN OSHEA, head of commodities, Hermes

PHIL TINDALL, senior investment consultant, Towers Watson

Supported by:


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WHOS WHO

ROBERT BROWN , chairman of Towers Watsons Global Investment CommitteeRobert joined Towers Watson in 2002 having spent 18 years in the asset management industry. Robert is a senior investmentconsultant and chairman of Towers Watsons Global Investment Committee, the group `responsible for all the firms capital marketassumptions and views. Robert also advises a small number of our largest clients and as such has a particular understanding of issues facing such schemes. Before joining Towers Watson, Robert spent seven years at First Quadrant where he was involved inmanaging equity market neutral and GTAA strategies and latterly headed its European operations. Prior to that he spent eleven years at NatWest Investment Management (now Gartmore) where he was a director in charge of their structured equities group.Robert is a graduate of the University of London and holds BSc and MSc degrees in economics. He is a member of the SecuritiesInstitute and an Affiliate Member of the Institute of Actuaries.

Marcus Grubb joined the World Gold Council in June 2008; he leads investment, marketing gold as an asset class with partners suchas ETF Securities and has overall responsibility for product innovation including the development of BullionVault. Marcus has over20 years experience of the global investment banking industry, in particular in equities, swaps and derivative products. Prior to joining the World Gold Council he was the founder Chief Executive of Swapstream, which was the largest inter-bank dealing exchange for interest rate swaps, now owned by the Chicago Mercantile Exchange. As Global Head of Equities at Rabobank, Marcusbuilt and ran the global primary and secondary equities business. Prior to Rabobank, Marcus was a top-rated senior investmentstrategist at UBS, Salomon Brothers and SBC Warburg. Marcus received an honours degree in Modern History & Economics fromthe Queens College Oxford University.

Fredrik Nerbrand joined HSBC in 2005 and, before moving to Global Research in 2010, he was Head of Global Strategy at HSBCPrivate Bank. He has worked as an equity and asset allocation strategist, and has been a columnist for the financial press. Fredrik has aBSc and MSc in Economics and Business Administration from Lund University, Sweden.

Neill Nuttall is based in London, with particular responsibility for global tactical asset allocation, total return and convertible bondportfolios. He is a member of the Global Strategy Team, responsible for deciding asset allocation for the GMAG's balancedportfolios. An employee since 1984, prior to joining the GMAG he worked for Jardine Fleming in Hong Kong as head of currency, Asian fixed income and convertible bond management, and more recently as a quali tative portfolio manager in the Currency Groupin London. Previously, he worked for Standard Chartered Bank in Hong Kong and Thailand. Neill obtained a BA (Hons) in Politicsfrom the University of Exeter.

Colin joined the firm in April 2008. He is responsible for managing the Hermes suite of commodity strategies and for driving thebusiness forward into the third-party asset management space. He has also implemented a commodity hedge fund managerprogram for the BT Pension Scheme. Prior to Hermes, Colin worked as an Investment Manager with Railpen Investments(investment manager to the Railways Pension Scheme) and joined the firm in 2005. He was involved in setting the strategic assetallocation for the Scheme and one of the main tasks was the recommendation of a commodity program.

Prior to joining Railpen, Colin worked at Mellon as an Investment Consultant. He began his career at HSBC Actuaries &Consultants Ltd where he worked in pensions consultancy. Colin is a Fellow of the Institute of Actuaries. He studied ActuarialMathematics & Statistics at Heriot-Watt University, Edinburgh and graduated with 1st Class Honours. Colin is also a TrusteeDirector of the Hermes Group Pension Scheme. Colin has spoken at a number of industry conferences and is widely quoted in thepress on commodity investing.

Phil joined Towers Watson in 2007 and is a senior consultant in the Investment Strategy team. He chairs the firms Beta Portfolio Group which is responsible for developing beta ideas and portfolios. He is also a member of our Portfolio Construction Group which buildsportfolios, including active management portfolios. Phil has 20 years experience in the investment consulting industry, including 14 years with Towers Perrin and 4 years as head of investments for IBMs European investment consulting group. As well as investmentstrategy work, Phils experience includes manager research and liability driven investment.

MARCUS GRUBB , managing director of investment, World Gold Council

FREDRIK NERBRAND , global head of asset allocation, HSBC Bank

NEILL NUTTALL ,managing director, chief investment officer and head of the Global Multi-Asset Group (GMAG), JP Morgan

COLIN OSHEA , head of commodities, Hermes

PHIL TINDALL , senior investment consultant, Towers Watson


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Current approaches to asset allocation

FTSE GLOBAL MARKETS: In the aftermath of the financialcrisis, what are the main considerations governing assetallocation strategies in your firm?ROBERT BROWN, CHAIRMAN OF TOWERSWATSONS GLOBAL INVESTMENT COMMITTEE: We have not changed our fundamental economic view forthe long term, and continue to believe we are in a period of slow developed-world growth, robust emerging-worldgrowth and sharp spikes in risk aversion. Growth risks haveincreased in the past month, which increases the reliance of investment returns on uncertain policy outcomes. In this environment we continue to emphasise that all investors mustensure portfolios are well diversified and stress-testedagainst a broad range of economic scenarios. In general, wesupport rebalancing of portfolios to strategic benchmarks,although this will be less attractive if the long-term trend inasset allocation is away from equities.

