| 19 September 2012-The value of gold in an investment portfolio |
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The value of gold in an investment portfolio A small allocation to gold could add significant benefits to a client’s investment portfolio, writes BetaShares's Drew Corbett. The value of including gold in a balanced investment portfolio was examined by Oxford Economics in 2011. A detailed analysis of the performance drivers of gold was conducted over an extended historical period and a forward-looking model was built to illustrate the likely gold performance under a range of scenarios. The results showed gold is expected to underperform assets like equities in a benign/growth environment, but is expected to add significant portfolio benefits in deflationary and inflationary economic conditions. Most importantly, the findings further exemplified that the inclusion of gold bullion in a balanced portfolio had the additional benefit of reducing the expected volatility in the investment returns. We have run some analysis for Australian investors to demonstrate the portfolio benefit of including a 5 per cent exposure to physical gold bullion (with the A$/US$ exchange rate hedged). We combined a 5 per cent allocation to physical gold bullion (currency hedged) with a 95 per cent allocation to the return of the S&P/ASX200. Drivers of gold value There are certain drivers which gold investors should be aware of, although in the last few years quantitative easing has been the primary driver of gold prices. Any further easing in the second half of 2012 is likely to further impact gold prices in the short term. Historically, quantitative easing has coincided with a sharply rising gold price. The simplest explanation of this phenomenon is that quantitative easing is typically linked with a rise in inflation, due to deliberate debasement of the US dollar and the euro. Inflation, or the spectre of inflation, leads investors to the ‘safe haven’ of gold, raising gold prices. Less discussed in the media as a driver of the gold price is official sector activity (governments, central banks, sovereign wealth funds), which has a material impact on the gold price. As at 2010, the sector held globally 30,500 tons, which was 15 per cent of total above-ground reserves. The growth in official reserves in the 2000s was led by the emerging markets (many of which moved into trade and current account surpluses during the 2000s) and followed by developed nations after the global financial crises. Net central bank buying of gold was 73 tonnes in 2010 and 77 tonnes in 2011, with greater demand contributing to the rise in gold prices. Another factor that is important to understand as an Australian gold investor is the value of the US dollar, which typically moves inversely with the price of gold. Since exchange rates were floated in the 1970s, several studies have tracked the link between the US dollar and gold. Such a link exists because a falling dollar increases the purchasing power of countries which do not use the dollar (and a rising dollar reduces their purchasing power). This may lead to a rise in the prices of commodities including gold (or drives them down in case of a stronger dollar). Also, in periods of US dollar weakness, investors may seek alternative stores of value, which tend to lead to a rise in gold prices. Therefore, if Australian investors have currency unhedged exposures to gold, when gold rallies, returns are likely to be eroded by the depreciation of the US dollar against the Australian dollar and vice versa. While there are other factors influencing the price of gold such as interest rates and political instability, the areas covered are most likely to have the largest effect on gold over the medium term. Gold under various future economic conditions Some potential scenarios in the future for investment markets – benign, deflationary and inflationary – were examined by the Oxford Economics study described above. In a benign scenario where the global recovery continues and global economic growth is maintained, gold was predicted to be a relatively weak contributor to portfolio returns. Growth assets like shares and property would likely provide better returns in this scenario. In a deflationary environment caused by continued instability in the global financial system, with peripheral European banking and sovereign defaults, the likely response would be a further debasement of the monetary systems through expanded quantitative easing. During times of deflation, gold was predicted to be an important component of the investment portfolio, with expected returns better than shares and property but behind the returns from bonds and cash. Finally, it was found that gold would also be a good store of wealth in an inflationary scenario, most likely driven by loose monetary policy. The current concern is that rising inflation might be repeated in the near- to -medium future – which could happen if economic recovery accelerates and liquidity isn’t withdrawn in pace with the recovery. Gold was predicted to be one of the best-performing assets during inflation, followed by equities. Bonds were the worst performer, as the return of capital at maturity doesn’t match the rising cost of real assets. Despite criticism from some corners that gold produces no income and is a poor investment, research shows that gold should perform well compared with other asset classes in most market conditions except during strong global growth. Under all other scenarios, gold is likely to add value to a balanced investment portfolio’s returns with the additional benefit of reducing volatility. |
