Glittering gains: Is there an investment case for gold?

Imran Hussein

Associate Consultant

The bottom line:

Gold can play a useful role in investment portfolios as a diversifier during periods of market stress, and sometimes act as a hedge against inflation over the long term. Although gold exhibits significant price volatility, it has generally produced strong returns (in fiat currency terms) during times of market uncertainty, however there have been periods of negative, or muted returns.

Gold is a symbol of wealth and status that’s lasted for centuries. It can be used for a wide range of purposes and is associated with all things luxurious, from jewellery to sports cars – even ‘high-end’ dining.

Jewellery comprises around 1/3 of global gold demand and is more stable. Demand from the investment sector is significantly more volatile and is the main driver of the gold spot price. This sector includes financial institutions such as central banks, gold Exchange Traded Products (ETPs) and other similar offerings.

Large institutions are building up gold reserves, again?

Over the last decade, central banks have been net buyers of gold following two decades of being net sellers. Central bank gold purchases reported in 2022 hit their highest level since 1967, only a few years before the abandonment of the Bretton Woods agreement.

As of 2022, the United States holds the largest gold reserves in the world, at approximately 9,223 metric tons of gold (up from 8,133 in 2021). Other countries with significant holdings include Germany, Italy, France, China and Russia.

Countries hold significant amounts of gold reserves for various reasons. One of the primary reasons is to serve as a store of value and a hedge against inflation and currency fluctuations. Gold is considered a safe-haven asset and is seen as a reliable store of value, especially during times of economic uncertainty or crisis.

Additionally, holding gold reserves can help to increase a country's financial stability and credibility. A lack of counterparty risk has also been cited as a key attraction for the increased purchase of gold by central banks when compared with other asset classes and foreign currencies.

How to access gold?

1. Physical gold

You can buy physical gold in the form of bars, coins or jewellery. However, this method requires you to store and secure the gold yourself which can be costly and cumbersome.

2. Gold Exchange-Traded Products (ETPs)

Investors can also gain exposure to gold through ETPs such as Exchange Traded Funds (ETFs) or Exchange Traded Commodities (ETCs). These are traded on exchanges and aim to provide direct exposure to the price of gold. Gold ETFs are investment funds that buy and sell physical gold or gold futures contracts, while Gold ETCs are debt securities backed by physical gold held by the issuer or a third-party custodian. Both of these products charge management fees.

We believe this is the most accessible method for investors interested in allocating to gold.

3. Gold futures and options

Futures contracts are agreements to buy or sell a specified amount of gold at a predetermined price and date in the future, while options give the holder the right, but not the obligation, to buy or sell gold at a specific price on or before a specific date in the future. These instruments offer liquidity however rolling futures and options can be expensive.

4. Gold mining stocks

Investing in stocks of companies that are involved in the mining, refining or marketing of gold. However, these stocks are more correlated to the broad equity market than gold and therefore offer fewer diversification benefits.

Background and performance to date

With a total market cap of c. $12 trillion and an average daily trading volume of $180 billion, gold is one of the largest, most liquid assets in the world and its price has seen significant appreciation in fiat currency terms over the past few decades.

Historical gold price per ounce in USD, 31 December 1969 – 28 February 2023

Source: Global Financial Data, Refinitiv Datastream and Invesco

Impact of currency on returns

Returns for gold are largely dependent on the investors’ currency, eg a GBP investor in gold would have considerably outperformed that of a USD investor over the last 50 years, mainly due to the pound depreciating vs the dollar. Gold is priced in dollars, and the depreciation of GBP vs USD means that it takes more GBP to buy the same amount of USD needed to purchase gold.

Looking at the price of one US dollar in gold ounces, the USD has declined in value relative to gold (it takes more US dollars to purchase the same amount of gold). Gold can therefore act as a store of value and a hedge against inflation, particularly for investors concerned about the purchasing power of their currency decreasing. Gold’s price recently increased amidst the bank turmoil in relation to SVB and Credit Suisse, further supporting the notion of gold acting as a safe haven asset and a diversifier during periods of market stress.