For investors with a medium-term approach to assetallocation, recent moves have exposed some opportunitiesat the margin. While we emphasise the downside risks togrowth, and expect market volatility to remain elevated, we view equity markets as moderately attractive on a three- year view. The sharp falls witnessed in recent weeks appearto have outpaced the deterioration of economic funda-mentals. We believe government bonds are moderately unattractive relative to cash on a short-term view. With alonger-term horizon, current depressed levels of yields areconsistent with economic fundamentals. However, in thenear-term, yields provide very limited upside, and non-trivial potential downside (if risk aversion fades for whatever reason). For short-term investors this return dis-tribution is unattractive.

FTSE GLOBAL MARKETS: What needs to happen forequities to reacquire their traditional appeal?NEILL NUTTALL, MANAGING DIRECTOR, CHIEFINVESTMENT OFFICER AND HEAD OF THEGLOBAL MULTI-ASSET GROUP (GMAG), JPMORGAN: The recent breakdown in equity markets leadsus to question whether sufficient value has returned to justify a long-term commitment to the asset class. The casein favour lies in the rise in dividend yields across severalmarkets; with the Eurostoxx index now offering a yield of 5.8% and the FTSE 100 3.8%. Using a simple metric orig-inally employed by Arnott & Bernstein (A&B), a reasonableback-of-the-envelope estimate for forward-looking ten- year real returns is provided by the sum of the currentdividend yield and the average per capita real GDP growthover the past ten years, less a dilution factor. Essentially this equates to the yield plus a proxy for real dividendgrowth, which A&B found to be relevant. While such anapproach is highly imperfect, it suggests that the most at-tractive region is Europe, with an A&B prospective realreturn of about 5% per annum, followed by the UK at just

over 4% pa and the US at just under 3% pa. Althoughequities look appealing versus bonds, for which current real

yields suggest poor real returns over the next decade, they are not yet sufficiently compelling given the macro andpolicy uncertainties.

We should remember that equities are an essent ialcomponent of the capital structure. As an asset class, equitiesmay be experiencing a secular bear market, but this hashappened before in the last 100 years or so: between19071921, 19291942, and 19661982. The average of thesebear phases is approximately 14 years, and assuming that thecurrent bear market commenced in 2000 (or even with the1997/8 Asian/LatAm/Russian/LTCM crisis), then the bear iscloser to its end than its beginning. Equities will reacquiretheir traditional appeal, typically after the majority of investors have capitulated, at which point they will re-emerge as the highest returning of the major asset classes.FREDRIK NERBRAND, GLOBAL HEAD OF ASSETALLOCATION, HSBC BANK: In my view, structuralequity markets are based on five main pillars: the first of

which is low valuations. As a comparison, US equities arecurrently trading at 20.2x cyclically-adjusted price earnings(CAPE) according to Shiller data. Since 1881 the averageCAPE for US equities has been 16.4. Actually, we haveonly seen CAPE higher than current levels 22% of the timesince 1881. Second, we need high real interest rates.

Virtually independent of whichever measure of real interestone looks at, rates are low. The flip side of the Asiansavings glut is an outsized demand for western assets andbonds in particular. Coupled with a very challenging growth outlook, real rates are likely to stay low for sometime. However, only once they have moved north should

Fredrik Nerbrand, global head of asset allocation, HSBC Bank. Photograph kindly supplied by HSBC Bank, September 2011.


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risk assetssuch as equitiesfind more support fromfalling discount rates. The next pillar is low leverage. Theglobal economy is still highly leveraged despite some recentconsumer deleveraging. Only once balance sheets havehit a more solid footing can a sustainable growth in

leverage take hold. Let us just hope that policy makers haverealised that more debt added to an existing debt problemis not a solution. Four, a strong demographic outlook is alsohelpful. A protracted period of limited birth rates andageing population has made much of the West appearmore and more like Japan. For example, Western Europecurrently has 3.8 potential workers per pensioner. Thisratio will drop to 1.9 by 2040 according to US CensusBureau estimates. By comparison, Japans labour-to-pensioner ratio is currently 1.8, down from a peak of 5.1 in1990. Finally, we need to see the potential for deregulation.Given that policy makers are fretting about how to regulateour way out of a recession, this route for productivity gainsappears shut. We live in a world of born-again regulators.

In summary, the pillars are not in place for a structuralequity market. That said there will be plenty of trading op-portunities going forward as markets deal with the prospectof more persistent permafrost than first envisioned.

FTSE GLOBAL MARKETS: As investors increasingly look towards emerging markets and ever more alternativeasset classes, is there a limit to what can justifiably becalled an investible asset class?MARCUS GRUBB, MANAGING DIRECTOR OFINVESTMENT, WORLD GOLD COUNCIL: By grouping a very disparate range of assets together underthe alternatives label we often risk masking the very different risk and return profiles they each represent andthe different investment objectives they may fulfill. From anallocation perspective, and beyond any regulatory con-straints, an asset or asset class under consideration shouldbe examined in terms of its key drivers and its impact onthe broader portfolio over time.

