In a previous piece, I illustrated a more active approach to core-satellite portfolio construction. While managing the core in a pro-active way mostly deals with fine tuning a multi-beta exposure and then applying active risk management, more creativity can be utilized for the satellite.
In this regard, there are probably two main approaches: active alpha or crisis alpha. The first would require a strategy geared toward exploiting market anomalies that may lead to superior performance; such outperformance may realize itself via concentrated and targeted bets or via uncorrelated performance when measured over a certain timeframe. On the other hand, the latter would implement a strategy not only generally uncorrelated to the traditional core, but that would be able to produce superior performance especially during times of great stress for traditional asset classes.
This is an important distinction often overlooked: alternative investments which are usually generalized as a solution for alpha exposure may provide superior performance, especially over longer time frames, but not necessarily at times of significant liquidity and credit breakdowns for traditional asset classes. A detailed factor analysis may uncover superior returns for many alternative strategies; however, it may also reveal a degree of sensitivity to fundamental price drivers common to traditional assets that may be much higher than desired. Only a few strategies seem to be providers of crisis alpha or outperformance in time of significant stress in traditional betas: gold seems to fit that definition.
The successful run of the precious metal in the last ten years has been sparked by a confluence of positive factors such as extremely easy global monetary policy and a socio-economic transition from an age of optimism to a zero-sum era. These elements reversed a downward trend in gold entrenched since the famous top in the early 1980s. Central banks have been reversing their selling course as well, as they relaxed their monetary policy.
This new dynamic rendered gold a stronger candidate for portfolio allocation. The ability of gold to provide crisis alpha makes it a perfect asset for inclusion in a zero-beta satellite.
Gold does not produce a stream of cash-flows which makes it difficult to analyze, based on classic valuation metrics such as DCF models, leaving most of the analytical work reliant on the study of supply and demand. However, as the metal increases its magnetism for investment flows, its continued lack of correlation to traditional asset classes becomes the ultimate analytical input.
The World Gold Council ran a number of interesting statistics and scenarios in a recent working paper showing how gold has been a consistent risk diversifier in addition to its traditional role as a store of wealth.
Their analysis showed that a 3.3% to a 7.5% allocation to gold (depending on the composition of the portfolio and the investor currency of reference) can improve the risk adjusted profile of the allocation even when other alternative assets are included.
In one of the tables produced by the study, we can see two different portfolios, a standard one allocated 55% equities, 25% fixed income, 5% cash, and 15% alternative investments. A conservative version allocated 30% equities, 50% fixed income, 10% cash, and 10% alternative assets. The portfolios were tested for the trading period from January 1987 to June 2011 utilizing U.S. Dollar denominated assets. In all cases portfolios with gold included scored higher Information Ratios with an optimal allocation to gold between 3.3% and 4.4%.
In this new turbulent investing environment, it is my belief that the old approach of trading around the mean hoping that investment returns will conform to an unrealistic bell curve will continue to disappoint and a more aggressive approach toward hedging and/or exploiting tail risk will continue to be key for some time.