9 
9 THERE IS NO PERFECT INVESTMENT. ANYONE WHO TELLS YOU otherwise is trying to sell you something. Our discussion of the so-called standard asset classes like equities and bonds was filled with anecdotes about the many ways in which these asset classes can disappoint investors. It should not be surprising that investors are constantly on the lookout for novel investments that can provide a better risk-return trade-off than the old standbys.
Investors searching for a better mousetrap often do so in what most people call alternative investments. Alternative investments combine standard asset classes in novel ways or invest in companies or asset classes typically outside the purview of the public markets. Typically these vehicles are off-limits to most individual investors and are the province of institutional investors. Over the past decade, alternative investments have become an increasingly important part of the portfolios of pension and endowment funds.
Endowment funds in particular have embraced alternative investments over the past decade. Some, like John Bogle, might argue that this effort has been misplaced. In a speech to a group of university endowment managers, Bogle notes how a very simple portfolio made up of 50% domestic bonds and 50% domestic equities performed roughly in line with the average endowment fund over a 15-year period.1 After taking into account risk, the simple indexed portfolio outperformed the machinations of the endowment funds. Bogle points out that for the smaller endowment funds that do have the resources of Ivy League institutions, a simple approach to investing may make more sense.
More so than in the standard asset classes, alternative investments rely far more on the performance of the fund manager. That is why larger institutions with larger budgets and staffs seem more adept at investing in alternatives. Alternatives are typically more costly, complex, leveraged, and illiquid than other investment vehicles. These are all things that we have cautioned investors to avoid in their investment journey. Despite that, alternatives are worth paying attention to for a couple of important reasons.
The first is that alternative investments are oftentimes accessible to individual investors via proxy. That is, there exist publicly traded vehicles that represent a good enough substitute for an alternative investment. For intrepid investors, these proxies may represent good diversification opportunities. Second, alternative investments often become mainstream investments over time. The ETF revolution is accelerating the process by which novel strategies and asset classes become available to the broader public.
Despite the hype, alternative investments are by no means perfect, but they are an important part of the financial landscape. In a certain sense, it is good that alternative investments are difficult to access. This keeps investors from venturing into areas in which they are not well versed. For intrepid investors, learning more about alternative investments makes perfect sense.
To say that hedge funds are an important part of the world of investing would be an understatement. Globally, hedge funds have some $2 trillion in assets under management, but that number likely understates their importance because many of these funds are often leveraged.2 In addition to their size, they are also the most active market participants. One could argue that, on the margin, hedge funds set the price for most publicly traded securities.
Given this importance, hedge funds attract a great deal of attention from the media. It has long been the case that hedge fund managers are the stars of the world of investing. In many of the best books on investing of late, like The Big Short by Michael Lewis and The Greatest Trade Ever by Gregory Zuckerman, hedge fund managers are at the heart of the narratives. It wasn’t always the case that hedge funds were so high profile. When hedge funds got off the ground in the 1950s, they were a mere curiosity. Not until the new century did hedge funds become an industry unto itself. The term hedge fund stems from that time, when the funds were run with “hedged” exposures in the hope of generating absolute returns. While hedge funds used to represent a particular investment strategy, now the name has more to do with the compensation structure than the actual strategy employed. The best managers today want to run hedge funds, and the biggest investors want to invest in hedge funds.
Hedge funds today are characterized more by their structure than their strategies. Hedge funds are loosely regulated, private investment partnerships that typically charge high fees in the hope that they generate high, positive, and uncorrelated returns. These funds often follow complex, opaque strategies and require investors to lock up their capital for an extended period of time. Hedge funds now follow every conceivable strategy, some of which are very highly focused on particular niches, whereas others range widely across asset classes and borders. Hedge funds are limited in that only accredited investors, i.e., wealthy individuals and institutions, can invest. Some of the largest and most accomplished hedge funds have been closed to new investors for some time now.
On the face of it, hedge funds have accomplished what they have set out to do. In a study, Ibbotson, Chen, and Zhu found that over a 15-year period the average hedge fund on average generated significant alpha in both bull and bear markets.3 And on the face of it, the funds earned their very high fees. Other research shows hedge fund alpha declining over time and now nearing zero.4 Another big problem is that hedge fund investors seem to have the same problem as individual investors. They buy high and sell low.