However, in light of what we have hopefully learnt fromthe recent past, allocators are also increasingly sensitive to theliquidity, transparency and stability characteristics of assetsbeing considered for inclusion in a portfolio. Investor concernregarding the counterparty risk inherent in many derivativeproducts has also never been higher. Many so-called alter-nativeshave been found to be lacking in one or more of these properties, leading them to be judged as overly risky inthat regard and therefore less investable. The reason wehave such confidence in our arguments that gold should beseen as a basic portfolio building blockwhat we term afoundation assetis that it can be proven to have benefi-cial attributes in addressing most of the risks that causeinvestors to hesitate when considering alternatives.

FTSE GLOBAL MARKETS: What comes first, asset alloca-tion or fund selection?NEILL NUTTALL: In general, as we were reminded in the2002 report by Lord Myners, market beta, and therefore

strategic asset allocation, typically drives 90% of perform-ance returns. As such, it should be the first consideration inportfolio construction. We would caveat this with the factthat it is important to ensure a full review of your oppor-tunity set, to ensure that you have a way to invest in eachof the asset classes represented in your strategic allocation;otherwise, fund selection could be problematic and implic-itly determine the asset allocation.

We believe that allocating to an asset class that providesdiversification and helps the portfolio to meet risk andreward objectives is essential, even if this must be done by investing through a sub-optimal managerwhile alphamay detract from performance, beta could be beneficial. Inaddition, it is important to remember that in seeking tointroduce diversification at every level of the portfolio con-struction process, fund selection (manager research, styleand process) is an important component of any portfolio.MARCUS GRUBB: Many asset managers are aware of therobust body of evidence, for example, from Brinsonslandmark studies and Ibbotsons more recent work, thatasset allocation is by far the major determinant of portfolioreturns over the longer term. However, the degree to whichthis evidence has been translated into practice is far lessclear. There is, perhaps, a simple behavioural aspect tothisan understandable reluctance to put statistics abovedirect relationships. However, the existing research appearsfairly conclusive; asset allocation strategy is the funda-mental driver of returns over time.

One of the key issues here may be that there are rela-tively few asset classes or funds or, indeed, fund managers,



Phil Tindall, senior investment consultant, Towers Watson. Photographkindly supplied by Towers Watson, September 2011.


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that can be relied upon to deliver counter-cyclical per-formance to the benefit of the broader portfolio. There aremany assets and fundswhether mainstream or exoticthat can be pursued for specific periods for their returnpotential. There are, however, relatively few that exhibit suf-ficient counter-cyclical characteristics that they can reliably function as longer-term portfolio insurance assets, offering balance and protection during market stress and asset con- vergence. These are the assets, such as gold, generally in-dependent of the tendencies of the wider market, which webelieve are most valuable in offering stability to asset allo-cation strategies, and such strategies will then underpin thefund selection process.

FTSE GLOBAL MARKETS: Does the trend towards greaterdiversity require improved governance?PHIL TINDALL, SENIOR INVESTMENT CONSULT-ANT, TOWERS WATSON: Investors should not ignorethe potential high costs and governance associated withactive management and illiquid, less price-transparentasset classes. In fact, they should be self-critical when con-sidering their governance competencies before committing heavily to diversity strategies. However, the trend towardsgreater diversity should not preclude lower governancefunds from either outsourcing to specialists, using diversi-fied pooled funds or using better, cheaper beta.

Not long ago, portfolio returns were broken down intoeither beta or alpha. Beta was associated with market returnson basic asset classes such as equities and bonds. Alpha wasanything that could not be explained by these index returns,

and represented skill, which was (and still is) expensive.Over the last few years, academia has turned the spotlighton hedge fund returns, once regarded as the ultimate inpure alpha. Research suggests that a decent proportion of hedge fund returns can be reproduced with relatively

straightforward trading strategies, many of which have beencaptured in a new wave of indices, such as reinsurance,currency carry and volatility indices. These funds are moreliquid and much less expensive than traditional hedge fundsmaking diversity potentially cheaper and more readily acces-sible for lower governance funds. If properly constructed,these new betas should have a strong diversifying effect ona funds portfolio, but critically at the right price.

The risks of an equity-focused strategy are high, especially given the economic uncertainty we face going forward.

While the theory of diversification has been put to the testover the last couple of years, we believe it is more importantthan ever, particularly over the medium to longer term. New beta opportunities can help institutional funds to build amore diversified portfolio to improve investment efficiency,but investors need to assess how much governance they have and are prepared to commit as well as the costsinvolved if they are to make the effort worthwhile.

FTSE GLOBAL MARKETS: If your firm runs a TAA strategy in-house: what are the critical components of a goodasset allocation model?FREDRIK NERBRAND: Our dynamic asset allocationprocess is based on three main drivers: economicmomentum, relative valuations and financial conditions.

We have constructed a series of proprietary global leading economic indicators, which aim to forecast the industrial,consumer and trade cycle. In our view, most indicators arestill focused on geographies. This makes limited sense asthe global cycle is increasingly more integrated. There is noholy grail with regards to relative valuations but we tend tofocus on implied discount rates for our cross-asset views.Finally, we run a number of financial conditions indicatorssuch as the HSBC Clog index. In addition, we run aggregatereal bank lending data in order to assess inflationary/defla-tionary pressures coming from money supply.NEILL NUTTALL: Diversification across asset classes,models and factors is key in the construction of a robusttactical asset allocation (TAA) model. Historically, TAA models have focused on the directional decisions, namely stock versus bond, and bond duration. In addition, the in-formation captured has typically centred on valuation

which, although an important component of any TAA model, is heavily influenced by time horizon and operatesbetter over an intermediate period. Furthermore, the assetclasses addressed have typically been the major, developed,equity and bond markets (as this is where there is the besthistorical data).

