Traditionally, investors have looked at gold as an inflation hedge and, sometimes, as an asset to protect them only in times of financial distress. While gold can serve in this role, its main value stems not only from these traits. Gold provides a unique source of diversification to an investor’s portfolio. It tends to have low correlations to most assets usually held by institutional and individual investors whether it is in good times or bad. It preserves wealth: Besides providing inflation protection, gold also acts as a currency hedge, in particular against the dollar with which gold correlates negatively. Moreover, it helps to manage risk more effectively by protecting against infrequent or unlikely but consequential negative events, often referred to as “tail risks.”
In recent years, investors have become more aware of the value gold can add to their portfolio. However, many do not realize that all the characteristics gold brings to an investor’s portfolio (diversification, risk management, and store of wealth) are underpinned by supply and demand dynamics that have undergone important developments in recent years. The global nature of the gold market and its diverse uses make it a unique asset. Here, we discuss the role that investment, jewelry, technology and official sector purchases play in the gold market.
The 2007-2009 financial crisis has brought back into perspective alternative strategies that place more emphasis on risk management. By using lessons learned during these tough times, investors may be better prepared when a new unforeseen event occurs. We believe gold’s role extends beyond affording protection in extreme circumstances. There are cost-effective strategies that can provide such protection without sacrificing return, and we show that gold can be an integral part of these strategies both for short- and long-term investors.
Using a portfolio optimizer, we find that including gold in a portfolio can reduce the volatility of the portfolio without necessarily sacrificing expected returns. Moreover, we show that including gold in portfolios not only delivers better risk-adjusted returns, but also can help to reduce potential losses. Specifically, we show that gold can generally expand the efficient frontier and reduce the value at risk (VaR) in a portfolio. We find that even relatively small allocations to gold, ranging between 2.5 percent and 9.0 percent, can increase risk-adjusted returns and help reduce the weekly 1 percent and 2.5 percent VaR of a portfolio by between 0.1 percent and 18.5 percent based on data from December 1987 to July 2010.
Developments In The Gold Market
Like any freely traded good or service, the price of gold is determined by the confluence of demand and supply. Demand for gold has traditionally come from three sectors—jewelry, industry and investment—while supply has come from newly mined gold, official sector sales and the recycling of above-ground stocks.
However, the gold market has experienced important developments over the past decade which, in turn, have influenced the performance of gold’s price. On the supply side, mine production remains lower than 2001 levels, despite a higher gold price. Producer de-hedging reduced the supply of gold coming from the miners. At the same time, rising mining costs put a higher floor underneath the gold price. The period has also been marked by a fundamental shift in the behavior of central banks, who were large suppliers of gold to the market in 2001 but became net purchasers starting in Q2 2009.
Meanwhile, on the demand side, strong GDP growth and a growing middle class in key jewelry-buying markets like India and China have contributed to higher price levels. While new ways to access the gold market were releasing pent-up investment demand, the advent of gold exchange-traded funds have allowed investors to buy gold on stock exchanges for the first time. However, the development of gold-backed ETFs in 2003 was mirrored by growing general interest in gold ownership, as evidenced by the concurrent rise in coin and bars sales.
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