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As the new decade begins, investors face an expanding list of challenges around asset management and portfolio construction. 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).
Investors have embraced alternatives to traditional stock and bond investments in pursuit of diversification and higher risk-adjusted returns. The share of non-traditional assets among global pension funds, for example, increased from 7% in 1998 to 23% in 2019 – this is 30% in the US2 (Chart 1). And a similar pattern can be seen in the portfolio composition of individual investors.3
Gold allocations have been recipients of this shift. Gold 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.4
The principal factors behind this growth include:
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.
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.5 Over this period, gold’s long-term return was comparable to stocks and higher than bonds. Gold has also outperformed other major asset classes over the past two decades (Chart 2).
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. These diverse sources of demand give gold a particular resilience: the potential to deliver solid returns in good times and in bad (Focus 2).
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.6
In particular gold’s performance can be explained by four broad sets of drivers:
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.7 Such periods are characterised by low interest rates, reduced consumption and investment, and financial stress, all of which tend to foster demand for gold.
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.8 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.
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. 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, the S&P 500 fell by 50% from December 2007 to February 2009. Gold by contrast held its own, rising 14% over the same period.9
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. Importantly too, gold allows investors to meet liabilities when less liquid assets in their portfolio are difficult to sell, undervalued and possibly mispriced.
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.
The gold market is large, global and highly liquid.
We estimate that physical gold holdings by investors and central banks are worth approximately US$3.7tn, with an additional US$900bn in open interest through derivatives traded on exchanges or the over-the-counter market.10
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.
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 investor portfolio. For example, an average US investment portfolio would have achieved higher risk-adjusted returns if 2.5%, 5% or 10% of the portfolio were allocated to gold over the past decade (Chart 7). The positive impact has been particularly marked since the global financial crisis.
In addition to historical back-testing, a more comprehensive optimisation analysis based on New Frontier Advisors Resampled EfficiencyTM 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).11
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,12 and for investors who hold alternative assets, such as commodities (Focus 3), real estate, private equity and hedge funds.13
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 investment portfolios worldwide.
Gold’s unique attributes as a scarce, highly liquid and un-correlated asset prove 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% for nearly five decades, 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 the current environment of high political and economic uncertainty, historically low interest rates and 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).
1See (Chart 7) for more details behind the composition of the hypothetical average US investment 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. www.willistowerswatson.com/en-US/News/2020/02/global-pension-assets-on-the-rise
32019 US Trust High Net Worth allocation survey.
4As of 31 December 2019.
5During 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.
6Qaurum 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.
7Oxford Economics, The impact of inflation and deflation on the case for gold, July 2011.
8See the demand and supply section at Goldhub.com.
9Based on the S&P 500 Index and the LBMA Gold Price PM from the end of December 2007 to the end of February 2009.
10See the holders and trends section at Goldhub.com.
11Analysis 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.
12Gold as a tactical inflation hedge and long-term strategic asset, July 2009.
13How gold improves alternative asset performance, Gold Investor, Volume 6, June 2014.
14See: Gold: the most effective commodity investment, September 2019, and Gold: metal by design, currency by nature, Gold Investor, Volume 6, June 2014.