While valuation should be taken into account, otherfactors such as momentum and the business cycle are alsoimportant. Momentum/technical factors tend to work betterover a shorter-term horizon (say, less than 12 months). The

Robert Brown, chairman of Towers Watsons global investment committee. Photograph kindly supplied by Towers Watson, September 2011.


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opportunity set should be widened to address as many assetclasses and sectors as possible. In addition, increasing weightshould be given to relative value decisions within assetclasses, to avoid the limited concentration of decisions acrossasset classes. Risk is another important consideration: to be

aware of position sizing and the calibration of the risk con-tribution from each position is essential to long-term success.In our view, when people have experienced disappointing performance in TAA programmes the processes have beentoo narrowly focused.

Allocations to commodities

FTSE GLOBAL MARKETS: What roles can gold play in yourportfolio?FREDRIK NERBRAND: The traditionalist view of gold isfor one of value storage and as a hedge to tail risks. Goldshould do well in both an inflationary period, or indeed ina world of deflation and increased default risks. Similarly,the opportunity cost for holding gold is minimal given theprevailing, low, real interest rates. While all of these issuesare likely to persist, our main reason for holding gold is asa diversifier. In an investment world which is dominated by risk-onand risk-off, any asset that offers uncorrelatedreturns should remain well bid. Almost independently of the period used for estimating the cross-asset correlation,matrix gold offers just that. For example, if we apply a two-criteria acid test for how much gold to have in a 50/50equity bond portfolio: one, by adding gold we reduce volatility; two, by adding gold we do not want to addtracking error of say more than 1%. A balanced portfolioshould then have roughly 5% in gold. If we compare this with the weight that invested gold has in comparison toglobal bonds and equities, the current weight in gold is only 0.21%. Hence, there is ample scope for a reweighting inglobal asset markets.MARCUS GRUBB: Gold has been the star performing asset over the last decade and gold market fundamentalsand the macro environment are both highly conducive toa continued bullish outlook. However, this should not blindinvestors to its primary appeal as a strategically significantasset; that is, its long-term diversification benefits and itshedging abilities in various circumstances and conditions.To put it more simply, gold functions as portfolio insuranceand is typically at its most valuable when most needed.These benefits can be proven statistically and historically,and are very much in evidence now.

FTSE GLOBAL MARKETS: How effective is gold as a long-term inflation hedge?NEILL NUTTALL: We note that gold has been a store of value for over 2,500 years. There are short periods whenthis has not been the case (such as 1982-2002), but we lean very much in favour of the evidence of the longer-termhistory. Gold tends to have low correlation to many otherasset classes and even other commodities, and is typically considered a hedge against inflation. In contrast to other

commodities, gold does not perish, tarnish or corrode, which makes it attractive as a long-term store of value. Itis also considered to be a currency hedge, particularly against the US dollar, to which is it negatively correlated.Investor activity in the gold market, as reported by the World Gold Council, continued to be robust in the secondquarter of this year, with strong flows into exchange-traded funds and also purchases of gold bars and coins,particularly in Asia and Europe. Interestingly, demand inIndia as a result of rising inflation and an increase inpersonal wealth has led to a surge in the launch of gold-backed savings and investment vehicles.

Gold is considered a safe haven as an asset thatmaintains an intrinsic value, particularly in an environ-ment with falling risk appetite and a lack of conviction inthe economy and banking system. Cynics point out thatthere is no central bank for gold, which can act to debaseits currency. Historically, gold has posted strong real returnsduring periods of high inflation, and lesser returns during periods of low and moderate inflation. Over a long-term investment horizon, gold has clear diversification benefits.Over the shorter term, investment in gold can help againstinterim increases in inflation but does not tend to performas strongly as other assets. As gold is not an incomeproducing asset unless it is leased out, it becomes more astore of wealth in a zero interest rate environment. There isan old anecdote that a sovereign coin (just under a quarterof an ounce) has always been worth enough to pay for ameal for two at the Savoy. Using pricing as at today, thisseems a reasonable indicator of the price of goldand if gold keeps rallying, the quality of the bottle of wine accom-panying the meal can be improved!



Marcus Grubb, managing director of investments, World Gold Council. Photograph kindly supplied by the World Gold Council, September 2011.


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FTSE GLOBAL MARKETS: Commodities are also often seenas an inflation hedge. Does this tend to overshadow theother benefits of commodities?COLIN OSHEA, HEAD OF COMMODITIES,HERMES: Many of the developed market central banks

raison dtreis low inflation. However, in light of the globalrecession the central banks policy bias is now towardsmore inflation to create nominal GDP growth and employ-ment. Similarly, developed governments now saddled withsubstantial debt as a result of credit crisis bailouts preferinflation and nominal growth over deflation and stagnategrowth. It is not surprising then that inflation has edgedhigher and pension funds are increasingly wary of inflationeffects on future pensions.