Using dollar-weighted returns, Dichev and Yu show that investors in hedge funds have historically earned much lower returns than previously thought.5 A dollar-weighted measure of returns takes into account the actual dollar returns, not the percentage, that investors earn in hedge funds. When this measure is used, hedge fund returns no longer show any alpha and reliably lag the returns for the S&P 500.
These less-than-stellar results jibe with what Warren Buffett has been saying for some time now: “I think people who invest in hedge funds, in aggregate, are unlikely to do well. Hedge funds are in the midst of a fad. It’s distinguished by an extraordinary amount of fees. If the world is paying hedge funds 2% and a percentage of the profits, and the losers fade away, then it won’t be good for all investors. Obviously, some will do well, but not in aggregate.”6 It’s not surprising that Warren Buffett entered into a highly publicized bet that the stock market, as measured by the S&P 500, would outperform a basket of hedge funds over a 10-year time period.7
Investors could likely live with this underperformance if hedge funds did a good job of protecting their returns during a market downturn. In the aftermath of the Internet bubble, hedge fund indexes were able to maintain positive performance. However, in the critical year of 2008, hedge funds experienced large losses, albeit smaller than the ones experienced by the overall stock market. This disappointing performance is largely a function of the popularity of hedge funds. One can see in the data that somewhere in the middle of the past decade hedge fund returns became more correlated with equity market returns.8 The era of “hedged returns” has long since passed. Hedge funds are now, for the most part, mutual funds with good marketing and bloated fees.
Despite this evidence, there will always be a measure of hedge fund envy for some investors. The exclusivity of hedge funds and the media attention lavished on the very best managers will always make hedge funds seem like an opportunity that is just out of reach. The complexity, high costs, and illiquidity of hedge funds make them an inappropriate investment for the vast majority of investors. Given these very real hurdles to performance, most investors are fortunate that they cannot invest in hedge funds.
However, no one can deny the influence of hedge funds on the changing investment menu for individual investors. There are new ETFs that try to replicate the returns of various hedge fund strategies. In addition, a number of mutual funds now employ hedge fund–like strategies. Investors today can invest in strategies like merger arbitrage and long-short equity. Since these are mutual fund or ETF structures, individuals maintain a measure of liquidity, unlike hedge fund investors. Investors in these more public vehicles should not expect returns much better than that experienced by hedge fund investors themselves. Even if these funds avoid the problems of complexity and liquidity, they still run into the issue of higher-than-average fees and turnover.
One of the themes of this chapter on alternative investments is that for intrepid investors there are often publicly traded companies or vehicles that proxy for alternative investments. This sort of approach definitely adds portfolio complexity but can quench the desire of some investors to participate in this arena. So for investors who think that hedge funds will remain a preferred home for investor capital, there are some publicly traded companies whose main business is to manage hedge funds. In that respect, you can potentially earn the benefits of the hedge fund business model without the risk of actually investing in a fund.
Hedge funds have a certain mystique that is, despite the mixed performance record, not going away any time soon. Some argue that recent hedge fund performance shows that they are “morphing into long-only funds.”9 If that is the case, then individual investors need not give hedge funds a second thought. Investors today have easy and cheap access to all manner of long-only strategies while avoiding the high fees and complexity of hedge funds.
Hedge funds are a much-sought-after alternative investment because they promise both exclusivity and an attractive risk-return trade-off. Hedge funds by and large use publicly traded instruments to try to create attractive returns. The other significant part of the alternative investment industry works outside the public markets. Private equity and venture capital generate returns with private companies. For many investors, the exclusivity of private investment drives their interest and clouds their judgment about the actual investment merits.
Many investors in the past decade became enamored with the so-called endowment model of investing. This model strives to replicate the portfolios of elite university endowment funds that emphasize alternative investments in an attempt to generate returns uncorrelated with the financial markets. In their book The Ivy Portfolio, Mebane T. Faber and Eric W. Richardson discuss the endowment fund model and its applicability to individual investors.10 The financial crisis and subsequent bear market highlighted the dependence of this model on the health of the overall economy and financial system.
