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1 r a t her t han a s a f e haven For Professional Advisers only - not for onward distribution Investors exposure to gold continues to grow but we believe that more consideration of the risks is needed. Steady flows mean that almost 2,500 metric tons of physical gold, valued at more than $130 billion, are now held in physical gold exchange-traded funds (ETFs). The case for owning gold is very compelling: Western governments are destroying the value of fiat currencies to gain short-term competitive advantages Monetisation of debt is the inevitable end game for Western central banks and governments Geopolitical risk and failing economies create demand for safe havens Very strong historical performance with low long-term correlation to other asset classes Very high investor risk aversion in other asset classes. The risks of owning gold at current prices have also grown: Gold volatility is the same as equity volatility, and has tracked equity volatility since 2008 Over the long term, equity and gold have shown no correlation in returns Over the past three years correlation between gold and the S&P 500 has risen to almost 0.8 Dr. Ana Cukic Armstrong Joint managing partner Patrick Armstrong, CFA Joint managing partner The case for an allocation to gold in a diversified portfolio remains, but it should now be viewed as a speculative asset, with bubble like characteristics, rather than a safe haven. An allocation to gold has served investors very well, but as with all investments that seem to be perfect, when they fail, they fail spectacularly. All of the compelling benefits, added to the fact it is almost impossible to value, provide the necessary ingredients for a bubble in gold prices. Gold s current high correlation with equities, and similar implied volatility, means investors hoping for a diversification benefit from gold holdings may be badly let down. One of the most striking results of our analysis is that the correlation between gold and silver has declined from 0.86 (between 2004 and 2012) to 0.67 between 2010 and Recently a portfolio of equities and gold has had less diversification benefits than a portfolio made up of gold and silver holdings. 1

2 Investors exposure to gold continues to grow but we believe that more consideration of the risks is needed. The case for owning gold is very compelling. Western governments and central banks have been destroying the value of fiat currencies in a bid to deal with their massive debts and deficits. Quantitative easing, or money printing, is a form of currency devaluation, which helps a country s competitiveness. It also ultimately leads to inflation, which is the only viable solution Western governments have to address their unsustainable debt to GDP ratios (the others options being above-normal growth, outright default or austerity, none of which are credible solutions). In the face of currency devaluation it makes sense to hold real assets, such as gold, that represent a store of value. All of the compelling benefits, added to the fact it is almost impossible to value, provide the necessary ingredients for a bubble in gold prices % Growth of S&P 500 and Gold S&P 500 Gold Dec-02 Dec-04 Dec-06 Dec-08 Dec Source: Bloomberg, AIM, 31 December February Strong performance from gold has led to everincreasing exposure to gold for retail investors. Geopolitical risk and failing economies create demand for safe havens. Investors have a tendency to look to the asset classes that performed well during the previous crisis and assume that they will perform a similar function during the next crisis. However, valuations tend to be overlooked and these asset classes move into bubble territory. Golden performance Gold, having performed well after the Lehman crisis and during subsequent eurozone sovereign debt-related equity sell-offs, has many such characteristics. Over the past three years, gold has returned 21.6% annualised in US dollar terms (27/02/09 29/02/12). It traded at $440 per ounce in January 2005 and exceeded $1900 per ounce last year. 2

3 We believe gold should now be viewed as a speculative investment, with bubble-like characteristics rather than a safe haven. Ten years ago gold was not owned by retail investors but was primarily held by central banks. Strong performance, uncorrelated returns with other asset classes and the advent of easily-accessible ETFs have seen investors make ever-increasing allocations to the precious metal. Steady flows mean that almost 2,500 metric tons of physical gold, valued at more than $130 billion, are now held in physical gold ETFs. High correlation to equities, and similar volatility, means investors hoping for a diversification benefit may be badly let down Are we entering a new correlation regime where gold is evolving from a safe haven to a risky asset? Diversification doubts We continue to believe that an allocation to gold makes sense in a diversified portfolio, but investors should not view it as a safe haven without its own inherent risks. 1. The implied volatility of gold is as high as that of equities. Gold volatility has been as high as equity volatility and tracked equity volatility for many years now. However, gold has not been exposed to a sustained sell-off for the past decade, and this has led to complacency from investors. Given its implied volatility, if a sell-off in gold occurred, the magnitude would be similar to the losses suffered by equities in past crises. 2. The correlation of gold to equities has gone from 0 to 0.8. Over the long term, gold has been a perfect portfolio diversifier positive returns with no correlation to traditional asset classes. Over the past three years gold prices have shown a correlation of 0.8 with the S&P500. Implied gold and equity volatility Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Source: Bloomberg, AIM, March Gold and equity volatility have moved together since 2008 and are at almost identical levels currently Source: Bloomberg CBOE Gold Volatility Index VIX Index Rolling three year correlations: S&P 500 vs Gold Rising and very high correlation to equities 02/01/ /01/ /01/ /01/2012 Rolling three year correlations have moved from -60% three years ago to +80% today 3