Just as compound interest is the eighth wonder of the world and crucial for wealth creation, inflat ion has theopposite compound effect and can lead to wealth destruction. While many defined benefit pensions include a promise toindex benefits within their liability portfolio, it is difficult toinclude inflation explicitly within the strategic asset allocationof pensions investment portfolio. Thus inflations potentialimpact can be under-estimated for many pensions.

Commodity futures are a good inflation hedge for tworeasons. Commodity spot prices capture unexpected jumpsin inflation, in particular jumps driven by input cost ( i.e.energy and food). The cash collateral of commodity futurescaptures the short-term trend inflation through the return oncash and its exposure to short-term interest rates. On theother hand, gold has appreciated considerably over the lastfive years, not due to inflation over that time but rather dueto golds safe haven identity amidst systemic risks.

While inst itutional investors cite diversificat ion andinflation hedging as the most important reasons to investin commodities, commodity returns, especially in compar-ison to equity returns, have been overlooked.

MARCUS GRUBB: Many investors are undoubtedly drawn to commodities because they are perceived, onaggregate, they provide inflation-hedging potential. Alter-natively, however, some investors see commodity exposure

as a means of access to emerging market growth and may therefore be drawn more to the corresponding potentialreturns. In the case of gold, viewing it primarily as part of the commodities complex means investors are likely to beadopting a somewhat one-dimensional view and are

therefore potentially blinkered to its wider attributes,beyond its inflation protection benefits. Earlier in the year we undertook some research, published as Gold: acommodity like no other , which showed that gold, which istypically less volatile than most commodities, and less cor-related to equity markets during recessions, offers portfoliodiversification and risk reduction benefits that cannot beduplicated through investment in commodity baskets.

However, that is not to say we underestimate goldsappeal as an inflation hedge. We recently commissioned in-dependent research from the highly respected consultantsat Oxford Economics modelling the impact of various in-flationary scenarios on portfolios and golds optimal allo-cation within them. In the context of higher inflationoutlooks, golds allocations were seen to increase, rein-forcing the substantial body of evidence supporting goldsreputation as a reliable and enduring store of value.

FTSE GLOBAL MARKETS: When investing in commoditieshow should investors choose between direct physical in-

vestment, a portfolio of commodity-related stocks orcommodity futures? Does this vary between different typesof commodities?NEILL NUTTALL: The first consideration around invest-ment in commodities within a portfolio would be the in-

vestment instruments permitted within client guidelines.Direct physical investment provides the purest exposure tocommodities in that the performance is not impacted by investor behaviour. However, physical commodities havethe obvious disadvantage of the need for storage, which canbe difficult as conditions need to be appropriate to avoiddevaluation of the commodity. In addition, the potentialenvironmental impact of storage must be considered,together with the cost of insuring these tangible assets.

Investment through derivatives provides an easier way of accessing the commodity market, although by nature of themarket, price fluctuations through investors buying andselling the instrument and levels of liquidity will impactperformance (through the backwardation or contango inthe futures market), rather than this purely reflecting thesupply and demand of the underlying commodity. Invest-ment through ETFs can provide broad index exposure andsimplify transactions, although it is important for investorsto understand the differences in exposure within theseproducts. For example, the Goldman Sachs Commodity Index has a heavy bias towards energy, while exposure inthe UBS Dow Jones index is more diversified across broadsectors. While performance of commodity stocks can oftenmove in line with the underlying commodity price, funda-mentally these are equities and therefore are subject toadded risk/return from general operations, labour costs,political risk within many regions in which they operate (for

Asset class risk, return & premia vs. 10 year government

25%

20%

15%

10%

5%

0%Commodities Equities Liabilities (10yr govt)

R e t u r n / R i s k

Total returns Risk Premia

10.1%

20%

2.1%

9.7%

15%

1.7%

7.8%

4.9%0.0%

The chart above highlights that over the past 40 years commodity futures have yield returnssimilar to equities and in this case slightly exceeded commodities. This trend is similar over shorter time periods such as five and ten years. Commodities while acting as a suitable androbust inflation hedge can also over the long-term add returns to a diverse investment portfolio.Source: Hermes, Barclays Capital, MSCI, and Hermes, supplied September 2011.


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example, Africa and Asia) and regulatory changes (forexample, within mining, or oil exploration). Such stocks arelikely to move downwards in a broad market sell-off andmay therefore be less diversifying than other means of investing in commodities.MARCUS GRUBB:

While we can only comment on gold with any authority, I think there is an increased motivationamong investors to seek investment vehicles backed by physical holdings of real assets. This is, essentially, drivenby a need for stability and security in uncertain times anda corresponding demand for greater transparency andreduced counterparty risk. For example, in the gold ETFmarket, we have seen investors clearly prefer physically-backed products that allow no derivative component, asdistinct from synthetic-based ETFs, because they areseeking to minimize counterparty risk.

Many of the investment vehicles you mention will haverisk-return profiles that diverge considerably from the value of associated physica l assets . Investment incommodity-related equities and sector funds, for example, wil l undoubted ly increase exposure to idiosyncraticcompany risk (although this may also offer more upsidepotential) and the traditional route to commodity invest-ment for many institutional investors, through a basket of collateralised futures, involves a completely different set of risks, including the ability of counterparties to successfully implement strategies to counter issues such as negativeroll yield.COLIN OSHEA: Today, commodity investors have many more ways to invest in commodities than even two orthree years ago. The plethora of exchange-traded productshas opened the door to exposure in exotic, rare earth metalssuch as rhodium to vanilla exposure in gold. As investorsaddress the question why invest in commodities ( seediagram in the next page ), the answer will lead them to thenext question: how to invest in commodities?

