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The Golden Dilemma 10 Pickers Outperformed Their Benchmark Indices Claude B What Drives Corporate Pension Plan Contributions: Moral Hazard or Tax Benefits? 58 XUANJUAN CHEN, TONG YU, AND TING ZHANG In testing moral hazard and tax benefit hypoth- eses regarding defined benefit plan funding and contribution incentives by incorporating sponsors’ bankruptcy risk, the authors proposed that high- bankruptcy-risk sponsors have a strong moral hazard incentive because the put value of the U.S. Pension Benefit Guaranty Corporation guarantee is high. For low-bankruptcy-risk sponsors, the put value is low; maximizing tax benefits associated with pension contributions becomes a powerful incentive. Results based on sponsors’ voluntary Contents contributions support both hypotheses. VOL. 69, NO. 4 h JULY/AUGUST 2013 Equity Investments Active Share and Mutual Fund Guest Editorial Performance 73 Lessons on Grand Strategy 6 ANttI PETAJISTO CHARLES D. ELLIS, CFA Using Active Share and tracking error, the author Alternative Investments sorted all-equity mutual funds into various catego- ries of active management. The most active stock The Golden Dilemma 10 pickers outperformed their benchmark indices CLAUDE B. ERB, CFA, AND CAMPBELL R. HARVEY even after fees, whereas closet indexers underper- Although gold has been around for thousands of formed. These patterns held during the 2008–09 years, its role in diversified portfolios is not well financial crisis and within market-cap styles. Closet understood. The authors critically examined such indexing has increased in both volatile and bear popular stories as “gold is an inflation hedge.” markets since 2007. Cross-sectional dispersion in Investors face the following dilemma: The real price stock returns positively predicts performance by of gold is historically very high and may revert stock pickers. to the mean, but if prominent emerging markets increase their gold holdings, the real price of gold “Sell in May and Go Away” Just Won’t may rise even further from today’s elevated levels. Go Away 94 SANDRO C. ANDRADE, VIDHI CHHAOCHHARIA, Portfolio Management AND MICHAEL E. FUERST The authors performed an out-of-sample test of Flight to Quality and Asset Allocation in the sell-in-May effect documented in previous a Financial Crisis 43 research. Reducing equity exposure starting in TERRY MARSH AND PAUL PFLEIDERER May and levering it up starting in November per- With respect to the recent financial crisis, the sists as a profitable market-timing strategy. On authors argue that the appropriate adjustments average, stock returns are about 10 percentage to portfolio allocations in response to the market points higher for November–April half-year peri- dislocation are determined by equilibrium consid- ods than for May–October half-year periods. The erations (supply must equal demand) and depend authors also found that the sell-in-May effect is on individual investors’ characteristics relative to pervasive in financial markets. societal averages. Using a simple model that cap- Book Reviews 106 tures the magnitude of the recent crisis, the authors show that the optimal tactical adjustments for most In the Future 112 portfolios require a turnover of less than 10%. RODNEY N. SULLIVAN, CFA Articles in this publication qualify for CE credit under the guidelines of the CFA Institute Continuing Education Program. Articles each qualify for 1 CE credit; Perspectives pieces each qualify for 0.5 CE credit. Financial Analysts Journal Volume 69 · Number 4 ©2013 CFA Institute The Golden Dilemma Claude B. Erb, CFA, and Campbell R. Harvey Although gold has been around for thousands of years, its role in diversified portfolios is not well understood. The authors critically examined such popular stories as “gold is an inflation hedge.” Investors face the fol- lowing dilemma: The real price of gold is historically very high and may revert to the mean, but if prominent emerging markets increase their gold holdings, the real price of gold may rise even further from today’s elevated levels. he global equity and fixed-income markets disaster protection. We then examined basic supply- have a combined market value of about $90 and-demand factors. Remarkably, the new supply Ttrillion.1 Institutional and individual inves- of gold that comes to the market each year has not tors own most of the outstanding supply of stocks increased substantially over the past decade even and bonds. At current prices, the world’s stock of though the nominal price of gold has risen fivefold. gold is worth about $9 trillion. Yet, investors own We also looked at the distribution of gold ownership only about 20%, or less than $2 trillion, of the out- in both developed and emerging market countries standing supply of gold. A move by institutional and estimated the impact on gold demand if key and individual investors to “market-weight” gold