Sectors: Investment
Focus 1: Understanding gold valuation
Gold does not conform to most of the common valuation frameworks used for stocks or bonds. Without a coupon or dividend, typical discounted cash flow models fail. And there are no expected earnings or book-to-value ratios either.
Our research shows that, in fact, valuing gold is intuitive: its equilibrium price is determined by the intersection of demand and supply which we highlight with QaurumSM.8
- Economic expansion: periods of growth are very supportive of jewellery, technology and long-term savings
- Risk and uncertainty: market downturns often boost investment demand for gold as a safe haven
- Opportunity cost: the price of competing assets, especially bonds (through interest rates) and currencies, influence investor attitudes towards gold
- Momentum: capital flows, positioning and price trends can ignite or dampen gold's performance.
New decade, renewed challenges
As the new decade begins, investors face an expanding list of challenges around asset management and portfolio construction. Among these:
- Low interest rates, which may push investors to seek riskier assets at elevated valuation levels and, for US pension funds in particular, may increase the value of liabilities, possibly reducing their funding ratio
- Continued financial market uncertainty ranging from geopolitical tensions, to expectations of diverging global economic growth and an increase in asset volatility.
We believe that gold is not only a useful long-term strategic component for portfolios, but one that is increasingly relevant in the current environment. (see 2020 Gold Outlook).
The increased relevance of gold
Institutional investors have embraced alternatives to traditional stocks and bonds in pursuit of diversification and higher risk-adjusted returns. The share of non-traditional assets among global pension funds increased from 7% in 1998 to 26% in 2018 – this is 30% in the US2 (Chart 1).
Gold allocations have been recipients of this shift. It is increasingly recognised as a mainstream investment as global investment demand has grown by an average of 14% per year since 2001 and the gold price has increased by almost six-fold over the same period.3
The principal factors behind this growth include:
- Emerging market growth: economic expansion – particularly in China and India – increased and diversified gold’s consumer and investor base (see Chart 13, and Chart 24 in the full report)
- Market access: the launch of gold-backed ETFs in 2003 facilitated access to the gold market and materially bolstered interest in gold as a strategic investment, reduced total cost of ownership and increased efficiencies (see Chart 14 in the full report)
- Market risk: the global financial crisis prompted a renewed focus on effective risk management and an appreciation of uncorrelated, highly liquid assets such as gold (see Chart 15 in the full report). Today, trade tensions, the growth of populist politics and concerns about the economic and political outlook have encouraged investors to reexamine gold as a traditional hedge in times of turmoil (see Chart 25, and Chart 26 in the full report)
- Monetary policy: persistently low interest rates reduce the opportunity cost of holding gold and highlight its attributes as a source of genuine, long-term returns, particularly when compared to historically high levels of global negative-yielding debt (see Chart 23 and Table 2 in the full report)
- Central bank demand: a surge of interest in gold among central banks across the world, commonly used in foreign reserves for safety and diversification, has encouraged other investors to consider gold’s positive investment attributes (see Chart 16 in the full report).
Gold’s strategic role
Gold is a clear complement to stocks, bonds and broad-based portfolios. A store of wealth and, a hedge against systemic risk, currency depreciation and inflation, gold has historically improved portfolios’ risk-adjusted returns, delivered positive returns, and provided liquidity to meet liabilities in times of market stress.
1. A source of returns
Gold is long considered a beneficial asset during periods of uncertainty. Historically, it generated long-term positive returns in both good times and bad. Looking back almost half a century, the price of gold has increased by an average of 10% per year since 1971 when the gold standard collapsed.4 Over this period, gold’s long-term return was comparable to stocks and higher than bonds.5 Gold has also outperformed other major asset classes over the past two decades (Chart 2 and Chart 17 in the full report).
This duality reflects the diverse sources of demand for gold and differentiates it from other investment assets. Gold is used to protect and enhance wealth over the long-term and it operates as a means of exchange, because it has global recognition and is no one’s liability. Gold is also in demand as a luxury good, valued by consumers across the world. And it is a key component in electronics.6 These diverse sources of demand give gold a particular resilience: the potential to deliver solid returns in good times and in bad (Focus 1).
Beating inflation, combating deflation
Gold is long considered a hedge against inflation and the data confirms this. The average annual return of 10% over the past 49 years, has outpaced the US consumer price index (CPI).