Physical commodity exposure is more akin to privateequity with long lock-ups and a high dependence on localknow-how. For example, purchasing farm land in Brazilmight highlight bottlenecks in bringing the crop to market,the countrys shipping infrastructure down to the microeco-nomics of local labour productivity and relevant labour laws.

Equity commodities typically exhibit a higher relation-ship with equity markets than with underlying commodity prices. For example, a basket of the top diversified oilmajors has a beta of 0.7 or higher with MSCI All World butless than 0.3 to the price of crude oil.

In other words the global equity market explains a sub-stantially higher proportion of the oil majors returns than theprice of crude oil. Equity valuation includes a large propor-tion of expectations over the long run. On the other hand,commodity futures represent the current clearing price forthe supply and demand of the commodity in question.

A basket of commodity futures provides the portfoliodiversification investors seek. Per Barclays Capital annualinvestor survey the most compelling reason for commodity exposure among institutional investors is diversification;

over 40% cite diversification more than any other reason toinvest in commodities. Historically, the basket of commodity futures across various sectors (such as indus-trial metals, energy and agriculture) has exhibited low cor-relation with equities and bonds.

FTSE GLOBAL MARKETS: Scarce resource management isfocusing investors on strategic commodities. How muchdoes the growing scarcity of resource figure in yourapproach to investing in commodities?FREDRIK NERBRAND: As the world looks set to remain ina subdued growth environment for the foreseeable future webelieve investors will focus on two things. Productivity gains(wherever they can be found) and resource constraints. On ourestimates, iron ore, copper, coal and platinum demand are alllikely to outpace supply in coming years. Hence, we believethese should have a relatively large weighting in an asset al-location. In our portfolio our strategic weight to industrial,energy and agricultural commodities is 15% (on top of the 10%in gold). However, due to the deteriorating economic outlook we prefer to underweight commodities at the moment to 9% while keeping gold at 10%.

FTSE GLOBAL MARKETS: How can you capitalise on thegrowth outlook for commodities?COLIN OSHEA: Some academics have thrown into thequestion the relationship between strong GDP growth andequity valuations. Through further share issuance and or



Neill Nuttall, managing director, chief investment officer and head of Global Multi-Asset Group (GMAG), JP Morgan. Photograph kindlysupplied by JP Morgan, September 2011.


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technological innovation, macro-economic growth may translate into higher overall wealth but not necessarily higher equity earnings per share.

Commodity futures represent the current clearing price orsupply and demand of a particular market whereas commodity

equities represent anything from the present value of dis-counted expected earnings over many years to the capitalstructure of that particular company. For these reasons,commodity futures rather than commodity equities exhibit astronger relationship to the commodity supply and demand inmajor emerging market economies.

For example, China continues to invest in its infrastructurerequiring significant amounts of copper, so much that Chinais the largest consumer of global copper, representing over 45%of global copper consumption.

Similarly, densely-populated emerging economies such asIndia and China are experiencing three development trends which all lead to higher agricultural imports: one, less rural andhigher urban population leading to less and a more expensiverural labour force; two, urban sprawl and higher car usagereducing arable land; three, a higher protein diet of beef andpork further up the food chain thereby requiring more grainsfor feedstock and leading to higher consumption per capita.

Finally incremental increases in energy demand continueunabated in non-Organisation for Economic Co-operationand Development (OECD) countries, in particular emerging Asia. Today the global economy is utilising more barrels of crude oil than ever before, over 89m barrels a day. Of thisdemand, the non-OECD represent 48%. While the OECDcountries demand has declined by 2m barrels a day over thelast two years the non-OECD demand has more than com-pensated for this drop in demand. Emerging market equitiesGDP growth rates may not be as important to companysearnings per share and therefore equity investors. Howeverhigher growth rates translate directly into higher demand forcommodities and therefore higher clearing prices and higherreturns for commodity investors.

Risk and returns

FTSE GLOBAL MARKETS: How must portfolios be con-structed to prepare for extreme or Black Swan events.MARCUS GRUBB: We examined this very question in a

recent report entitled Gold: hedging against tail risk , looking specifically at the impact that an allocation to gold wouldhave on a portfolios in the event of a tail risk i.e. marketbehaviour outside normal statistical probability. Throughanalysing different portfolio compositions and variantsaround a benchmark portfolio, we assessed the long-termrisk profile of these combined assets in previous periods of extreme market stress, both when gold was included and

when it was absent. The research found that for threequarters (18 out of 24) of the tail risk scenarios analysed(from a period between 1987 and 2010), portfolios whichincluded gold consistently outperformed those which didnot. Thus, small allocations to gold (ranging, for example,from 2% to 10%) can increase risk-adjusted returns andhelp reduce the weekly 1% and 2.5% VaR of a portfolio by up to 18.5%.

