Frame: GLD Looks Bright Again

March 27, 2014

After last year’s brutal sell-off, the macroeconomic situation looks to favor gold once again, Cougar’s Frame says.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Deborah Frame, vice president of investments at Toronto-based Cougar Global Investments.

Gold was a big winner in the aftermath of the financial crisis, as prices rallied nearly 170 percent from late 2008 to late 2011, boosted by ultra-loose monetary policies and risk aversion.

Following a massive correction of 28 percent in 2013, gold went on to recover by more than 10 percent in just over two months in 2014.

So, is gold back as an asset class, and is it time to give the big gold bullion ETF, SPDR Gold Shares (GLD | A-100), a fresh look? To answer this question, we need to look at where the economy is heading and where sentiment currently stands.

Our research tells us that gold behaves best in chaos, followed by growth, inflation, recession and finally stagnation. As we move from stagnation to growth after five long years of mixed economic indicators, it’s not surprising to see the price of gold rising again.

But without a definitive shift in sentiment that lines up with this view, the recovery is unlikely to be sustained.

Fund flows help with this, but they provide two very different types of insights. Traditional mutual fund flows provide us with a window into more persistent trends coming from longer-term investors. By contrast, ETFs—often used as short-term trading vehicles, give us an indication of sentiment shifts among institutional traders.

ETF flows are thus especially helpful in identifying changes in investor attitudes at the asset class level, and help to explain the correction in the gold price post-2011 as well as the recovery that we’re seeing in 2014.

Lessons Learned From 2008-2009

Economic events can create structural shifts in the perception and acceptance level of risk. The global financial crisis of 2008-2009 is one example of these structural changes, which, in our modeling, we refer to as “chaos.”

Gold tends to reduce losses that may be incurred during tail-risk events. While gold bullion has no credit or counterparty risk, there are additional attributes that make gold a superior portfolio diversifier. When estimating the appropriate mix of assets that go into a portfolio, most investors assume that the distribution of asset returns is close to “normal.”

By normal, we mean that returns are symmetric, and the majority of them—95 percent, to be precise—fall within two standard deviations. In practice, this is rarely the case. Most asset class returns have skewed distributions and are commonly negatively skewed. So-called heavy tails, where investors experience returns beyond two standard deviations, occur more frequently than a normal distribution would predict.

Gold provides diversification benefits by having far less probability of negative returns (fewer heavy tails) in environments when other asset classes are heavily negatively skewed.

Looking back at events including Black Monday in 1987; the Long Term Capital Management crisis in 1998; and the global financial crisis of 2008-2009, World Gold Council analysis shows that gold mitigated portfolio losses incurred by investors during almost all tail events under consideration.

Why does the diversification benefit of gold appear to have disappeared completely in 2013?



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