Downloadpdf Investment update; Liquidity

Overview

  • Global portfolio composition continues to shift with larger allocations to alternatives
  • Many of these alternative investments have previously helped portfolio performance but are less liquid than traditional investments
  • The hunt for yield in a low-rate environment has also encouraged riskier fixed income investments
  • Increased alternative and lower quality fixed income exposure could result in a more volatile and less liquid portfolio overall.

The shift to risker and less liquid assets strengthens the case for an allocation to gold, given its unique combination as a highly liquid diversifier, that can reduce portfolio volatility.

Investors are shifting more assets to less liquid alternativess

Portfolio composition has changed in response to the low-rate environment. Investors have moved further out on the credit curve, building high yield exposure and long-term Treasury positions in their search for yield.1 And, although fixed income allocations remain significant, they are declining.

Data from Greenwich Coalition2 and Mercer3,  as well as anecdotal evidence from one-on-one conversations with investors and global conferences, suggest that along with this reduction in fixed income, investments in alternatives and ‘other’ assets (such as real assets and infrastructure) have been growing. In fact, results from a recent market survey conducted in partnership with the Greenwich Coalition respondents noted they are targeting a third of their portfolio in alternatives and other assets over the coming three years (Chart 1). But a key characteristic of these investments that should be considered is liquidity, particularly as we enter a higher inflationary period. 

Many of the alternative investments have helped portfolio performance historically, but they often offer a much lower liquidity profile. In combination with the shifts in fixed income positioning this increases portfolio volatility and duration risk, and decreases the liquidity profile of the overall portfolio.

 

Chart 1: Investors expect one-third of their portfolios to be allocated to alternatives or other assets*

Investors expect one-third of their portfolios to be allocated to alternatives or other assets*

Survey results of five hundred global institutional investors

Investors expect one-third of their portfolios to be allocated to alternatives or other assets*
Survey results of five hundred global institutional investors
*Other is 40-50% real assets, which include real estate and infrastructure. Source: Coalition Greenwich 2021 Institutional Gold Allocation Assessment, World Gold Council

Sources: Coalition Greenwich, World Gold Council; Disclaimer

*Other is 40-50% real assets, which include real estate and infrastructure.

Advantages and disadvantages of less liquid assets

Private markets are usually longer-term strategies that carry illiquidity premiums. Part of their appeal to investors is that they are not marked-to-market (MTM) as frequently as, say, a listed equity, which consequently can understate the true volatility and valuation of both the asset and the whole portfolio. This, in turn, can create a problem when markets enter risk-off environments.

Following the Global Financial Crisis (GFC), a major question investors often asked hedge fund and private equity managers was, “How long would it take you to exit all your positions?”. The reasons for this usually centred around concerns over counterparty risk, along with the restrictions to quickly exit illiquid positions when they needed to source capital. This remains a concern today: 42% of investors surveyed by Greenwich ranked liquidity concerns as one of their top three drivers of long-term allocation decisions.4

This liquidity question comes further to the forefront as investors explore more volatile assets like cryptocurrencies or non-fungible tokens (NFTs), or farmland and collectibles, which can take a significant amount of time to buy or sell with varying degrees of bid/ask spreads. Gold may help to answer the question.

Gold is less volatile than nearly all alternative investments and on par or less volatile with global equities (Chart 2).

 

Chart 2: Gold volatility remains below nearly all alternative investments and reduces portfolio volatility

Gold volatility remains below nearly all alternative investments and reduces portfolio volatility

Five-year average daily volatility of various assets*

Gold volatility remains below nearly all alternative investments and reduces portfolio volatility
Five-year average daily volatility of various assets*
*Note: We utilised asset classes with reliable long-term statistics that provide data on at least a weekly basis. Assets like hedge funds, collectibles, farmland and OTC debt were excluded because of infrequency of data which supports our argument of inconsistent mark-to-market information and less liquidity Source: Bloomberg, World Gold Council

