Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Gold: it’s all about correlations
Gold has intrigued investors for almost as long as its existence, first as a store of wealth and currency and now as, well, what? Frontier, has taken a look at gold’s worth to professional investors. And it’s not about an inflation hedge.
Frontier’s Chris Trevillyan, director of investment strategy, and Nicholas Thomas, senior consultant, have examined the facts and myths surrounding gold in a paper, ‘A Golden Conundrum: why investors are weighing up the most prized element‘, published last month (July 23).
“Institutional investors have generally had little investment in gold because it provides no yield, unlike equities or bonds, and is therefore difficult to value,” they say. “However, prospective returns from traditional asset classes are low and rising inflation expectations mean more investors are considering if an allocation to gold should be considered.”
Deep-seated beliefs about the investment characteristics of gold – such as being a good hedge against inflation – suggest it could have a role to play for professional investors. But not all the beliefs stand up to scrutiny.
The paper says that gold displays some of the characteristics of both currencies and commodities and can’t be valued using common valuation methods because it has no cash flows. It is like a commodity in that it is mined and can be traded but has limited industrial use.
About half of gold production goes to make jewellery and the rest held by investors, including ETF promoters, and central banks as a store of wealth. For instance, during the GFC, central banks tended to reverse their gold sale program to re-build some of their reserves. Investors drive the price volatility because production is steady at about 1.5-2.0 per cent growth a year and demand also fairly even.
The paper says there appears to be some link between the price of gold and changes to the money supply over the long term. Rapid money supply growth in the 1970s was associated with increased inflation and the price of gold. Coincident with stabilisation of the money supply in the 1980s and 1990s was a decline in the gold price until about 2000. The recent jump in money supply growth to fight the impact of covid-19 could potentially be supportive of the gold price in the medium term.
Inflationary expectations may also help the price but gold actually has only a mixed track record as an inflation hedge, according to Trevillyan and Thomas. Even in the 1970s when the gold price and inflation both rose, the correlation was inconsistent. There were times when the gold price fell well ahead of a decline in inflation. There has not been a sustained period of deflation since the uncoupling of gold by central banks in 1970 but gold performed poorly from the 1980s until the end of the tech bubble when inflation was positive but declining.
Also, as a safe haven in a crisis, its history is mixed. Gold did not perform well in the GFC, for instance, and may act more like a safe haven when there is a lack of confidence in fiat money. “This is where gold’s inability to produce cash flows is a benefit,” the authors say. “It has no counterparty that could default.”
But, gold does have diversification benefits in a traditional portfolio, with performance being lowly correlated with most major asset classes, such as equities of all types, sovereign bonds and currencies.
In terms of a forecast for gold’s performance, the authors say that the future depends on gold continuing to perform as it has for thousands of years. It has historically held its purchasing power and delivered a positive real return over the very long term. (Over the six months to June 30, the price slipped 2.6 per cent to US$1,778.29 an oz.)
Frontier believes gold will deliver a slightly lower return above inflation than cash – currently expected to be about CPI plus 2 per cent – over the very long term.
“However, in the near term, our expectation is that cash will not deliver that excess return to the CPI; in fact, we assume that cash will deliver a negative real return over the next 10 years. This potentially makes gold a more interesting investment prospect.”
The authors’ final word is: “The allure of gold remains.”