Cumulative price return January 1971-February 2023

Source: Bloomberg, data shown gross of fees to 28 Feb 2023, Gold Spot Price monthly % change (USD/oz), LBMA Gold Price (GBP/oz)

Does gold provide diversification benefits?

Over the last 20 years, gold’s diversification benefits have been supported through showing positive returns on average during global equity ‘down’ months, and even higher returns on average in months where global equities were up. It has also exhibited low correlation against other traditional asset classes and broad commodity indices.

Source: Bloomberg, data shown gross of fees to 28 Feb 2023. MSCI Daily TR Gross World Local, Barclays Global Agg Corp Bonds (USD), Gold Spot Price monthly % change (USD/oz), US Treasury TIPS 0-5 Years Total Return Index USD, S&P Goldman Sachs Commodity Index Total Return USD, FTSE World Government Bond Index (WGBI) USD.

Is gold an inflationary hedge?

Gold has traditionally been viewed as a safeguard against inflation, particularly after the end of the Bretton Woods system in 1973. The abandonment of the gold standard made currencies more volatile and led to an increase in inflation, and subsequently the price of gold.

However, gold has experienced mixed returns for investors during high inflationary periods. For instance, from 1980 to 1984, when the average global annual inflation rate was 11.4% p.a. (OECD YoY% Average global inflation), the price of gold fell by c. 10% p.a. in USD terms, making it challenging to view gold as a solid hedge against inflation in the short term.

Key risks

One drawback of gold is that it pays no income. It doesn’t pay dividends like stocks or have a coupon like bonds. Therefore it is not possible to calculate expected value based on cashflows. Its return is purely derived through changes in price. It is therefore difficult to set an expected return for gold. As can be seen below, gold exhibits strong volatility with returns varying significantly depending on the initial investment date. The key message here is that the timing of investment can be critical if the intention is to only hold gold for the short term.

Monthly five year rolling returns pa 31 December 1940 – 28 February 2023

Source: Global Financial Data, Refinitiv Datastream and Invesco, Gold USD. Performance shown gross of fees.

Whilst the price of gold has appreciated over the long term, the volatility for gold has historically been higher than other ‘traditional assets’ as shown in the chart below. This heightened volatility helps to explain the disparity in performance for gold over different time periods. Therefore, allocating to gold may not be suitable for investors with a short time horizon and long-term investors need to be comfortable with the volatility.

Expected risk-return over 20 years pa to 28 February 2023

Gold generally exhibits higher levels of risk to global equities, however its returns have varied significantly. Over the last 20 years it has produced similar returns, although this largely depends on the initial investment date. When compared against broad market indices for global equities and commodities, gold has fared well across multiple time periods - see performance comparison chart here.

Environmental, social and governance issues

Gold-mining operations expend around 130 terawatt-hours per year. Beyond energy expenditure, gold mining damages the environment in other ways like toxic waste and landscape destruction. However, responsible gold miners can mitigate risks and contribute heavily to the communities and host countries they operate in, through the likes of improvement to infrastructure. Further, most of the gold being traded today has already been mined.

The LBMA (London Bullion Market Association) helps to set standards for the quality, purity, and production of gold and silver traded in London.

Conclusion

Gold can play a useful role in investment portfolios as a diversifier and can sometimes act as a hedge against inflation. However, gold’s historical returns vary significantly depending on start and end points, even over multi-decade periods.

A strong emphasis should be placed on holding gold for the long term if introducing a strategic allocation within a portfolio. A small portfolio allocation (5-10%) can provide diversification benefits during periods of market stress and help to protect against fiat currency debasement, however investors should be comfortable with significant volatility. A strategic allocation to gold should be tranched over time to avoid investing at a particularly unfavourable period.