The challenge for most investors is that both private equity and venture capital represent leveraged bets on the equity market. What this means in practical terms is that the performance of private equity and venture capital relies on a strong stock market—more specifically, a stock market that is receptive to IPOs. In the case of venture capital, the IPOs are start-up companies operating in the broadly defined technology sector. In the case of private equity, the goal is to bring companies public that were once private and that are now carrying significant debt. While there is increasing merger and acquisition activity among private investors, the public markets still set the valuation of companies on the margin.
So in this regard, private investments don’t really represent a way of reducing portfolio risk. By all accounts, these investments are riskier than the overall equity markets. This additional equitylike risk would be acceptable if it came along with enhanced returns. That is indeed what private equity investors say they are counting on.11 The evidence is there for private equity outperforming public markets over long periods of time.12 The problem is that once you take into account the liquidity risk that private equity investments face, their return premium is essentially eliminated. Franzoni, Nowak, and Phalippou find that this liquidity risk is the same risk facing investments in public markets. So not only does private equity not generate abnormal returns, but the perceived diversification benefits of private equity are also illusory.13
There is a bigger problem facing investors in private equity, and that is one we keep revisiting—high fees. Private equity and venture capital, like their hedge fund brethren, typically earn both a management fee on the funds they manage and performance fees on successful investments. These fees all add up over the typical life of a private equity or venture capital fund. Private equity and venture capital may represent some of the smartest investors around, but the investors in their funds ultimately pay for the privilege of investing alongside them many times over.
Kaplan and Schoar find that there is a great deal of heterogeneity in the returns to private equity, meaning the top firms tend to generate the highest return and repeat that performance over time.14 The only sensible strategy for investing in private equity and venture capital seems to be to invest with the top firms that have a demonstrated track record of outperformance. The problem is that those firms are largely closed to new investors and never were open to individual investors.
The challenge in venture capital is even worse because in large part there is far less investment capacity for venture capital than there is for private equity. There is no shortage of investors who want to invest in venture capital to find the next Google or Facebook. The challenge is that the high-profile “wins” for venture capital usually mask a slew of lower-profile failures. This hindsight bias makes low-frequency, high-profile events like IPOs seem more likely than in reality. For intrepid investors, there are opportunities in the public markets to act like a private investor.
In the past few years, it has become increasingly popular for the large private equity managers to go public. For example, industry leaders like KKR and the Blackstone Group have chosen to become publicly traded. The reasons for this are many, including succession planning and a desire to become more diversified alternative investment firms. Whatever the motivation, they now provide investors with a way to play private equity without having to invest in an underlying fund. Other investors are focused on the niche of business development companies that act in many ways like private equity firms. In both of the above cases, there are even ETFs that allow for instant diversification. Venture capital is a bit tougher, but there are some public companies that act like venture capital firms. These proxy plays are not perfect substitutes for the real thing and require a level of research beyond the scope of most investors’ skills.
David Swensen, who is a leading expert in endowment fund investing, has a message for individual investors when it comes to alternative investments like hedge funds, private equity, and venture capital. He recommends that “prudent investors avoid asset classes that derive returns primarily from market-beating strategies.”15 Swensen notes the difficult challenge that lies in trying to identify (and invest) in superior managers.
The firms engaged in private equity and venture capital play a key role in the functioning of the market economy. It would be hard to imagine the markets without them. In a very real sense, all investors benefit from the work of private equity professionals and venture capitalists. The challenge for average investors is that they don’t have easy, inexpensive access to these asset classes. Whatever access they do have is mediated with layers of fees upon fees. As with most alternative investments, the allure of private investments is less than meets the eye.
Alternative investments need not be limited to novel asset classes. Options are not novel in that they are based on or derivative of already existing securities. However, options-related strategies can generate novel returns not accessible in other ways. Most analysts would not include options-related strategies in a chapter on alternative investments. A quick survey of options strategies should show that the inherent flexibility of options makes them a unique approach to generating novel return streams.
