In the world of investment, it is like a competition with two types of market participants: winners and losers. The winners make money, while the losers accept the loss. To become a winner, asset allocation becomes a vital process in achieving better investment returns. Within asset allocation, risk diversification is the core of portfolio construction. In this article, we will explore the role of commodities in the world of investment.

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Asset Allocation and Diversification: The Core of Investment Strategy

Asset allocation refers to the strategic distribution of investments across various asset classes, such as equities, bonds, foreign exchange, funds, real estate, private equity, and commodities within a portfolio. The primary goal is to balance risk and reward according to an investor’s specific risk tolerance, investment goals, and time horizon. Proper asset allocation is essential for maximizing returns while minimizing risk, allowing investors to create a diversified portfolio designed to mitigate the impact of market volatility. A wise investor never puts all their eggs in a single basket.

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Importance of Asset Allocation

Asset allocation plays a pivotal role in determining the risk and return profile of an investment portfolio. Since different asset classes exhibit varying levels of risk and return characteristics, their performance often fluctuates under different market conditions. For instance, equities (stocks) tend to offer higher returns over the long term but come with higher volatility, while bonds provide more stability but typically offer lower returns. The goal of asset allocation is to create a blend that aligns with an investor’s objectives, helping them navigate market cycles and achieve a smoother investment journey.

Proper asset allocation is crucial because it reduces the emotional aspect of investing. When investors follow a well-thought-out allocation plan, they are less likely to make impulsive decisions during periods of market stress, such as selling off assets in panic or chasing high-performing investments without considering the associated risks.

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Impact on Investment Portfolio

The asset mix within a portfolio directly influences both the risk and return potential. For example, a portfolio heavily weighted toward equities may deliver high returns during bull markets but also expose the investor to significant losses during downturns. Conversely, a bond-heavy portfolio might protect against volatility but could miss out on substantial gains in periods of economic growth. Therefore, the right asset allocation can optimize portfolio performance by combining growth-oriented assets (equities) with more defensive assets (bonds, cash, or real estate).

Rebalancing is another key aspect of asset allocation. Over time, market movements may shift the balance of the portfolio, causing it to deviate from its original allocation. For instance, if equities perform well, they could represent a larger portion of the portfolio, increasing the overall risk. Periodic rebalancing ensures that the portfolio remains aligned with the investor’s risk tolerance and financial objectives, maintaining the desired risk/return profile.

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Why Diversification is Essential for Risk Management

Diversification is the practice of spreading investments across various asset classes, industries, and geographic regions. Its primary goal is to reduce unsystematic risk—the risk associated with a specific company, sector, or market. By holding a diversified portfolio, investors lower the probability that poor performance in one area will significantly impact their overall portfolio.

For example, stocks in the technology sector may experience a downturn due to regulatory challenges, while stocks in other sectors, such as healthcare or utilities, may perform well during the same period. Similarly, investing in international markets helps mitigate the impact of domestic market volatility. Bonds, particularly government bonds, tend to move inversely to equities in times of economic uncertainty, offering a hedge against stock market declines.

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Risk Diversification – Commodities: Gold

Gold has been a valuable asset since the earliest days of civilization and was used as currency in ancient Egypt and Mesopotamia. Today, gold still holds its strong position and is recognized as a financial asset in global markets. In the last article, we discussed how investors leverage gold to hedge against market uncertainties, such as inflation, geopolitical tensions, presidential elections, and regulatory changes. In this section, we will explore the role of gold in an investment portfolio and the strategies associated with it.

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Portfolio Diversification

Gold's historical performance has shown a low or negative correlation with traditional assets such as stocks and bonds. This means that when equities and bonds are underperforming, gold may not be affected in the same way, and could even appreciate. Including gold in a portfolio can reduce overall volatility and provide downside protection. For example, in times of economic downturn or stock market crashes, gold may help smooth out portfolio returns, acting as a buffer against losses in other asset classes.

