In a deep dive into the fundamentals, the World Gold Council claims gold has a key role as a strategic long-term investment and as a mainstay allocation in a well-diversified portfolio

Gold is a highly liquid asset, which is no one’s liability, carries no credit risk, and is scarce, historically preserving its value over time. It also benefits from diverse sources of demand: as an investment, a reserve asset, gold jewellery, and a technology component. These attributes mean gold can enhance a portfolio in three key ways:

• Delivering long-term returns 
• Improving diversification 
• Providing liquidity

Combined, these characteristics make gold a clear complement to stocks and bonds and a welcome addition to broad-based portfolios.

Moreover, the shift towards a greater integration of environmental, social and governance (ESG) objectives within investment strategies has important implications and we believe gold can play a role in supporting these. Gold — from established investment sources — should be recognised as an asset that is responsibly produced and delivered from a supply chain that adheres to high ESG standards. Gold also has a potential role to play in reducing investor exposure to climate-related risks.

Gold's key attributes – 1. Return

A long-term source of return

Investors have long considered gold a beneficial asset during periods of uncertainty. Yet, historically, it has generated long-term positive returns in both good and bad economic times. Its diverse sources of demand give gold a particular resilience and the potential to deliver solid returns in various market conditions (Figure 1). Gold is, on the one hand, often used as an investment to protect and enhance wealth over the long term, but on the other hand it is also a consumer good, via jewellery and technology demand. During periods of economic uncertainty, it is the counter-cyclical investment demand that drives the gold price up. During periods of economic expansion, the pro-cyclical consumer demand supports its performance. Combined, these factors give gold the ability to provide stability under a range of economic environments.

Looking back over half a century, the price of gold in US dollars has increased by nearly 8% per year since 1971 when the US gold standard collapsed. Over this period, gold’s long-term return is comparable to equities and higher than bonds. Gold has also outperformed many other major asset classes over the past 3, 5, 10 and 20 years (Chart 1).

Moreover, the diversity of its sources of demand help to make gold a less volatile asset than some equity indices, other commodities or alternatives (Chart 2).

Gold has long been considered a hedge against inflation and the data confirms this: since 1971 it has outpaced the US and world consumer price indices (CPI). Gold also protects investors against high inflation. In years when inflation was between 2%-5%, gold’s price increased 8% per year on average. This number increased significantly with even higher inflation levels (Chart 3). Over the long term, therefore, gold has not just preserved capital but also helped it grow.

Our research also shows that gold should do well in periods of deflation. Such periods are characterised by low interest rates, reduced consumption and investment, and financial stress, all of which tend to foster gold demand.

Store of value

Historically, major currencies were pegged to gold. That changed with the unravelling of the US gold standard in 1971 and the eventual collapse of the Bretton Woods system. Since then, with few exceptions, gold has significantly outperformed all major currencies and commodities as a means of exchange. And although this outperformance was particularly marked immediately following the end of the gold standard, gold has clearly continued to outperform most major currencies in the more recent past (Chart 4). A key factor behind this robust performance is that gold mine production has grown slowly over time – increasing by approximately 1.7% per year over the past 20 years.

By contrast, fiat money can be printed in unlimited quantities to support monetary policy, as exemplified by the quantitative easing measures in the aftermath of the Global Financial Crisis (GFC) and the COVID-19 pandemic. In these crises, many investors turned to gold in order to hedge themselves against currency devaluation and preserve their purchasing power over time.

In fact, the rapidly increasing US money supply and the low-rate environment fostered an optimal environment for gold to perform well (Chart 5).

Gold's key attributes – 2. Diversification

Diversification that works

This robust performance is not surprising. With few exceptions, gold has been particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses (Chart 7).

But gold’s correlation does not just work for investors during periods of turmoil. It can also deliver positive correlation with equities and other risk assets in positive markets, making gold a well-rounded efficient hedge (Chart 8).