In summary, we found a modest strategic holding of gold consistently reduces the probability of significantportfolio losses during extreme market events and,moreover, the downside protection on offer does nothinder potential upside. This research supports our otheranalyses of optimal portfolio composition that have re-peatedly shown that in multiple market conditions an al-location to gold can reduce the volatility of a diversified in-

vestment portfolio without sacrificing expected returns.

FTSE GLOBAL MARKETS: When selecting funds andmanagers, what are some of the red flags and irregulari-ties to note?NEILL NUTTALL: The key factors that we consider inselecting managers in our fund of fund portfolios are risk-adjusted performance and consistency of alpha generation,people and process. Some investors tend to focus heavily on performance, but, of course, past performance is noguarantee of future results. An understanding of processcan often be more helpful in portfolio construction,enabling diversification across investment processes,

which can lead to a portfolio that is more resilient toshorter-term cycles and performance shocks.

In terms of underperformance of managers, this wouldnot automatically be a red flag, but underperformance ina period in which the process should be outperforming (forexample, a value-biased manager in a period in which

value is performing strongly) and in which the managerexpects to be outperforming is cause for concern andalarm. This would be one indication of a major red flag,namely style drift. If the investment process is more qual-itatively driven, any disruption in the portfolio manage-ment team can be a challenge. If the process takes more of a quantitative approach, the reliance on a single portfoliomanager may be less evident and therefore less significant

when there are portfolio management changes.Source: Hermes, September 2011.

Why Commodities? Diversification

Inflation protection Event risk insurance

Positive risk premium

How? Swaps

Futures Exchange-traded fund

Equities Physical

What? Index or Active

Benchmark (DJ-UBS,GSCI, RICI) Collateral

(Cash, Credit, TIPs)

Who? Fiduciary (Fund,

Pension) Investment Bank

Hedge fund In house

Why invest in commodities?


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FTSE GLOBAL MARKETS: How do TAAs work in practice?NEILL NUTTALL: A well-formulated tactical asset allocationstrategy provides a framework for incorporating consistent market views aimed at generating a high quality alpha stream. They do so by systematically shifting asset weights relative to a benchmark to take advantage of marketinefficiencies and opportunities. As such, a broad opportunity set is desirable. At the same time, an effective TAA frameworkhas the capability to manage the incremental risk (tracking error) associated with movements away from a strategicbenchmark. The means of implementation of shorter-term views is likely be dictated by the specifics of individual clientguidelines. The most efficient way of implementing tacticaldecisions is through the use of derivatives. This is the quickest,most capital efficient and most precise method of implemen-tation. Where investment guidelines prevent the use of such in-struments, it is still possible to implement through physicalholdings, although this comes with some limitations. While thebenefits of TAA are perhaps greatest in low-return/high-riskmarkets, those strategies capable of targeting tracking error while maximizing excess returns are well positioned to becustomised to meet specific risk/return objectives across arange of investments and market environments.

FTSE GLOBAL MARKETS: How can investing in non-corre-lated assets such as gold or real estate help hedge againsta fall in an overall investment portfolio?MARCUS GRUBB: The concept of a portfolio diversifica-tion relies upon the notion of non-correlated assets and is

the cornerstone of modern portfolio theory. Yet, eventhough the theory is half a century old and familiar tomost investment professionals, implementing it in practicestill seems problematic for many. So much so, in fact, that we frequently hear fund managers suggesting that, in view

of globalisation and the experience of the financial crisis,the concept of diversification is primarily of academicinterest rather than practical value. We suggest thisargument is based on a somewhat superficial view of diver-sification, often due to the fact that the co-variance prop-erties of many assets are not fully understood, possibly because their values are often studied in isolation or without sufficient examination of the underlying marketfundamentals. For example, to date, professional invest-ment in so-called alternativeshas largely consisted of hedge funds, private equity and real estate, all of whichproved to be highly correlated in the financial crisis becauseof the close relationship of their drivers to macroeconomicfactors. Your question describes real estate as an uncorre-lated asset but it was dragged down with most other assetsduring the crisis, and, significantly, has continued to be vul-nerable to prevailing market conditions and recessionary pressures. Golds lack of correlation, by contrast, is under-pinned by its very diverse set of drivers and can be provento hold across markets, geographies and time.

The investment outlook

FTSE GLOBAL MARKETS: What are the next frontier marketsfor investors?NEILL NUTTALL: We believe that frontier markets arethe next wave of emerging market investing, and that thelast frontier region is Africa, and more specifically, sub-Saharan Africa. Africa is clearly very diverse and individualcountries are at different stages of development withintheir capital markets. One of the greatest challenges for thesub-Saharan region is the development of infrastructure, which is being aided by overseas investment. China, forexample, has become a leading sponsor of infrastructureprojects in Africa, including hydropower and railroadprojects in sub-Saharan Africa. As these sub-Saharanmarkets (for example, Nigeria and Kenya) develop, they should offer higher returns to investors, but this will notcome without elevated levels of risk. When investing intoinefficient markets, it is crucial to opt for an active portfoliomanager with deep knowledge of countries and industriesand a comprehensive understanding of the specific risks as-sociated with each frontier market. Africas status as the lastremaining frontier region means it offers many exciting op-portunities for long-term investors as its economies andmarkets play catch-up with the rest of the world. Strong GDP growth (between 2004 and 2008 real GDP growth insub-Saharan Africa has averaged 6.5%, according to theIMF) is testament to the dramatic structural changes thatare transforming the continent. Notably, the continents de-mographics are supportive. According to the UN, popula-tion growth in Africa through 2015 is forecast to rise faster



Colin OShea, head of commodities, Hermes. Photograph kindly suppliedby Hermes, September 2011.


