China edition

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 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 across the globe have embraced alternatives to traditional stocks and bonds in pursuit of diversification and higher risk-adjusted returns. For example, the share of non-traditional assets among global pension funds increased from 7% in 1999 to 23% in 2019² (Chart 1).

Gold allocations have been recipients of this shift. It is increasingly recognised as a mainstream investment; evidenced by global investment demand that has grown by an average of 14% per year since 2001 and a gold price that has increased 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 – has increased and diversified gold’s consumer and investor base (see Chart 13, and Chart 25 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 16 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 23, and Chart 24 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 26 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 15 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 (Chart 18 in the full report).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 15 years (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 8% over the past 15 years, has outpaced the Chinese consumer price index (CPI). 

Gold also protects investors against extreme inflation. In years when inflation was higher than 3% gold’s price increased 18% 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. Not only does it exhibit a low correlation to most major assets (see Chart 27 in the full report) but its negative correlation to stocks and other risk assets increases as these assets sell off (Chart 23, p14). 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. For example, Shanghai Stock Composite Index fell by over 60% from December 2007 to February 2009. RMB-denominated gold, by contrast, held its own and increased in price, rising 64% over the same period.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 (see Chart 24 and Chart 25 in the full report) Importantly too, gold allows investors to meet liabilities when less liquid assets in their portfolio are difficult to sell, or are 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 Chinese RMB 26tn, with an additional Chinese RMB 7tn in open interest through derivatives traded on exchanges or the over-the-counter (OTC) market.¹³

The gold market is also more liquid than several major financial markets, including German Bunds, euro/GBP and the Shanghai Stock Composite Index, while trading volumes are similar to 1-3 year US Treasuries (Chart 6). Gold’s trading volumes averaged Chinese RMB 1tn per day in 2019. During that period, OTC spot and derivatives contracts accounted for Chinese RMB 542bn and gold futures traded Chinese RMB 451bn per day across various global exchanges. Gold trading volumes on Shanghai Gold Exchange and Shanghai Futures Exchange contributed to Chinese RMB 42bn and Chinese RMB 62bn. Gold-backed ETFs offer an additional source of liquidity, with the Chinese-listed funds trading an average of Chinese RMB 1.8bn 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, ten and 15 years underlines gold’s positive impact on an institutional portfolio. It shows that the average Chinese insurance fund would have achieved higher risk-adjusted returns if 3%, 5% or 8% 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 Chinese RMB-based investors can benefit from a material enhancement in performance if they allocate between 3% and 8% 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.

	15-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	4.68%	4.86%	2.83%	2.88%	2.66%	2.97%	8.74%	9.49%
Annualised volatility	8.24%	7.90%	6.38%	6.11%	7.24%	6.80%	4.33%	3.98%
Risk-adjusted returns	56.75%	61.54%	44.33%	47.08%	36.74%	43.67%	201.81%	238.80%
Maximum drawdown	-34.72%	-33.73%	-17.00%	-16.14%	-17.00%	-16.14%	-3.23%	-2.98%

*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, China Securities Index, ChinaBond Pricing Center, 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. 8% over the past 15 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 3% and 8% of gold to a Chinese RMB 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 Chinese insurance fund average portfolio. In addition, refer to important disclaimers and disclosures at the end of this report.

²Willis Towers Watson, Global Pension Assets Study 2019, February 2020 and Global Alternatives Survey 2017, July 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 see Appendix in the full report

⁶See Chart 11, on page 11 in the full report.

⁷Qaurum is a web-based quantitative tool that investors can use to intuitively understand the drivers of gold’s performance based on these four broad sets of drivers: economic expansion; risk and uncertainty; opportunity cost and momentum.

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 Shanghai Gold Exchange’s Au9999 from 31 December 2007 to 28 February 2009.

¹¹See Chart 24 in the Appendix in the full report

¹²See also Chart 25 in the Appendix in the full report

¹³See Chart 10 and Figure 1 in the Appendix as well as the holders and trends section at Goldhub.com.

¹⁴Analysis 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.

¹⁵Gold as a tactical inflation hedge and long-term strategic asset, July 2009.

¹⁶How gold improves alternative asset performance, Gold Investor, Volume 6, June 2014.

¹⁷See: Gold: the most effective commodity investment, September 2019, and Gold: metal by design, currency by nature, Gold Investor, Volume 6, June 2014.

Footnotes