China edition

Sectors: Investment

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

 

Chart 1: Investors continue to add alternative investments, including gold, to their portfolios

Chart 1: Global investors have added alternative investments, including gold, to their portfolios* - China edition

Sources: World Gold Council, Willis Towers Watson; Disclaimer

*As of December 2019. Based on Willis Towers Watson Global Pension Assets Study 2019, published February 2020.

 

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).

 

Chart 2: Gold has delivered positive returns over the long run, outperforming key asset classes

Chart 2: Gold has delivered positive returns over the long run, outperforming key asset classes - China edition

Average annual return of key global and domestic assets in Chinese RMB*

Sources: Bloomberg, Shanghai Gold Exchange, World Gold Council, Wind; Disclaimer

*As of 31 December 2019. Computations in Chinese RMB of CSI Money Market Fund Index, Shanghai Stock Composite Index, Bloomberg Commodity Total Return Index, MSCI EM Total Return Index, MSCI DM Total Return Index, ChinaBond New Aggregate Total Return Index, and spot for Shanghai Gold Exchange’s Au9999. For compounded annual growth rates see Appendix.

 

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.

 

Chart 3: Gold has historically rallied in periods of high inflation

Chart 3: Gold has historically rallied in periods of high inflation - China edition

Gold returns in Chinese RMB as a function of annual inflation*

Sources: Bloomberg, Shanghai Gold Exchange, World Gold Council; Disclaimer

*Based on annual changes of Shanghai Gold Exchange’s Au9999 and Chinese Consumer Price Index between 2004 and 2019. **For each year on the sample, real return = (1+nominal return)/(1+inflation)-1.

 

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. 

 

Chart 4: Gold has outperformed all major fiat currencies over time

Chart 4: Gold has outperformed all major fiat currencies over time - China edition

Relative value between major currencies and gold since 1900*

Sources: Bloomberg, Harold Marcuse – UC Santa Barbara, World Gold Council; Disclaimer

*As of 31 December 2019. Based on the annual average price of a currency relative to the gold price. **The ‘Mark’ was the currency of the late German Empire. It was originally known as the Goldmark and backed by gold until 1914. It was known as the Papermark thereafter.

 

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.

 

Chart 5: Gold’s correlation with stocks helps portfolio diversification in good and bad economic times

Chart 5: Gold’s correlation with stocks helps portfolio diversification in good and bad economic times - China edition

Correlation between gold and Chinese stock returns in various environments of stocks’ performance*

Sources: Shanghai Gold Exchange, World Gold Council, Wind; Disclaimer

*As of 31 December 2019. Correlations computed using weekly returns based on Shanghai Stock Composite Index, CSI Chinese Commodity Composite Index and Shanghai Gold Exchange’s Au9999 since December 2004. The middle bar corresponds to the correlation conditional on Shanghai Stock Composite Index’s weekly return changing less than one standard deviation over the full period. The bottom bar corresponds to the correlation conditional on Shanghai Stock Composite Index’s weekly return falling by more than one standard deviations (or ‘s’) respectively, while the top bar corresponds to Shanghai Stock Composite Index’s weekly return increasing by more than one standard deviations. The standard deviation is based on the same weekly returns over the full period.

 

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.  

 

Chart 6: Gold trades more than many other major financial assets

Chart 6: Gold trades more than many other major financial assets - China edition

Average daily trading volumes in Chinese RMB*

Sources: Bloomberg, Bank for International Settlements, UK Debt Management Office (DMO), Germany Finance Agency, Japan Securities Dealers Association, London Bullion Market Association, Wind; Disclaimer

*Based on estimated one-year average trading volumes as of 31 December 2019, except for currencies that correspond to March 2019 volumes due to data availability. **Gold liquidity includes estimates on over-the-counter (OTC) transactions and published statistics on futures exchanges, and gold-backed exchange-traded products. For methodology details visit the liquidity section at Goldhub.com.

