F-Squared Investments present an outlook on the gold industry. They look at the past 12 years of gold’s performance, noting its unique circumstances as an asset class untethered to others. F-Squared Investments is a a quantitatively based boutique investment firm.
The year 2013 is over. Time to tally up the gains and losses, reflect on the ups and downs in the investment world, and just possibly, find a lesson or two to be learned. Led by the U.S. equity markets, 2013 had many winners. And there was at least one very prominent loser, gold, represented by the SPDR Gold Trust (ETF) (NYSEARCA:GLD), which was down -28.3%.
What made that drop so noticeable and so newsworthy was that it was the first calendar-year loss for gold since the beginning of the millennium. For 12 years, through two bull and bear cycles, three U.S. presidential campaigns, two wars, inflation fears, deflation fears, irrational exuberance, a nasty credit crisis, Enron, the Facebook Inc (NASDAQ:FB) IPO, and the near collapse of the euro, gold always showed positive returns on an annual basis.
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A consistent 12-year trend naturally starts to look like a sure thing. But now that the spell has been broken, the press is full of logical and obvious-in-hindsight explanations of why gold went down.The Fed’s bond-buying program is now winding down, and it has yet to cause a rise in inflation. The situation in Europe has stabilized. The U.S. credit rating downgrade and the government shutdown turned out to be non-events. There are others.
Due to its low correlation to other asset classes, gold is part of many of our Indexes, including virtually all our Alphasector Allocator Indexes (the “Indexes”), and along with real estate, represents a combined 10% allocation to real assets in the Indexes. For example, in our AlphaSector Allocator Index, our quantitative model signaled the Index to remove gold in late December of 2012 at prices somewhat below its 2012 high of $174.07 which was hit on October 4, 2012. The Index then stayed out of gold for all of 2013. Further, because the portfolio construction rules of the Index dictate that if we are not allocated to gold, but are still positive on the U.S. market (i.e. no allocation to cash equivalent ETFs), we allocate the proceeds from removing gold into the S&P 500. We essentially swapped an asset that would go down 28% in value during 2013 for another that would go up 32% during the same year. As gold would otherwise make up 5% of the Index, this move alone resulted in an appreciation of 3% in the Index for the year.
Defensive Position in Gold – AlphaSector Allocator Index*
The gold asset class is shown as a selected sample chosen to illustrate divergent performance of the markets in the year 2013, and is not intended to represent all major asset classes of the AlphaSector Indexes. And what subtle insight into the future led us to this very profitable decision? A sage viewpoint on the Fed’s next move or on international relations, perhaps? Faith that the politicians in Washington would decide to be grown-ups and find a workable compromise on the budget?
At our core, we at F-Squared Investments are volatility and price trend investors. Our allocation decisions are based on the pattern of prices and volatility of an asset. GLD began to trend downward with increasing volatility, so our quantitative model removed gold from the Indexes. All that other information, the Fed, the fate of the Eurozone, and so on, was not part of our investment algorithms, and we believed that it was already reflected in the price and volatility movements of gold. Our view is that the market is pretty good at what it does and that, by and large, all the important news stories and the predictions of the near future that go with them are baked into the prices of assets, gold included.
Of course, believing that markets are pretty good at what they do is a long way from believing that they are perfectly efficient. We believe that news gets reflected in prices, but not instantly. New information is usually not reflected by sudden jumps (or drops) in prices but by trends, upward or downward tendencies in prices that can last weeks or months. Changes in levels of volatility can move more rapidly, and can often be an indicator of a negative price trend. These two factors are blended together in our investment models to determine the right time to exit a sector, asset class, or investment category.
And so it was with gold: 2012 was an up year for GLD (+6.6%), but by the day we got out in December, it was down -6.9% from its October high. That is a significant down trend, and combined with its volatility pattern, it was enough for our quantitative model to pull the trigger and remove gold from the Indexes. Meanwhile, our U.S. Indexes had no allocation to cash equivalents, so the allocation from gold was put into the S&P 500. Both those trends, gold moving downward and U.S. stocks moving upward, continued throughout 2013, and we maintained the positions we took last December for the entire year.