What are alternative investments and do you need them? Eric Letendre, CFA, a senior portfolio manager at People's United, discusses alternative investments.
Q. What exactly are alternative investments?
A. Normally, when we approach the investment process and asset allocation, we look at three (3) asset classes: stocks, bonds and cash (or money market short term instruments like CD's). Over the last few years, a fourth asset class has evolved and for lack of a better term, we call it "alternative investments". It is made up of gold (which I want to focus on this morning) and other precious metals, commodities like oil, grains, etc and real estate. Large institutional investors like pension funds have always had access to these asset classes because of their size, but with advances in technology, smaller individual investors can have access to these investments.
Q. Why should investors be considering gold and alternative investments?
A. The primary reason is to achieve greater diversification. And that is the best way to reduce risk. We tend to focus on returns and making money for our clients, but we need to also keep focused on minimizing risk. With globalization and advances in technology, it is getting to be very difficult to achieve diversification. As markets become more interconnected, investments tend to move in tandem together. When things start to look bad in Europe, the bad news spreads to Asia, North America and Latin America very quickly. Developed markets and emerging markets move in the same direction. When things are going well, all the markets seem to move up together. Unfortunately, when things are going badly, like in 2008, markets tend to move down together too. There is no place to hide. Except for gold.
Q. Why is gold such an attractive investment idea?
A. Gold is a difficult investment to analyze. Because it is so different from stocks and bonds, as a trained securities analyst, there is a formal methodology to analyze stocks and bonds and gold just doesn't fit in. Gold just sits there. It doesn't pay a dividend or interest, so there is no income coming off of it. It is really just a play on the global supply and demand for gold. We know the supply figure pretty well and we can calculate the amount of gold that will be mined. The real question is "What is the demand for gold going to be?" and that is very speculative.
Gold does well in two (2) environments: hyperinflationary environments and during periods of extreme economic and/or political turmoil. Up until the early 1970's, gold was highly regulated and controlled by the government. The price was fixed at $35 an ounce and it didn't really trade freely like it does today. When governments decided to deregulate gold and move their currencies off the gold standard, gold began to trade in the 1970's and went from $35 an ounce to $875 an ounce! It was perceived as a great hedge against inflation. But inflation hasn't been a problem for the last few decades and that isn't what is driving the interest in gold. Since 2008, people have become more concerned and fearful about the global economy beginning with the near collapse of the global financial system in 2008 and then the concerns regarding the possible dissolution of the European Union and the problems with Greece, Spain, Italy and weaker countries.
Q. Should we be buying gold now?
A. We believe that gold represents a core component of a diversified portfolio for the long-term investor. On a short-term tactical basis, gold is out of favor. Stocks have been doing well (up 16% last year) so money has been flowing out of gold into the stock market. The price of gold peaked in August 2011 at a little over $1,900 an ounce and it currently trades around $1,600 an ounce. As long as inflation stays well behaved and the world remains relatively calm, gold will probably continue to languish. But if the world becomes more tumultuous, governments can't control their deficits and political crises erupt, then gold may become more attractive. It is always a good time to look at investments that are out of favor.
Q. How does one actually invest in gold?
A. Up until recently, you had to buy physical gold and store it. That is pretty cumbersome and requires you to have a vault and trying to liquidate it is pretty difficult. But you can participate in gold investing through exchange traded funds (ETF's) which trade like stocks but follow the price of gold. Much easier and cheaper than holding actual gold.