Any survey of options strategies is going to be incomplete. Stated simply, options are contracts to buy or sell an asset in the future at a set price. Because an option’s price is derived in part from the price of other assets, options are considered derivatives like futures contracts, which we will discuss later in the chapter. In the past decade, investors have really taken to options trading. According to data from the Options Clearing Corporation, the average daily options volume has gone up sixfold from 2001 to 2011.16
The malleability of options makes them good vehicles for experienced traders who are looking for novel ways to express market opinions. As Jared Woodard writes: “So what are options good for? Options allow you to say more, and to say it more precisely than you ever could with stocks or futures alone. Everyone implicitly thinks in terms of options … So one of the benefits of executing trades with options instead of just stock alone is that options allow you to say all the things you wanted to say already, but couldn’t.”17
The challenge for novice investors is to recognize that the inherent flexibility of options means that options can be abused as easily as they can be used thoughtfully. Earlier we noted how complexity, illiquidity, and leverage are three prime portfolio killers. For better or worse, options trading strategies hit all these danger zones. Options pricing is complex. A Nobel Prize in Economics was awarded for the creation of the theory behind options pricing. It is best to think of options and options strategies as a whole other language that needs to be learned.
By definition, options are less liquid than their underlying security. Many stocks and ETFs do not have listed options. For traders, illiquidity makes profiting from options strategies more difficult. One of the aspects most interesting to traders is that options and their lower prices make it possible to take positions not possible using the underlying security. This is also where novice investors get into trouble. Investors can unwittingly take on bigger, more leveraged positions without being fully aware they are doing so.
Despite these potential pitfalls, options are flexible and allow investors to create positions that can, not will, profit from different market conditions. An options trader has many more degrees of freedom than a trader who can only go long and short. Options pricing depends on implied volatility. Implied volatility is essentially the level of volatility that traders expect an asset to undergo during the life of the option. In effect, options traders aren’t trading stocks; they are trading expectations about volatility.
To demonstrate just how meta markets can become over time, a “derivative of a derivative,” the CBOE Volatility Index, or VIX, has become increasingly popular with market participants. This index tracks the implied volatility of options traded on the S&P 500. Among its many purposes, the VIX serves as a “fear index.” When traders bid up options prices (and volatility), this is indicative of market fear. So the options market does more than serve as a means of trading; it provides market participants with further information as well. The VIX, and the futures that trade based on it, is also the basis for a number of popular ETPs. Thus, not only can traders track market fear; they can trade it explicitly.
One reason why options have become more popular over the past decade is that they provide investors a means of hedging their underlying equity position. The past decade has been a volatile disappointment to most investors, and options-related strategies have been one way investors have tried to cope. For example, the most common systematic options strategy that investors use is the covered call, often known as the buy-write strategy. A buy-write strategy involves writing (or selling) call options on an underlying equity position. In exchange for giving up further upside on the underlying position, the seller of the call receives a premium. Contrary to popular opinion, this stream of revenue is not income or a dividend. Call premiums are compensation for a trade-off for forgoing further profit on the upside. In an environment where stock prices have gone nowhere over a long period of time, a buy-write strategy has outperformed.
The disappointment of traditional portfolio management tools in the aftermath of the financial crisis has made many investors fearful of previously unrecognized risks. These so-called tail risks are often hedged by purchasing far-out-of-the-money options that will become valuable if markets fall dramatically. These strategies are costly to implement and are profitable only rarely. The cost of tail risk strategies derives in part from the need to constantly be buying options that largely expire worthless. The bigger question investors who feel like they need tail risk protection should ask themselves is whether they are taking on too much equity market risk to begin with.18
In contrast, there is reason to believe that options markets generally overprice risk, i.e., volatility. This volatility risk premium is pronounced in the market for equity index options.19 One explanation is that investors demanding portfolio protection bid up the price of options beyond their fair value. This systematic overpricing is an opportunity for investors willing and able to sell options premiums. That is not to say that this sort of strategy is without risk. In fact, selling options is riskiest in times of severe market stress—exactly the time when most investors are craving safety, not additional volatility.
We have limited our discussion of options to systematic strategies in part because these are the only strategies we can define and analyze. Any discussion of options is, by definition, incomplete because the world of options is infinitely complex. In this complexity, however, lie a range of strategies that investors can use to literally sculpt returns. The use of options comes with costs, not least of which is the educational efforts needed to become competent in their use. However, options-related strategies do represent real alternatives to the returns available on standard asset classes.