This benefit arises from gold’s dual nature: as both an investment and a consumer good. As such, the long-term performance of gold is supported by income growth. Our analysis bears this out, showing that when equities rally strongly their correlation to gold can increase. This is driven by a wealth effect supporting gold consumer demand, as well as demand from investors seeking protection against higher inflation expectations.

Gold’s key attributes – 3. Liquidity

A deep and liquid market

Portfolio impact – 1. Risk/reward profile

Risk/reward profile

Long-term returns, liquidity and effective diversification all benefit overall portfolio performance. In combination, they suggest that the addition of gold can materially enhance a portfolio’s risk-adjusted returns.

Our analysis of investment performance over the past 3, 5, 10 and 20 years emphasises gold’s positive impact on an institutional portfolio (Chart 11).

It shows that an average USD portfolio would have achieved higher risk-adjusted returns and lower drawdowns if 2.5%, 5%, 7.5% or 10% were allocated to gold (Chart 12 and Table 1).

In addition to a traditional historical simulation, a mean variance optimisation analysis suggests that an allocation to gold may result in a material enhancement to portfolio risk-adjusted returns by shifting the efficient frontier upwards. For example, a portfolio with gold could deliver a higher return for the same level of risk, or the same return for a lower level of risk (Chart 13).

The ‘optimal’ amount of gold varies according to individual asset allocation decisions. Broadly speaking, the analysis suggests that the higher the risk in the portfolio – whether in terms of volatility or concentration of assets – the larger the required allocation to gold, within the range in consideration, to offset that risk (Chart 14).

Portfolio impact – 2. ESG credentials

Gold’s ESG credentials and contributions

Potential risks and challenges

Given the risk/reward trade-off associated with any investment, it is important to acknowledge and understand not only opportunities, but also key risks.

Non-standard valuation: 
Gold does not directly conform to the most common valuation methodologies used for equities or bonds. Without a coupon or dividend, typical models based on discounted cash flows, expected earnings, or book-to-value ratios struggle to provide an appropriate assessment for gold’s underlying value. This presented an opportunity for the World Gold Council to develop a framework to better understand gold valuation.

Our gold valuation framework allows investors to understand the drivers of gold demand and supply and, based on market equilibrium, estimate their impact on price performance.

No cash flows:
A widely perceived drawback of gold is that it does not provide any regular income, unlike other asset classes such as bonds, property or even some company stocks. But the reason for this is simple: gold has no credit risk. There is no promise to repay. Nor does it bear any counter-party risk. This means, however, that investors depend on price appreciation to benefit from gold. And in this regard gold has a good track record. It has generated long-term positive returns in both good and bad economic times. At the same time, gold has outperformed many other major asset classes over various investment horizons (3 years, 5 years, 10 years, 20 years, and 50 years). Gold’s strong performance is no coincidence: it is a by-product of the underlying demand and supply dynamics, which combine a natural scarcity with diverse sources of demand including jewellery, technology, investment and central banks.

Price volatility:
Gold is a great diversifier to a portfolio because it behaves so differently to equities and bonds, not because it has a low volatility. And while gold is a less volatile asset than some equity indices, other commodities or alternatives, in some years the metal has posted close to 30% gains (2010) and in other years it has posted close to 30% losses (2013). On balance, however, gold has an asymmetric correlation profile with equities; in other words, it does much better when equities fall than it does badly when equities rise.

Conclusion

Perceptions of gold have changed substantially over the past two decades, reflecting increased wealth in the East and a growing worldwide appreciation of gold’s role within an institutional investment portfolio.

Gold’s unique attributes as a scarce, highly liquid and uncorrelated asset enable it to act as a diversifier over the long term. Gold’s position as an investment and a luxury good has allowed it to deliver annualised returns of nearly 8% since 1971, comparable to equities and more than bonds and commodities.

Gold’s traditional role as a safe-haven asset means it comes into its own during times of high risk. But its dual appeal as an investment and a consumer good means it can generate positive returns in good times too. This dynamic is likely to continue, reflecting ongoing political and economic uncertainty, and economic concerns surrounding equity and bond markets.

This article is a re-post from here.

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