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Apr 09, 2015 04:41 PM IST | Source:

This is how gold reduces risk & enhances portfolio returns

Over 13 years time period gold has demonstrated that inclusion of gold in portfolio reduces portfolio risk and enhances risk adjusted returns substantially

Rajiv Shastri
Peerless Fund Management

There has been a lot of debate in recent years on the validity and advisability of Gold as an investment instrument. The financial services industry is clearly divided on this, with some feeling that Gold is a “barbarous relic” with no place in an investment portfolio. Others differ, citing returns generated by Gold through time as adequate reason for its inclusion. To our mind, this debate misses the point entirely, especially in the Indian context.

The domestic price of gold in India is a function of two underlying prices; the international price of gold expressed in US Dollar terms and the price of the US Dollar, expressed in terms of Indian Rupees. With both playing a role, any analysis of the domestic price of gold in India becomes far more complicated than any other domestic investment avenue. And while few in India have the skill sets to analyse this complex composite price, there are many who are willing to express a view on it. We intend to do neither.

We look at the relationship between Gold and other domestic investment avenues purely from an empirical perspective, not focusing on Gold as an investment instrument, but as a risk management tool. To do so, we incorporate Gold into an investment portfolio that comprises of equity and debt in various proportions to analyse the impact it has on portfolio risk and consequently, the portfolio’s risk adjusted return. The goal of this exercise is to arrive at an investment allocation that outperforms bonds, not only from a returns perspective, but also from a risk adjusted returns perspective.

Rajiv Shastri
Rajiv Shastri
MD & CEO|Peerless Funds Management Co Ltd

Assumptions and proxies: Before we commence a discussion on the outcomes of this exercise, a discussion on the assumptions and proxies we use is relevant.

For Bonds, we use the CRISIL Composite Bond Fund Index as a proxy. This provides the limitation as to the start date of our analysis since this index is available only from March 30st 2002. We model a 1.5% expense ratio on index values to arrive at a post expense return that an average bond fund would have generated in these years.

For Equity, we use the S&P BSE Sensex as a proxy. We model a 2.5% expense ratio on these index values to arrive at a post expense return that an investor would have made through these years.

For Gold, in the early years of the analysis, we use the international price of Gold converted into India Rupees at the prevailing exchange rate and adjusted for then prevailing customs duties. From the time that a composite domestic price for Gold is available, in the form of a MCX traded price, this price is considered. We model a 1% expense ratio to arrive at a post expense return for investors from Gold.

We model an expense ratio of 1.80% on the portfolio strategy as a whole to arrive at a post expense return achieved by investors who invest in in. The end date of the analysis is March 31st, 2015

The portfolio is rebalanced back to its target weightages on the first working day of every month. All changes in portfolio weights between two rebalancing dates are purely on account of the price movement of the individual investment instruments.

Another factor that influences allocation is the belief that while investors may choose to hold a bulk of their financial investments like stocks and bonds through an investment strategy, most in India hold physical Gold outside any investment strategy. As such, the proportion of Gold in an investment strategy needs to be restricted to a reasonably low number. We cap it at 20%.

Analysis details:We analyse rolling returns for 1, 2, 3 & 5 year periods through these 13 years. The analysis period results in 3,067 observations of1 year, 2,773 of 2 year 2,480 of 3 year and 1961 of 5 year rolling returns. For each of these investment avenues (Equity, Bonds, Gold and the Hybrid strategy), we ascertain median, maximum and minimum returns generated for each rolling return periods. In addition, we ascertain the number of observations in which each of these options have generated negative returns, in number as well as a percentage of total observations. We also ascertain the standard deviation of the returns generated by each investment option for each rolling time period as a representation of the volatility of these returns. We finally arrive at the risk adjusted returns for each combination by dividing the median return by the standard deviation.

Analysis outcomes:With Gold allocation capped at 20%, the proportion of the other asset classes is driven by the returns and risk adjusted returns. The allocation that results in an extremely satisfactory empirical outcome is as follows,

The return and risk adjusted return outcomes generated by this strategy over a 1 year rolling return period are as follows,

One can see from the above table that the median returns generated by the hybrid strategy are more than twice that of a pure bond portfolio. But while the maximum returns are also significantly higher, the minimum return is also lower over this short period of time. What is remarkable is the fact that the probability of loss is reduced significantly. As one can see from the table above, investments in equity generate negative returns more than 18.5% of the time, Gold generates negative returns more than 18% of the time and even a pure bond strategy generatesnegative returns more than 8% of the time. The hybrid strategy, which is essentially a combination of the three, in comparison, generates negative returns just 4.14% of the time. This brings out the risk mitigating nature of the hybrid strategy in full; that a combination of 3 risks can actually be lower than each of them individually. Therefore, it is small wonder that the risk adjusted returns of the hybrid strategy are better than all the individual asset classes, including bonds.

The fact that this sharp reduction in risk and increase in risk adjusted return are visible over a relatively short period may give rise to doubts that the attempt to introduce counteracting risks may hurt returns over longer periods. However, gains not only continue to accrue over longer time periods, they are considerably enhanced. The outcomes for 2, 3 and 5 year rolling return periods are as follows,

One can see from the above tables that while both median and maximum returns for the hybrid strategy would have been double that of a pure bond strategy, the minimum return is even more enhanced in all periods. Also, since return volatility falls sharply as the time period grows, the hybrid strategy delivered significantly higher risk adjusted returns as well.

Conclusion: While in certain market conditions Gold may not excite the imagination as an investment option, going by empirical evidence it has a meaningful role to play as a risk management tool. Our analysis which covers 13 years of historical data indicates that the inclusion of Gold in a portfolio reduces portfolio risk and enhances risk adjusted returns substantially.

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