Gold also protects investors against extreme inflation. In years when inflation was higher than 3% gold’s price increased 15% on average (Chart 3). Over the long-term, therefore, gold has not just preserved capital but helped it grow.
Notably too, research by Oxford Economics shows that gold should do well in periods of deflation.8 Such periods are characterised by low interest rates, reduced consumption and investment, and financial stress, all of which tend to foster demand for gold.
Outperforming fiat currencies
Investor demand has been boosted by persistently low interest rates and concerns about the outlook for the dollar, as these factors affect the perceived opportunity cost of holding gold.
Historically, major currencies were pegged to gold. That changed with the collapse of Bretton Woods in 1971. Since then, gold has significantly outperformed all major currencies as a means of exchange (Chart 4). This outperformance was particularly marked immediately after the end of the Gold Standard and, subsequently, when major economies defaulted. A key factor behind this robust performance is that the supply growth of gold has changed little over time – increasing by approximately 1.6% per year over the past 20 years.9 By contrast, fiat money can be printed in unlimited quantities to support monetary policy, as exemplified by the Quantitative Easing (QE) measures in the aftermath of the global financial crisis.
2. Diversification that works
The benefits of diversification are widely acknowledged—but effective diversifiers are hard to find. Many assets are increasingly correlated as market uncertainty rises and volatility is more pronounced, driven in part by risk-on/risk-off investment decisions. As a result, many so-called diversifiers fail to protect portfolios when investors need them most.
Gold is different, in that its negative correlation to stocks and other risk assets increases as these assets sell off (Download the full report to see Chart 26). The 2008-2009 financial crisis is a case in point. Stocks and other risk assets tumbled in value, as did hedge funds, real estate and most commodities, which were long deemed portfolio diversifiers. Gold, by contrast, held its own and increased in price, rising 51% from December 2008 to December 2009.10
This robust performance is perhaps not surprising.
Gold has consistently benefited from “flight-to-quality” inflows during periods of heightened risk. It is particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses (Download the full report to see Chart 25) Importantly too, gold allows investors to meet liabilities when less liquid assets in their portfolio are difficult to sell, undervalued and possibly mispriced.11,12
But gold’s correlation does not just work for investors during periods of turmoil. It can also deliver positive correlation with stocks and other risk assets in positive markets.
This dual benefit arises from gold’s dual nature: as an investment and a luxury good. As such, the long-term price of gold is supported by income growth. Our analysis bears this out, showing that when stocks rally strongly, their correlation to gold can increase (Chart 5), likely driven by a wealth-effect supporting gold consumer demand as well as demand from investors seeking protection against higher inflation expectations.
3. A deep and liquid market
The gold market is large, global and highly liquid.
We estimate that physical gold holdings by investors and central banks are worth approximately US$3.7trn, with an additional US$900bn in open interest through derivatives traded on exchanges or the over-the-counter market.13
The gold market is also more liquid than several major financial markets, including German Bunds, euro/Yen and the Dow Jones Industrial Average, while trading volumes are similar to the S&P 500 (Chart 6). Gold’s trading volumes averaged US$145bn per day in 2019. During that period, over-the-counter spot and derivatives contracts accounted for US$78bn and gold futures traded US$65bn per day across various global exchanges. Gold-backed ETFs offer an additional source of liquidity, with the largest US-listed funds trading an average of US$2bn per day.
The scale and depth of the market mean that it can comfortably accommodate large, buy-and-hold institutional investors. In stark contrast to many financial markets, gold’s liquidity does not dry up, even at times of acute financial stress.
4. Enhanced portfolio performance
Long-term returns, liquidity and effective diversification all benefit overall portfolio performance. In combination, they suggest that a portfolio’s risk-adjusted returns can be materially enhanced through the addition of gold.
Our analysis of investment performance over the past five, 10 and 20 years underlines gold’s positive impact on an institutional portfolio. It shows that the average US pension fund would have achieved higher risk-adjusted returns if 2.5%, 5% or 10% of the portfolio were allocated to gold. (Chart 7) and (Table 1). The positive impact has been particularly marked since the global financial crisis.
Looking to the future, stronger dynamics apply. Our analysis shows that US dollar-based investors can benefit from a material enhancement in performance if they allocate between 2% and 10% of a well-diversified portfolio to gold (Chart 8a).14
The amount of gold varies according to individual asset allocation decisions. Broadly speaking however, the higher the risk in the portfolio—whether in terms of volatility, illiquidity or concentration of assets—the larger the required allocation to gold, within the range in consideration, to offset that risk (Chart 8b).
