Gold holdings minimise the risk for mutual funds, says NCDEX study

Gold as an investment can stabilise returns and minimising the risk for mutual funds, foreign portfolio investors and financial institutions.

According to a study by the National Commodity and Derivatives Exchange (NCDEX), the correlation between the gold markets and the stock markets is negative. In other words, an investment in gold would automatically hedge an investment in stock.

Commodities make an attractive investment avenue because they are negatively correlated with other financial assets. Other financial assets are tied to the economic environment, whereas equities are anticipatory and measure the current value of expected future cash flows.

If markets are overheating, fund managers might question the sustainability of company earnings, anticipate inflation and interest rate rises and so value stocks accordingly, but commodities measure what is happening today.

In fact, in the overseas markets, funds that have allocated a certain portion of their portfolio to commodities have delivered strong returns over the last four years, and pension funds are increasingly convinced that commodities deserve a permanent strategic allocation in their portfolios.

Analysts say low correlation between the stocks and bonds with bullion could be used to diversify risk.

The table alongside gives a comparison of risk of the stock and bond portfolio return expressed as the volatility of the returns with and without investment in bullion in India.

According to the study, the risk-adjusted returns for the Indian markets, the measure of investment return in relation to the amount of risk it took on _ a portfolio diversified with bullion performs better.

This makes a case for fund managers and private bankers to immediately look at diversification of stock and bond portfolios with investments in bullion (gold and silver) help in improving the risk return characteristics of the portfolios.

In the US, pension funds, insurance companies, and large endowments already invest about 3-5 per cent of the assets in commodities.

Increasingly continental European funds are also finding commodities to be a useful tool balancing tool. A series of regulatory and market initiatives will be needed to similarly make commodities a useful investment option in India.

However, under existing provisions of the Securities Contracts (Regulation) Act, 1956 (SCRA), commodities and their derivatives do not fall under the definition of 'securities'. And as a result investment in these does not fall under the purview of the Securities and Exchange Board of India.

Mutual funds are, therefore, prohibited from investing in commodities, including bullion and their derivatives.

If the expectation that authorities will formulate regulations enabling diversification of portfolio in commodities soon comes through, then investors will get the benefit of a portfolio less prune to volatility.