Investment Portfolio Construction Enhancements

Precious metals are a form of commodities that are rare and possess high economic value. The value of these metals is based on various factors including their relative scarcity, use in industrial applications and investment demand. Precious metals can serve an important role in an investment portfolio for several reasons including for capital appreciation and favorable returns, to increase diversification (exhibit 1) as an inflation and currency hedge, and for protection during periods of economic and market upheaval.

As the name suggests, precious metals consist of a basket of metals (usually gold, silver, platinum and palladium) as opposed to a single metal such as gold. A basket approach provides diversification benefits while preserving the unique investment characteristics of each precious metal.

Investment options include buying the physical asset, investing in a company that mines for the metal, or through a professional money manager. Professional money managers use different approaches to gain exposure to this asset class, often using sophisticated strategies such as structured notes and derivative contracts.

The investment team at Cape Cod 5 selected an experienced, well-regarded investment manager with a long history in the asset class. Exposure is achieved through a low-cost exchange-traded fund (ETF) offering substantial liquidity. The fund holds physical assets (actual bars of the precious metals) through an independent custodian.

Emerging market government bonds are debt instruments issued by developing countries. While emerging equity markets are associated with higher risk factors, their debt can be attractive. Yields on these types of bonds are compelling and compare favorably against high yield corporate bonds on a credit-adjusted basis. In addition to income, these bonds can provide diversification benefits.

Emerging market debt has grown significantly over the past decade. The emergence of more regions issuing debt has increased the volume of bonds, creating greater liquidity, wider country participation and higher quality issuers. Today, the emerging markets bond market has become a completely standard asset class for many investors.

Bonds can be issued in U.S. dollars (hard currency) or local currency. Local currency issuance has gained in popularity and demand in recent years. While governments remain the largest issuer, the corporate market has grown steadily. Bonds issued in local currency can be “hedged” to eliminate the impact of changes in local currency value relative to the U.S. dollar, which can increase volatility. To avoid this, Cape Cod 5 selected an investment manager focused on a broadly diversified, low-cost U.S. dollar denominated portfolio.

Treasury Inflation-Protected Securities (TIPS) are a type of bond designed to protect against rising consumer prices. TIPS are indexed to inflation, have U.S. government backing, and pay investors a fixed interest rate as the bond’s par value adjusts to changes in the inflation rate. In an inflationary environment, the Treasury pays interest on the adjusted par value of the bond, creating a rising stream of interest payments. In a deflationary environment, the face value and interest payments of TIPS decrease but maintain purchasing power with the now lower cost of goods and services.

TIPS offer a real rate of return – the return of an investment after inflation is taken into account. Conventional bonds keep a fixed face value until maturity and offer a nominal return with no inflation adjustment. With traditional government bonds, inflation can erode the purchasing power of future interest and principal payments. TIPS can be an effective diversification tool and have demonstrated an ability to lower overall portfolio volatility due to their low correlation with other types of investments.