Sources: Bloomberg, World Gold Council; Disclaimer

*Note: We utilised asset classes with reliable long-term statistics that provide data on at least a weekly basis. Assets like hedge funds, collectibles, farmland and OTC debt were excluded because of infrequency of data which supports our argument of inconsistent mark-to-market information and less liquidity

Improve your liquidity profile with a gold allocation

The reason we highlight the shift to illiquid assets is because gold provides the capital and liquidity needed during a market selloff. Gold trades between more than US$100bn per day in total, and its most accessible venues – gold-backed ETFs and gold futures – represent US$57bn per day.5 Gold tends to buffer portfolio drawdowns and is often one of the first assets sourced by investors to increase portfolio capital or, sometimes, to buy distressed securities (Chart 3). A common question we hear in the early phase of a sharp market sell-off when gold also falls is “Why isn’t gold higher?”. In such situations, investors sometimes sell some of their gold position, because of its strong liquidity. However, the gold price historically bounces back quickly, improving the performance of the portfolio.

A prime example of this is the COVID-19 selloff of March 2020. During the market crash, gold sold off 12% (peak to trough) over seven trading days6, yet recovered to finish the month flat.7 Meanwhile, the S&P 500 finished the month down 13%, global hedge funds lost 6%, and listed private equity lost 29%.8  In this instance, gold would have decreased overall portfolio volatility. Additionally, using gold to build positions in some of the distressed assets would have meaningfully increased 2020 returns; many assets finished the year significantly higher, while gold finished the year up 25% on its own.9

 

Chart 3: Gold trades more than many other financial assets

Gold trades more than many other financial assets

One-year trading volumes of various major assets in US dollars*

Gold trades more than many other financial assets
One-year trading volumes of various major assets in US dollars*
*Average daily volumes from 1 December 2020 to 1 December 2021, except for currencies that correspond to March 2019 volumes due to data availability. **Gold liquidity includes estimates of OTC transactions and published statistics on futures exchanges, and gold-backed exchange-traded products. Source: Bloomberg, Bank for International Settlements, UK Debt Management Office (DMO), Germany Finance Agency, Japan Securities Dealers Association, Nasdaq, World Gold Council. On Goldhub.com see: Gold trading volumes.

Sources: Bloomberg, Bank for International Settlements, UK Debt Management Office (DMO), Germany Finance Agency, Japan Securities Dealers Association, Nasdaq, World Gold Council; Disclaimer

*Average daily volumes from December 2020 to December 2021, except for currencies that correspond to March 2019 volumes due to data availability.

**Gold liquidity includes estimates of OTC transactions and published statistics on futures exchanges, and gold-backed exchange traded products. Shaded area of gold volumes represents the estimated non-reported LBMA trade data

On Goldhub.com see: Gold trading volumes.

In the hunt for returns, gold’s liquidity profile strengthens its investment case

Alternative investments, many of which are less liquid than exchange-traded investments, are likely to makeup larger percentages of investment portfolios. While the investment rationale makes sense from a historical perspective, portfolio liquidity is likely to decline. Gold is a well-established portfolio diversifier and hedge that has delivered long-term positive returns. 

However, the quality of gold’s liquidity further strengthens the rationale for an allocation to gold as portfolio compositions change.

Footnotes

1Investment Update: Rates pose risks but also unlock opportunities for gold.

2Rethink, Rebalance, Reset: Greenwich Coalition, Q3 2021.

3Asset Allocation Insights: Pension allocation trends, 2021, Mercer.

4Ibid.

5Five-year average trading volumes of the OTC and exchange traded gold markets from 1 January 2017 – 13 December 2021.

6Gold price change between 9 March 2020 and 19 March 2020

7Gold price change from 28 February 2020 (US$1,610/oz) to 31 March 2020 (US$1,609/oz).

8Indices used: Private equity index - S&P Listed Private Equity Index, Hedge Funds – HFRX Global Hedge Fund Index, S&P 500 Total return Index.

9Based on the LBMA Gold Price PM from 31 December 2019 (US$1,514.75/oz) to 31 December 2020 (US$1,887.60/oz)

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