Options and futures are lumped together in the world of finance as derivatives. Futures are more straightforward instruments than options. Futures contracts represent an agreement to buy or sell a commodity (broadly defined) at a certain price on a future date. Futures were once limited to commodities, but long ago they were extended to include financial instruments as well.
Recently, investors looking for alternatives have begun focusing on the commodities futures markets. A lot of this interest can be traced back to 2006 when a paper on commodities futures by Gorton and Rouwenhorst and another by Erb and Harvey documented the historical returns of commodities futures.20 Investors and fund marketers quickly grabbed on to the results that showed commodities futures having equitylike returns along with a negative correlation with financial assets. This result was the holy grail for investors. Not surprisingly, the investment management industry took note. Many investment advisors responded to these findings by putting commodities futures funds into their recommended portfolio allocations. As a result, it is estimated that since 2006 the amount of assets under management dedicated to commodity investing has tripled.21
Unfortunately many investors misunderstood the more nuanced story in these results. Investments in commodities futures are not equivalent to investments in the underlying commodities themselves. The return on commodities futures is affected not only by changes in the spot price of the commodity but also by interest rates and what is commonly referred to as the roll return. As futures contracts expire, investors transitioning from one futures contract to the next will generate the roll return. The roll return historically had been positive for the commodity universe. However, the rush of capital into the commodities futures market greatly affected the pricing of these contracts and turned the roll return negative.
There is one approach to commodity investing that is based on the changing nature of the structure of commodities futures. A long-short approach to commodity investing that goes long commodities in backwardation and short commodities in contango has some interesting properties. Miffre finds that in comparison with other approaches, a long-short approach generates higher returns, lower volatility, and a lower correlation with equity markets.22 Unfortunately for most investors, this approach was not widely followed. Only recently has an ETP launched that follows this sort of commodity indexing strategy.
This financialization of the commodities markets shows up in another way as well. Commodities now trade more like other financial assets than they did prior to this era. This negates some of the original attraction investors saw in an investment in commodities futures. The financialization of commodities played out in a prominent fashion in the world of ETPs. We already noted how investors in natural gas and oil ETFs were disappointed that their funds lagged the returns on the underlying commodities. Fund advisors have responded to this disappointment with new and modified products to try to offset the effects of negative roll returns. A more sophisticated approach to commodities futures selection can help in regard to the roll return, but it can do nothing about the increasing correlation between commodities and financial assets. The diversification paradox once again rears its ugly head. Not only do new investors in commodities not experience the returns they sought, but they ruin the game for early adopters as well.
While the commodities futures boom was going on, another approach to investing in the futures market also was being implemented—managed futures. Instead of trying to create static long exposure to commodities, managed futures managers try to generate active returns from the global universe of futures contracts, including both commodities and financial futures. In this light, managed futures can be thought of as the cousin of hedge funds. However, managed futures differ from hedge funds in a very important fashion.
Historically, managed futures have had a very low correlation with the equity market and with various hedge fund strategies. In fact, managed futures strategies shine in periods of equity market turmoil. In 2008, an index of managed futures strategies was up some 14% in a year when equity markets plunged and hedge fund strategies fell some 18%.23 Research shows that almost all of the excess returns on managed futures come in periods when the equity markets are weak.24 On the flip side, this also means that managed futures strategies can lag while other strategies prosper. Despite this relative volatility, investors continue to pour money into managed futures in the hope of finding some true diversification.
The performance of managed futures is not without controversy.25 Many commodity trading advisors, or CTAs, charge fees that are similar to those charged by hedge funds. This means that a significant portion of these returns accrue to the manager and not the investor. Most CTAs can also be characterized as systematic trend followers. This makes sense given the performance of momentum-related strategies. However, this also means that their performance can be mimicked by indexes that do not require such high fees. The fact that these strategies are in a certain sense in the public domain has made vehicles available to the wider public.
There are now mutual funds and ETPs that track various indexes based on trend-following managed futures strategies, and investors should expect even more in the future. The question for investors is whether managed futures strategies will, like other popular strategies, fall victim to the diversification paradox. Managed futures strategies do have the historical weight of the momentum effect behind them. That being said, investors who buy into managed futures should do so for the promise of diversification and with a wary eye on too much money entering into the strategy.