Our analysis indicates that gold’s optimal weight in hypothetical portfolios is statistically significant even if investors assume an annual return for gold of between 2% and 4%--well below its actual long-term historical performance.
This works equally for investors who already hold other inflation-hedging assets, such as inflation-linked bonds,15 and for investors who hold alternative assets, such as real estate, private equity and hedge funds.16
Table 1: Gold increases risk-adjusted returns by reducing portfolio volatility and drawdowns across various time horizons
Comparison of average pension portfolio versus similar portfolio with 5% gold over the past one, five, ten and twenty years.
| 20-year | 10-year | 5-year | 1-year | |||||
|---|---|---|---|---|---|---|---|---|
| No gold | 5% gold | No gold | 5% gold | No gold | 5% gold | No gold | 5% gold | |
| Annualised return | 6.40% | 6.50% | 8.40% | 8.20% | 7.00% | 6.90% | 21.70% | 21.50% |
| Annualised volatility | 10.00% | 9.70% | 8.60% | 8.30% | 7.40% | 7.10% | 7.40% | 7.20% |
| Risk-adjusted returns | 62.80% | 67.10% | 97.70% | 98.80% | 94.60% | 97.90% | 293.80% | 298.70% |
| Maximum drawdown | -42.40% | -39.80% | -12.70% | -11.80% | -8.20% | -7.50% | -2.50% | -2.30% |
*Based on performance between 31 December 1999 and 31 December 2019. The average PF portfolio is based on Willis Tower Watson Global Pension Assets Study 2019 and Global Alternatives Survey 2017.
Ibid Source: Bloomberg, ICE Benchmark Administration, World Gold Council
Conclusion
Perceptions of gold have changed substantially over the past two decades, reflecting increased wealth in the East and a growing appreciation of gold’s role within an institutional investment portfolio worldwide.
Gold’s unique attributes as a scarce, highly liquid and un-correlated asset highlight that it can act as a genuine diversifier over the long term.
Gold’s position as an investment and a luxury good has allowed it to deliver average returns of approximately 10% over the past 50 years, comparable to stocks and more than bonds and commodities (see Chart 2)
Gold’s traditional role as a safe-haven asset means it comes into its own during times of high risk. But gold’s dual appeal as an investment and a consumer good means it can generate positive returns in good times too.
This dynamic is likely to persist, reflecting persistent political and economic uncertainty, persistently low interest rates and economic concerns surrounding stock and bond markets (see 2020 Gold Outlook).
Overall, extensive analysis suggests that adding between 2% and 10% of gold to a US-dollar based portfolio will make a tangible improvement to performance and boost risk-adjusted returns on a sustainable, long-term basis (see Chart 7).
Footnotes
1See (Chart 7) for more details behind the composition of the hypothetical average US pension fund portfolio. In addition, refer to important disclaimers and disclosures at the end of this report.
2Willis Towers Watson, Global Pension Assets Study 2018, February 2019 and Global Alternatives Survey 2017, July 2017. https://www.willistowerswatson.com/en-US/insights/2017/07/Global-Alternatives-Survey-2017
3As of 31 December 2019
4During the gold standard, the US dollar was backed by gold and the foreign currency exchange rates were dictated by the Bretton Woods System: https://www.imf.org/external/about/histend.htm.
5For other return metrics and y-o-y performance download the full report to see Appendix.
6Download the full report to see Chart 11 on page 10.
7Qaurum is a web-based quantitative tool that helps investors intuitively understand the drivers of gold’s performance that can be explained by four broad sets of drivers.
8Oxford Economics, The impact of inflation and deflation on the case for gold, July 2011.
9See the demand and supply section at Goldhub.com.
10Based on the LBMA PM gold price fix from 1 December 2008 to 30 November 2009.
11Download the full report to see Chart 10 and Figure 1 on p9 as well as the holders and trends section at Goldhub.com.
12Analysis based on the re-sampled efficiency methodology developed by Richard and Robert Michaud and praised as a robust alternative to traditional mean-variance optimisation. See Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Oxford University Press, January 2008.
13Gold as a tactical inflation hedge and long-term strategic asset, July 2009.
14How gold improves alternative asset performance, Gold Investor, Volume 6, June 2014.
15See: Gold: the most effective commodity investment, September 2019, and Gold: metal by design, currency by nature, Gold Investor, Volume 6, June 2014.