The gold standard

NEW YORK — "Looking for a pot of gold" isn't just a figure of speech — it's what institutional investors literally should be doing, according to a new study.

The study, written by Richard O. Michaud, founder and president of New Frontier Advisors LLC, Boston, and sponsored by the World Gold Council, shows that allocating 2% to 4% of total assets to gold futures can add diversification and better risk-adjusted returns.

Mr. Michaud's research found that between Jan. 1, 1974, and Dec. 31, 2005, gold produced an inflation-adjusted annualized return of 2.1%, as measured by the London PM Fix benchmark, compared with a 1.4% return over the same time period for U.S. Treasury bills.

While commodities in general have a very low correlation to traditional asset classes, making them powerful diversifiers, gold's correlation is even lower. Gold generally had a lower correlation to other asset classes than would a basket of commodities as measured by the Commodities Research Bureau index. Gold had a -0.15 correlation to U.S. T-bills, while the basket had a -0.09 correlation. Also, gold had just a 0.07 correlation to U.S. large cap stocks as measured by the Russell 1000 index, while the basket of commodities had a 0.14 correlation.

That's good news for investors seeking to reduce the volatility of their total portfolios. One of the cornerstones of investment icon Harry Markowitz's modern portfolio theory is that a mix of asset classes with low correlations to each other can create an efficient portfolio — one that delivers the highest possible return with the least amount of risk.

When run through New Frontier's patented Resampled Efficient Frontier technology — an optimization process that simulates hundreds of portfolios across the efficient frontier — even the riskiest portfolios did not become more risky with a 10% weighting to gold.

The study concluded that 2% would be an ideal allocation to gold for institutional investors with low risk tolerances, and up to 4% for institutional investors with more diversified portfolios. Additionally, the study found it's more difficult to make a case for gold for institutional investors with high risk/return return portfolios.

"An allocation to gold is wise for the usual tactical reasons," Mr. Michaud said in an interview. "Gold hedges against inflation and currency changes. It's clearly something that could add returns without changing the risk characteristics of a portfolio."

Katherine Pulvermacher, managing director of investment research at the World Gold Council, London, said institutions have yet to take the plunge into gold as a stand-alone investment because most institutions tend to look at commodities investing in terms of a broader group. "But the study we did with New Frontier shows that the risk characteristics of gold are quite different than other commodities."

"People are just only starting to look" at gold individually (as opposed to a basket of commodities), she said. "High-net-worth investors have been quicker and more open-minded in evaluating gold on its merits. They are saying, ‘let's see what the up- and downside potential of gold is and whether it can benefit investors.' (What) institutions are saying is that a 5% or 10% allocation to gold is too small to matter. However, even a small allocation to gold can be significant."

Michael Rosen, a principal and consultant at Angeles Investment Advisors LP, Santa Monica, Calif., was not convinced. "I think the correlation argument is ridiculous," he said. "If that's your argument, then why not just buy a T-bill? You'll earn 5% and that doesn't correlate to anything. If you think gold is an inflation hedge and that's why you're buying it, there are better ways to hedge against inflation, particularly through inflation-linked bonds."