The Hindu Business Line : Gold futures: Jewel in a portfolio

BUDGET 2005-06 has proposed the introduction of gold exchange-traded funds (ETFs). Gold has always been an attractive investment because it has a weak relationship with equity. It is highly likely that fund-houses will soon launch gold ETFs. Perhaps, fund of funds will also be launched with a mandate to invest in such ETFs.

But should investors buy gold for its diversification benefits? But for all the virtues of diversification, investors seem to be more risk seeking these days. Perhaps, their instinctive turning to fixed deposits is considered a strategy to control the higher risk from equity exposure. If that is the case, gold should merit a place in a portfolio not to control risk but as a high-returns generator.

What diversification?

Since the seminal work by Harry Markowitcz, portfolio diversification has been a much-touted investment management concept. The idea rests on constructing portfolio with low-correlated assets to control risk.

Indeed, by this definition, gold ought to feature in any asset allocation process. A simple regression of gold prices and the CNX S&P Nifty for the last 10 years shows very little relationship between the two. The relationship was statistically insignificant even for a smaller data set, from 2000 till date.

But controlling risk may not be an important factor for two reasons. First, returns from fixed-income investments have declined sharply in recent times while consumer prices have not kept pace. This makes it necessary for retail investors to aggressively seek higher returns on their equity portfolio.Second, the investment horizon has shrunk dramatically in the last 10 years.

An average retail investor may hold stocks for no more than a year, and that too because of loss-aversion affect. A shorter-horizon portfolio is essentially one for trading. Assets find place in such a portfolio based only on returns and not on correlation with other stocks.

Asset returns: Spot gold compares well with the Nifty index over a three-year period with the latter outperforming by 7 percentage points. But gold has been a poor returns-generator over a longer period. The yellow metal under performed the equity benchmark by nearly 40 percentage points over a 10-year period. A host of exogenous factors, ranging from government laws to central banks' decision to abandon the metal as a form of reserve, can affect its prices in the long run.

Trading in gold for a short term may, however, be advantageous. The 2000-02 period is a case in point. The Indian equity market tanked during this period, clocking a 38 per cent decline.

An investment in gold during that period earned 19 per cent. Note that including gold in a portfolio for diversification benefit is quite different from trading in gold that coincides with a period when the equity market tanks.

Diversification means holding the asset through the life of the portfolio. Because gold has been a low returns-generator over a longer period, such diversification could drag down portfolio returns. On the other hand, trading portfolio is built on some technical parameters. The short-run entry into and exit from gold will depend on the returns that it generates for a defined horizon.

But investing in physical gold even for the short-term might not be the optimal choice. The reason is that the asset does not earn income as equity or bonds do. Besides, this metal may not earn abnormal convenience yield, as is the case with agricultural commodities. A gold ETF also suffers from this problem because fund-houses will back the units with gold.

Gold futures are, hence, an attractive option. For a small outlay in the form of margin payments, these investors can use the metal as a returns-generator.

The additional amount that would have otherwise been used to buy gold units can be instead used to invest in liquid funds or short-term fixed deposits.

(Feedback can be sent to bvenky@thehindu.co.in)

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