 

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

 

Chart 7: Adding gold over the past decade would have increased risk-adjusted returns of a hypothetical average pension fund portfolio

Chart 7: Adding gold over the past decade would have increased risk-adjusted returns of a hypothetical average insurance fund portfolio - China edition

Performance of a hypothetical average insurance fund portfolio with and without gold*

Sources: Bloomberg, China Banking and Insurance Regulatory Commission, Shanghai Gold Exchange, World Gold Council; Disclaimer

*Based on performance between 31 December 2004 and 31 December 2019. The hypothetical average Chinese insurance fund portfolio is based on China Banking and Insurance Regulatory Commission’s published information and regulations on asset investment restrictions. It includes annually-rebalanced total returns of a 20% allocation to stocks (Shanghai Stock Composite Index as a proxy), 70% allocation to fixed income ( ChinaBond New Aggregate Total Return Index as a proxy), and 10% cash (CSI Money Market Fund Index as a proxy). The allocation to gold comes from proportionally reducing all assets. Risk-adjusted returns are calculated as the annualised return/annualised volatility. See important disclaimers and disclosures at the end of this report.

 

Chart 8a: Gold can significantly improve risk-adjusted returns of hypothetical portfolios across various levels of risk

Chart 8a: Gold can significantly improve risk-adjusted returns of hypothetical portfolios across various levels of risk - China edition

(a) Long-run optimal allocations based on return scenarios*

Sources: Bloomberg, China Banking and Insurance Regulatory Commission, Shanghai Gold Exchange, World Gold Council; Disclaimer

 

Chart 8b: Gold can significantly improve risk-adjusted returns of hypothetical portfolios across various levels of risk

Chart 8b: Gold can significantly improve risk-adjusted returns of hypothetical portfolios across various levels of risk - China edition

(b) Performances of optimal portfolios with and without gold under 5% targeted return *

Sources: Bloomberg, China Banking and Insurance Regulatory Commission, Shanghai Gold Exchange, World Gold Council; Disclaimer

*Based on monthly total returns from December 2004 to December 2019 of CSI Money Market Fund Index, ChinaBond New Aggregate Total Return Index, Shanghai Stock Composite Index and Shanghai Gold Exchange’s Au9999. Each hypothetical portfolio composition reflects a percentage in stocks, cash equivalent assets, bonds and gold. And asset weights’ adjustments are subjected by China Banking and Insurance Regulatory Commission’s investment restrictions on insurance funds. Analysis based on New Frontier Advisors Resampled Efficiency. For more information see Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Oxford University Press, January 2008.

See important disclaimers and disclosures at the end of this report.

 

Chart 9: Gold has outperformed all broad-based indices and all individual commodities

Chart 9: Gold has outperformed all broad-based indices and all individual commodities - China edition

15-year commodity and commodity index returns*

Sources: Bloomberg, Shanghai Gold Exchange, World Gold Council, Wind; Disclaimer

*Annualised returns from December 1999 to December 2019 in Chinese RMB. Indices include: Wind Chinese Commodity Index, Wind Chinese Grain Index, Wind Chinese Copper Index, CSI Chinese Agriculture Index, S&P GS Sliver Total Return Index, S&P GS Livestock Total Return Index, Bloomberg Commodity Total Return Index, Shanghai Gold Exchange’s Au9999 and PT9995 .

 

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, 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

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.

Important disclaimers and disclosures

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By receiving this information, you agree with the intended purpose of this information as being for educational purposes only.  Diversification does not guarantee any investment returns and does not eliminate the risk of loss.    

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Information regarding QaurumSM and the Gold Valuation Framework 

Note that the resulting performance of various investment outcomes that can generated through use of Qaurum, the Gold Valuation Framework and other information are hypothetical in nature, may not reflect actual investment results and are not guarantees of future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss.  World Gold Council and its affiliates and subsidiaries (collectively, “WGC”) provide no warranty or guarantee regarding the functionality of the tool, including without limitation any projections, estimates or calculations.