emerging market countries were to follow the same holdings would require them to offer current gold patterns of central bank gold ownership as in impor- owners a price sufficiently attractive to incentiv- tant developed countries. ize them to part with their gold, probably sending Gold has had an amazing recent run. From both nominal and real prices of gold much higher. December 1999 to March 2012, the U.S. dollar Should investors target a gold “market weight”? price of gold rose more than 15.4% a year, the U.S. Could they achieve a gold market weight even if Consumer Price Index (CPI) increased by 2.5% they wanted to? a year, and U.S. stock and bond markets regis- The goal of our study was to better understand tered annual gains of 1.5% and 6.4%, respectively. how we should treat gold in asset allocation. We Indeed, Saad (2012) noted a recent Gallup poll that started by examining a number of popular stories found that some 30% of respondents considered that are used to justify some allocation to gold, gold the best long-term investment, making it a such as inflation hedging, currency hedging, and more popular investment than real estate, stocks, and bonds. Claude B. Erb, CFA, is retired. Campbell R. Harvey is Although some might use historical returns to the J. Paul Sticht Professor in International Business at estimate long-run forward-looking expected returns, the Fuqua School of Business, Duke University, Dur- an expected long-run real rate of return on gold of ham, North Carolina, and a research associate at the about 13% a year (15.4% nominal minus an assumed National Bureau of Economic Research, Cambridge, 2.5% annual inflation) is implausible. Yet, it is essen- Massachusetts. tial to have some sense of gold’s expected return Editor’s Note: A short piece called “Chinese CFOs Think for purposes of asset allocation. Current views are China Should Triple Gold Holdings” and a Chinese sharply divergent. On one side is Warren Buffett translation of it are available as Supplemental Information (2012), who has compared the current value of gold at www.cfapubs.org/doi/suppl/10.2469/faj.v69.n4.1. with three famous bubbles—the tulip bubble, the Authors’ Note: Campbell R. Harvey is associated with dot-com bubble, and the recent housing bust: the Man Group, plc, as its investment strategy adviser. What motivates most gold purchasers is Some of the Man Group’s investment funds trade gold their belief that the ranks of the fearful as part of diversified commodity portfolios. Professor Harvey does not offer to the Man Group any advice on will grow. During the past decade, that gold investment, and the Man Group was not involved belief has proved correct. Beyond that, in providing financial or other support for this indepen- the rising price has on its own generated dent research. Claude B. Erb is unaffiliated and also has additional buying enthusiasm, attracting no conflict of interest. purchasers who see the rise as validating 10 www.cfapubs.org ©2013 CFA Institute The Golden Dilemma an investment thesis. As “bandwagon” Gold as an Inflation Hedge investors join any party, they create their Probably one of the most widely held beliefs about own truth—for a while. (p. 18) gold is that it is an inflation hedge. Jastram (1978) On the other side is Ray Dalio, who argued pointed out that historically gold has been a poor in a Barron’s interview (see Ward 2011) that U.S. inflation hedge in the short run, though it has been Treasury bills are no longer a safe asset and that a good inflation hedge in the long run. For Jastram, there will be an ugly contest to depreciate the three the short run was the next few years and the long main currencies (dollar, yen, and euro) as countries run was perhaps a century. Jastram used the phrase print money to pay off debt: “the golden constant” to communicate his belief that the real price of gold maintains its purchasing power Gold is a very underowned asset, even over long periods and that gold’s long-run average though gold has become much more popu- real return has been zero. Harmston (1998) built on lar. If you ask any central bank, any sov- Jastrom’s research, finding that in the long run, some ereign wealth fund, any individual what goods, such as bread, seem to command a constant percentage of their portfolio is in gold in price when denominated in ounces of gold.5 “Gold relationship to financial assets, you’ll find it as an inflation hedge” means that if, for instance, to be a very small percentage. It’s an impru- inflation rises by 10% a year for 100 years, the price dently small percentage, particularly at a of gold should also rise by roughly 10% a year over time when we’re losing a currency regime. the same period. The “gold-as-an-inflation-hedge” It is not surprising that there is so much dis- argument says that inflation is a fundamental driver agreement about gold’s future.
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