The desire of investors to diversify beyond financial assets is understandable. There is an almost primal urge on the part of investors to own tangible assets. These tangible, or hard, assets are best thought of as land or as products that are grown on or extracted from the land. Hard assets include investments in real estate, energy, metals, and agricultural products. We have seen that in many cases the futures market provides, at best, an approximation of the returns on some of these commodities. Investors interested in hard assets therefore have to turn to other means of getting this exposure.
Gold is one of the most discussed tangible assets and is in a certain way a special case. We will discuss gold further in the next section. Gold and other precious metals are the exception to the rule when discussing hard assets because investors today can get ready access to the commodity itself. Other hard assets are more difficult to access.
Institutional investors have the means to get direct access to hard assets. These institutions can invest in funds that hold oil and gas properties, timberland, farmland, and real estate. The rest of us have to be satisfied with indirect access to these hard assets through asset classes that include investments in real estate investment trusts (REITs), timber companies, oil and gas exploration companies, and miners. These asset classes are not a bad option. For instance, investors who gain exposure to hard assets via publicly traded vehicles can do so in an inexpensive fashion and have ready liquidity.
The other piece of good news is that an investor in the broad stock market already has some exposure to hard assets. For example, an investor in the S&P 500 already has a nearly 16% exposure to energy and materials companies. In light of this, some advisors recommend that investors need not have any additional allocation to hard assets. One hard asset class that is widely used is REITs. Real estate is a bit of an exception in the world of hard assets in part because of the size of the opportunity. According to the National Association of Real Estate Investment Trusts (NAREIT), the REIT industry at the end of 2010 covered companies with a value of some $389 billion. This fact and the higher dividend yield that REITs generate make it a popular asset class. Investors interested in real estate, both in the United States and overseas, have easy access to this asset class via funds and ETFs.
This easy access also highlights the problem with REITs as a portfolio diversifier. As REITs have become mainstream vehicles, their correlation with the equity markets has increased.26 Research shows that since 2001, the correlation between REITs and the S&P 500 has steadily increased. In 2008 in the midst of the financial crisis, a NAREIT index of REITs generated a total return of −37%, largely matching the horrible performance of the stock market. Over the long run, the performance of REITs is generally going to match the returns to the underlying properties; however, in the short term, REITs can get caught up in market turmoil.
An investment in hard assets represents a natural hedge. We all consume various commodities, albeit in different proportions. A commodity like gasoline is one of the most visible prices we experience on a daily basis. Therefore, an investment in commodities and hard assets represents a hedge against inflation. But hard assets can only represent a hedge if investors choose to be disciplined and rebalance their portfolios over time. For some investors who already have a well-diversified portfolio, owning an asset that can provide some protection against commodity inflation can be a comfort.
The range of hard assets is dizzyingly wide: from the biggies like energy and real estate to more narrow niches like timber and rare earth metals. For intrepid investors, there exist ETFs or companies that proxy for this exposure. However, one hard asset stands alone, partly because of the media attention it receives and partly because it has played a prominent role in society for millennia, and that is gold.
Few investments are more controversial than gold due in large part to the fervor that many investors have for the shiny metal. For these investors, gold represents the one true money that has served as a store of value for thousands of years and is the perfect investment in any potential economic environment. In opposition, an equally boisterous camp notes that gold has no intrinsic value. These skeptics point out that gold cannot be valued by conventional financial models and is prone to booms and busts, depending on the collective psyche of investors.
Of late the psyche of investors has led them to gold. For a brief moment in August 2010, the SPDR Gold Shares passed the SPDR S&P 500 ETF in terms of assets under management.27 In that same week, the polling firm Gallup reported that Americans had chosen gold over real estate and stocks as the “best long-term investment.”28 Companies that store gold bullion are running out of space as they try to keep up with demand.29 Given the strong performance of gold, the uncertainty surrounding the U.S. economy, and the ongoing malaise in the real estate and stock markets, this result shouldn’t be that surprising. Gold has become the ultimate “none-of-the-above investment.” At the beginning of the new century, this result would have surprised everyone but the hard-core goldbugs.