Why Gold is Important in Asset Allocation

1. Reduces Portfolio Risk: The inclusion of gold lowers portfolio risk due to its low correlation with other asset classes. This means that gold typically behaves differently than stocks or bonds, which helps in maintaining stability when other assets decline.
2. Liquidity: Gold is a highly liquid asset, making it easy to buy and sell quickly in global markets. This liquidity ensures that gold can be converted into cash quickly, adding to its role as an emergency asset in times of financial distress. Further, Gold has intrinsic value that is recognized globally. Whether in the form of physical bullion, gold mining stocks or ETFs like GLD and IAU, it is universally as a highly liquid commodity.
3. FX Hedging: Gold is often used as a hedge against currency risk, particularly for investors who are exposed to foreign markets or currencies that may depreciate. When dollar weakening, Gold goes stronger.

Why Positioning Gold in the Portfolio Now

Tactical hedges for potential thematic risks: In 2024, the market is full of uncertainties. From rate hikes and presidential elections to potential interest rate cuts, there are many things we cannot foresee. Thus, gold has become an excellent hedging tool in portfolios.

1. U.S. sovereign debt (USD 35 trillion as of 19 Sep 2024) has spurred EM central banks to triple their gold purchases.
2. Economic uncertainty and fears of currency depreciation are affecting Asian investors, particularly in the China market. As 2024 is a U.S. election year, the outcome of the election could have a huge impact on the Chinese market.
3. Historically, gold has been supported by interest rate cuts
4. Reverse relationship with US 10 year real yield.

From GLD's 6-month implied volatility, we observe narrow implied and realized volatility, which reflects a bullish view on gold in the market. Furthermore, with ongoing geopolitical tensions and the upcoming U.S. elections, we believe GLD calls offer an attractive risk/reward opportunity for investors to hedge against geopolitical risks.

As we are bullish on gold and aim to leverage it to hedge against market uncertainties, there are a couple of strategies that could benefit from the potential growth of gold.

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1.        Pure Long Call
Buy a call option on gold, and benefit from exercising it if the price of gold rises above the strike price. However, if gold does not move above the strike, you may lose the premium paid for the option.

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2.        Long Call + Sell Covered Call (Bull Call Spread)

Buy a call option on gold that is 5% out of the money, while simultaneously selling a call option on securities you currently own that is 10% out of the money. In this case, you might minimize or even offset the upfront cost by receiving the premium from selling the call. However, there are risks involved in this strategy. If the price of gold does not rise to the strike, you will lose the premium. Additionally, if the underlying security on which you sold the call rises above the strike, the counterparty has the right to exercise the contract, obligating you to sell the underlying security and potentially accept a loss.

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3.        Accumulator
By purchasing a Gold Accumulator, you can gradually accumulate gold over a specified period at a predetermined price, typically through a series of options or forward contracts. This strategy is primarily used by investors who are bullish on gold and want to acquire the metal over time. If the spot price is higher than the strike, the investor can purchase gold at the strike price. If the spot price is lower than the strike, the investor is usually required to purchase twice the predetermined number of gold shares. If the spot price is significantly below the strike, the investor is still obligated to purchase at the strike price, which could result in substantial losses.

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4.        Total Return Swap (TRS)

TRS on gold allow investors to gain exposure to the price movements of gold without directly owning the asset. In a TRS, total return payer pays the total return (price appreciation or depreciation and income) of gold, while the total return receiver (bullish gold investors) pays a fixed or floating rate. This structure offers a flexible way to hedge or speculate on gold’s price changes while avoiding storage and transaction costs associated with physical gold. It also allows for leveraged exposure, enabling investors to amplify their positions without actually holding the assets. However, if the price of gold declines, the total return receiver is obligated to pay the counterparty the amount equivalent to the depreciation in the value of gold, it might cause a substantial loss on investment.

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Conclusion

Gold's importance in a multi-asset portfolio stems from its unique characteristics: diversification, inflation hedging, safe-haven appeal, liquidity, and currency hedging. These qualities make gold a valuable addition, helping investors reduce overall portfolio risk, protect against market volatility, and provide a stable store of value during times of market uncertainty. While not typically a high-growth asset, gold’s defensive qualities can enhance the overall risk-adjusted returns of a multi-asset portfolio.

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