How can gold fit into a portfolio?

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How can gold fit into a portfolio?

Advisers and investment managers are often divided over whether an investor needs an allocation to gold in a portfolio at all, and if they do, how much it should account for.

Gold is probably best known as being a defensive asset. Over the years it has earned the name ‘safe haven asset’ because it is uncorrelated to bonds and equities.

For this reason, it can be a useful diversifier in a portfolio but like many alternative assets, it is not always clear how best to get exposure.

Alex Scott, deputy chief investment officer at Seven Investment Management, believes there is a decent case for holding gold.

If you look at gold versus benchmark bond and equity ETFs over a 10-year period, you will see clearly that gold is relatively uncorrelated to these asset classes.Nick Hammon

“We think well diversified portfolios can justify having some exposure to gold at present,” he says. “Low real yields are quite a helpful backdrop for gold as they reduce the ‘opportunity cost’ of holding gold, which of course produces no income, versus having cash on deposit instead.

“Gold has shown low correlation to both equities and bonds over time, and has potential as a hedge both against known risks – inflation, political/financial instability, US dollar weakness – and unknown or undefined risks.”

Going for gold

But Nick Hammond, executive director at Baird & Co believes gold is and always has been difficult to place in investment strategies. 

He explains: “On the one hand it is viewed as a safe haven providing insurance against tail risk events, as it did during the 2008 financial crisis.

"On the other hand it can sometimes behave more like a ‘risk on’ asset. For instance, the gold price has dipped along with equities these last few weeks.

“It comes down to the fact that assets display different correlation characteristics over different timescales. If you look at gold versus benchmark bond and equity ETFs over a 10-year period, you will see clearly that gold is relatively uncorrelated to these asset classes. In times of market and geopolitical stress, it is a fantastic ‘insurance policy’.”

BullionVault has an interactive tool on its website which shows investors the impact of adding gold to a 60:40 equity:bond portfolio.

According to BullionVault in a portfolio of UK investment assets, the value of gold as investment insurance has been great for hedging UK assets over the last 40 and 20 years.

Figure 1: Diversifying a simple UK portfolio with gold, 1977-2016

RiskNo gold    5% gold   10% gold   25% gold
Worst 1-year loss in per cent (2008)-13.1-10.4-7.6-9.2*
Worst 5 years (2000-04, annualised return)11.21.42.1
     
Total returns (no costs or tax)No gold5% gold10% gold25% gold
1077-2016 compound annual growth12.412.312.111.4
Last 20 years compound growth rate7.87.988.2
Average 5 years (middle of range, annual)12.912.511.710.8

*1990 figure; 2008 +0.8%

Source: BullionVault

It reveals having 10 per cent in gold almost halved the losses of 2008 on a simple 60:40 portfolio of UK equities and government bonds, while going 25 per cent gold reduced that risk still further.

However, over a longer period buying gold has made UK portfolios a little more volatile, cutting the overall annualised rate of return since 1977, according to BullionVault’s calculations.

Mr Hammond suggests: “In terms of asset allocation – it certainly makes sense to have a long-term strategic allocation to gold and most wealth managers have now woken up to this. 

“The amount will depend on your investor profile – what is your risk appetite and how much income do you need to generate – but typically you need to look at 1 per cent to 5 per cent for a long-term strategic allocation.”

Is there demand?

He points out the demand for gold is partly down to the fact there is limited supply, with only 175,000 tonnes in the world and supply only increasing by around 1.7 per cent a year. 

It also pays to know where demand for gold is coming from. The precious metal has a range of uses in jewellery, with demand coming from India and China in particular.

We access gold through exchange-traded products backed by physical gold holdings. In our view those are a robust way to access gold without the costs and difficulties of owning gold in physical form.Alex Scott

Gold also has its uses in technology, with the World Gold Council reporting increasing adoption of wireless charging and the development of features using LEDs has boosted demand.

Central banks also buy gold as they hold gold reserves.

Despite this, the World Gold Council reported demand actually declined slightly in the second quarter of 2017, compared to a year earlier.

Global gold demand in the second quarter was 953 tonnes, down 10 per cent on the second quarter of 2016 as inflows into exchange-traded funds slowed.

But within that, there are some bright spots, as Alistair Hewitt, head of market intelligence at the World Gold Council, acknowledges.

“Last year’s growth was solely down to record ETF inflows, while consumer demand slumped,” he notes. 

“So far this year we have seen steady ETF inflows in Europe and the US, jewellery demand has recovered with good growth in India, while retail investment and technology demand is up too.”

Having decided they want gold in their portfolio, what is the best vehicle for investors to get this exposure?

Mr Scott suggests: “We access gold through exchange-traded products backed by physical gold holdings. In our view those are a robust way to access gold without the costs and difficulties of owning gold in physical form.”

Annabel Brodie-Smith, communications director at the Association of Investment Companies, points out some investment company managers have exposure, particularly in the Sector Specialist: Commodities and Natural resource sector. 

“Investment company managers also invest in gold as a defensive asset,” she adds.

“For example, a number of investment companies in the Flexible Investment sector hold gold, with Personal Assets, which has a capital preservation strategy, currently holding 9.7 per cent of their portfolio in gold bullion and Ruffer holding 5 per cent of their portfolio in gold.”

Mining for gold

It is crucial investors get the type of exposure most suited to their investment goals.

One of the mistakes often made by investors is to invest in mining companies as a proxy for investing in actual gold, which Mr Hammond cautions against.

“For a start, gold miners are not closely correlated to gold as they use hedging to lock in prices. They also tend to fall with the rest of the market at times of corrections so you’re not getting your ‘insurance policy’.

"And there is always a risk of misstatement of reserves which can crater a miner’s share price,” he warns.

Instead, he believes an allocation to physical gold is the best approach.

“For your core allocation, physical gold will always be less risky and cheaper – it has no credit risk as it is yours and you hold it, it has very little liquidity risk because most bullion traders will always be happy to buy it back, and it has fully transparent pricing,” he reasons. 

“Importantly, it also has significant tax advantages. For example, there is no capital gains tax on UK bullion coins such as Sovereigns and Britannias.”

Mr Hammond continues: “You can also invest in relevant unit trusts, Oeics and pooled vehicles, but they can be costly with management fees of between 1.5 to 2.5 per cent.

"More importantly they are not pure plays as they often have little exposure to pure gold and more exposure to gold miners and other commodities such as diamonds.”

eleanor.duncan@ft.com