This skepticism would have arisen from the fact that after a gold bubble popped in 1980, gold, had done very little pricewise for the next two decades. During the 1980s and 1990s, gold prices moved in a broad range while financial assets like equities and bonds took center stage. It is not a coincidence that gold began its decade-long bull market right around the time the Internet bubble was popping. Since 2001, the price of gold has moved higher every year for 11 years straight. This kind of run has not happened since 1920.30
For good reason, gold has held a role in commerce since biblical times. Kings and rulers have gone to great lengths, oftentimes to their own detriment, to obtain gold. One reason for this is the unique chemical properties of gold. A look at the periodic table of elements shows only five real candidates for a store of value, including gold, silver, and platinum. Unfortunately silver tarnishes, and platinum has too high a melting point, leaving gold as the only logical candidate for money.31 While gold has been an obsession for millennia, it no longer serves in any meaningful way as money.
Another thing that has changed in the past 10 years is that gold has become a highly liquid and tradable commodity. The launch of the SPDR Gold Shares has altered the way in which investors hold and trade the precious metal. Gold is now accessible to investors both large and small and can be traded at the click of a mouse. Now that gold has been “ETF-ized,” it will be interesting to see if, and how, gold pricing has changed. We will not likely find this out until gold experiences a true bear market.
For some investors, a gold ETF is a passing curiosity. For example, the Permanent Portfolio mutual fund has held and continues to hold some 20% of its assets in physical gold. Other investors are far more interested in being able to accurately value and trade gold. Unfortunately for investors, models that accurately forecast the price of gold based on either fundamental (supply and demand) or economic (inflation) factors are few and far between.
The one factor that does seem to play an important role in gold pricing is real interest rates. Eddy Elfenbein demonstrates that when real interest rates are low, the price of gold tends to increase and that as real interest rates rise, the price of gold tends to fall.32 When real interest rates are low, the opportunity cost of holding gold is low, and investors give up little to hold the metal. However, when interest rates rise, then gold, with no yield to speak of, pales in comparison. This explains in part why the decades of the 1980s and 1990s were such a poor time for the owners of gold.
Gold represents only a very small fraction of world wealth; therefore, every investor can’t meaningfully increase his gold holdings. There just isn’t enough of it to go around. The question for investors is, what role should gold play, if any, in a broadly diversified portfolio? The answer lies somewhere in between what the gold skeptics and goldbugs would recommend. Gold still serves, even after its ETF-ization, as a decent portfolio diversifier. Diversified investors can pick a rebalancing bonus by holding gold since it often moves out of sync with financial assets.
Some investors like to hold the shares of gold miners in lieu of gold. In theory this makes sense because investors can often earn dividends from these companies. However, there are two big problems with this strategy. The first is that the price of gold miners can diverge from the price of gold for long periods of time. Second, among gold miners there is often political risk because their mines are often located in countries where the rule of law is tenuous, at best. Investors can look at gold miners, and other precious metals miners, as a substitute for gold bullion, but they should not expect a perfect correlation with gold or substantial outperformance.
In his book on the history of gold, The Power of Gold, Peter L. Bernstein writes that “gold reflects the universal quest for eternal life—the ultimate certainty and escape from risk.” Bernstein notes that people have the tendency to fall for the illusion of gold when they “take the symbolism of gold too seriously.”33 Anyone having read this far should recognize that there is no escape from risk, not in gold or any other alternative investment. We should not discount the long world history and unique role of gold, nor should we place too much faith in gold. We are all seeking the perfect investment, but gold fails that test like all the other assets that have come in its wake.
There is no perfect investment, but investors are constantly searching for alternatives that can provide higher returns, lower risk, or both.
Hedge funds play an important role in the financial markets, but their performance, weighed down by high fees and increased competition, has deteriorated and become more marketlike over time.
Private equity and venture capital play an important role in the economy, but the return picture for them is mixed. In any event, individual investors have at best limited access to these investment vehicles.
Options strategies allow investors to express all manner of market views, including hedging risks. However, options strategies come with a steep learning curve, higher costs, and illiquidity.
Managed futures have historically been good portfolio diversifiers generating returns in times of market stress.
Hard assets represent another diversification opportunity for investors, especially in light of their ability to partially hedge inflation risk.
Gold has been an object of desire for millennia but, like other alternative assets, fails the test of a perfect investment.