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than anywhere else in the world, at a rate of 2.2%. As aresult, Africa is expected to house the largest youth popu-lation in the world, creating interesting investment op-portunities as young workers spend their earnings.

FTSE GLOBAL MARKETS: The European and US sovereigndebt crisis looks to cross into the 2012 financial year: whatimpact will this have on your firms approach to asset al-location; particularly within the holding of assets based inadvanced markets?NEILL NUTTALL: The debt crisis has an impact on severalstages of the asset allocation process, including strategicasset allocation, intermediate views, cyclical views on the USand Europe and shorter-term tactical views. We believe thatongoing deleveraging in the developed world will be thedominant macro force for a number of years, and that thisrepresents a structural headwind for markets. From astrategic perspective, the biggest impact will be on a riskbasis and on our forward-looking view on volatility, partic-ularly for sovereign bond markets. This also leads to abroader assessment of the relative risk between emerging and developed markets. Historically, the risk of default hasalways been a concern for emerging markets, with an asso-ciated risk premium for investing in developing markets. Thisrecent shift in sovereign bond markets could lead to alevelling out of risk premium between developed andemerging markets. The impact of the sovereign debt crisis onasset allocation will be influenced by views on how long it will take to work through the process of resolution, and theimpact across global markets. On an intermediate-term view, there are significant structural headwinds as the USand Europe deal with their debt burdens. There is also aquestion of how long the downward impact on globalgrowth will lastwhether this will be a three-to-five-yearpressure or a longer, structural change. Our interpretation of the price action in risk assets in August is that the market iscoming to terms with the view that the headwinds will lastfor very much longer than had previously been expected.

FTSE GLOBAL MARKETS: What is the inflation outlook forthe US and Europe? What impact will this have on assetallocation?FREDRIK NERBRAND: The US and Europe increasingly resemble Japan in terms of the overall economic outlook. While policy makers are keen to boost activity through un-orthodox policies the underlying deleveraging takes prece-dence. The main issue that markets face is the lack of impactfrom QE on domestic activity. Labour markets and GDP haveseen little impact while emerging market growth has spurredinflation. In turn, this has muted real wages in the West,making the overall impact questionable. In a world wherestagnation takes hold we believe bond yields will remain low and investment grade credit spreads reaching tightening

further. Emerging market local currency bonds are also likely to remain well bid while equities flounder with high volatility given the uncertain growth outlook.MARCUS GRUBB: Economic growth in the developed

world still appears extremely sluggish and fragile and it can

be argued we are still in grave danger of sliding into a de-flationary trough. Certainly the outlook for 2012 is anything but rosy, but asset allocators need to look a little furtherthan the next 12 months. Over the medium term, rationalarguments can be made for a range of outlooks, from sig-nificant inflation, through disinflation to deflation. Wecommissioned the aforementioned research from OxfordEconomics, with an eye on the next three to five years, inorder to address these uncertainties and their impact on al-location decisions. Using their well-respected modelling techniques to define a number of macroeconomicscenarios, including inflation and deflation, the researchersthen examined the impact of such scenarios on optimisedportfolio allocations. The results indicated that an optimalallocation to gold rises in a more inflationary scenario, as

well as for more risk-averse investors in a limited growthand lower inflation scenario.

FTSE GLOBAL MARKETS: Is the time still right to begininvesting in gold?MARCUS GRUBB: The question here is one of investmentobjectives. If the motivation for investing in gold is because itis the most potent diversification asset available then there isundoubtedly a compelling argument for adding gold to any portfolio that does not already include an allocation. If,however, the question is one of opportunitythat is, how robust is the outlook for golds continued rise in valuethenour initial response is that we are not allowed to engage inprice forecasting. That said, we can confidently state that, evenafter a prolonged sequence of record highs, the underlying conditions that have driven the bull market thus far, both interms of market fundamentals and the macroeconomic envi-ronment, remain very supportive of the trend.

It is worth mentioning that, while golds price performancehas now been very impressive for over a decade, outperform-ing virtually all other assets, this is not its primary benefit forlong-hold investors. It is often difficult to get investors to lookbeyond price performance when considering an asset with anaverage annual price that has risen for ten consecutive yearsand when that price (at this time) is around 300% higher thanon the same date five years ago and 550% higher than adecade ago. Yet even more compelling for asset allocators is thestatistical evidence from portfolio optimisation research whichconsistently suggests there is an empirical case for holding goldin the context of a broader portfolio regardless of its immediateprice profile, because over the long term its potency as a diver-sifier can be proven to enhance the overall risk-return balanceof your investments. I

Disclaimer: All information here is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but noresponsibility or liability can be accepted by Berlinguer Ltd or FTSE Group for any errors, omissions or for any loss arising from the use of this publication. This has been reprinted forthe World Gold Council with the kind permission of Berlinguer Ltd. Copyright Berlinguer Ltd 2011. All rights reserved.


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