4 One of the most striking results of our analysis is that the correlation between gold and silver has declined from 0.86 (between 2004 and 2012) to 0.67 between 2010 and Recently a portfolio of equities and gold has had less diversification benefits than a portfolio made up of gold and silver holdings. Formation of bubbles Investor psychology seems to lead to situations where the asset class that best survived the previous market crash tends to go to an extreme valuation in the following years, moving into a bubble of its own. Technology stocks weathered the 1998 Asian currency crisis because their strong revenue growth reassured investors of their prospects despite the macro risks. Two years later these technology stocks were set to implode based on extreme valuations. During the tech wreck beginning in 2000, property and commodities performed very well and showed no correlation to broader equity markets. This set the stage for an immense amount of investment and speculation in these assets classes. Property became an ever-increasing element in many investors portfolios and new instruments based on property loans sowed the seeds for the property crash and the credit crisis beginning in 2008, while there was a 60% decline in the S&P GSCI Oil index. The safe havens from the last crash were gold, government bonds, Swiss franc and Japanese yen. Investor psychology seems to lead to situations where the asset class that best survived the previous market crash tends to go to an extreme valuation in the following years, moving into a bubble of its own Correlation and volatility study: Gold, S&P 500, Silver Correlation statistics While correlation between gold and the S&P 500 was between 2004 and 2012, the correlation increased to 0.79 between 2009 and If we include lags (lagged impact of 1, 6, 12 months), the correlation between gold and equity increases to 0.89 between 2009 and The correlation between gold volatility and VIX (an index of implied equity volatility) increased from 0.58 between 2004 and 2012 to 0.90 between 2009 and The correlation between the S&P 500 and VIX remains high at 0.77 (if lags are included) or 0.31 during and 0.35 between , in a static model. Gold and gold volatility remain uncorrelated. The correlation between silver and VIX is 0.74 (with lags) or 0.38 in a static model. Silver is more correlated with VIX than gold. An allocation to gold has served investors very well, but as with all investments that seem to be perfect, when they fail, they fail spectacularly. 4

5 Ar m s t r ong I nvestment M a nagers Important Information: For professional investors and advisors only. This document is not suitable for private customers. Issued by Armstrong Investment Managers LLP (AIM) which is authorised and regulated by the Financial Services. This presentation is intended for authorised or exempt persons (as defined in the Financial Services and Markets Act 2000) or to investment professionals as defined in the Financial Services and Markets Act 2000 (Financial Promotion) Order All other persons should disregard the contents hereof. AIM and its respective members, officers, and/or employers and/or agents do not accept any liability in respect of this presentation. Please note that past performance is not a guide to the future. It is not intended to constitute legal, tax or accounting advice or opinion. No representation or warranty, expressed or implied, is made as to the accuracy, completeness or thoroughness of the content of the information. The recipient should consult with its own legal, tax or accounting advisers as to the accuracy and application of the information contained herein and should conduct its own due diligence and other enquiries in relation to such information. Certain information in this presentation has not been independently verified by AIM. AIM disclaims any responsibility for any errors or omissions in such information, including the financial calculations, projections and forecasts set forth herein. No representation or warranty is made by or on behalf of aim that any projection, forecast, calculation, forward looking statement, assumption or estimate contained in this presentation should or will be achieved. Please note that, in providing this presentation, aim has not considered the objectives, financial position or needs of the recipient. This presentation does not carry any right of publication. Neither this presentation nor any of its contents may be reproduced or used for any other purpose without the prior written consent of AIM. 5

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