Gold: the most effective commodity investment

Why it is under-represented in commodity indices, under-invested and the potential impact on your portfolio

Most investors access this asset class via commodity indices, which invariably include gold.

But gold’s weighting within these indices undervalues its importance as a strategic portfolio asset (Table 1 and Table 2). Gold is, of course, a raw material used in the production of manufactured goods – the very definition of a commodity. But gold is much more than that. Gold is an investment as much as a consumer good, it is a multi-faceted asset that enjoys diverse supply and demand dynamics that play an important role in gold’s performance (See Appendix II for more information).

Standing apart from the commodities complex, gold deserves to be seen as a differentiated asset as it has historically benefited from six key characteristics.

• Gold has delivered better long-term, risk-adjusted returns than other commodities
• Gold is a more effective diversifier than other commodities
• Gold outperforms commodities in low inflation periods
• Gold has lower volatility
• Gold is a proven store of value
• Gold is highly liquid

Ultimately, commodities can be a relevant tactical asset, but a strategic gold allocation can supplement or replace a broad-based investment in commodities alone, as it may offer more widespread benefits (Chart 15).

Better returns, effective diversification

Outperforming commodities

Gold as an investment has performed broadly in line with the S&P 500 over the long term, delivering average annual returns of 10.4% since the elimination of the gold standard in 1971 (Chart 1), and a compound annual return of 7.6% (Chart 16, Appendix I).

But, when compared to commodities, gold has outperformed not only broad-based indices but sub-indices and most individual commodities too. All sub-indices, including precious metals, have fallen over the past five years. But gold has risen during that time. Gold has also outperformed major commodity sub-indices over the past 10 and 20 years (Chart 2), and outperformed most individual commodities, many of which have delivered negative returns in recent decades (Chart 17, Appendix I).

Chart 1: Annualised returns of gold and other assets

Gold returns are on par with the stock market over the long run*

^{*As of 30 June 2019. Based on total returns indices including MSCI US, MSCI EAFE, MSCI EM, JPMorgan 3-month US cash, BarCap US Bond Aggregate, Bloomberg Commodity for the 10- and 20-year average, and S&P GSCI since 1971 due to data availability. Gold performance based on the LBMA Gold Price. Data between January 1971 and 30 June 2018.}

Chart 2: Commodity sub-index returns

Gold outperformed commodity sub-indices over the past 5-, 10- and 20-years*

^{*Annualised returns through June 2019.
Indices include: S&P GS Energy Index, S&P GS Precious Metals Index, S&P GS Industrial Metals Index, S&P GS Non-Precious Metals Index, Gold (US$/oz) London PM fix.}

Diversification that counts

Gold has important diversification properties that come into their own during periods of systemic risk.

Gold has little or no correlation with many other assets, including commodities (Table 3), during times of stress. Crucially, however, the correlation is dynamic, changing across economic cycles to the benefit of investors.

Like other commodities, gold is positively correlated to stocks during periods of economic growth when equity markets tend to rise. However, gold is negatively correlated with other assets during risk-off periods, protecting investors against tail risks (Chart 3) and other events that can have a significant negative impact on capital or wealth – a protection not always present in other commodities.

This dynamism reflects the dual nature of gold as an investment and as a consumer good. When economic conditions are benign, expenditure tends to increase on items such as jewellery or technological devices (Chart 4), and this works in gold’s favour. During times of systemic risk, however, market participants seek high-quality, liquid assets that preserve capital and minimise losses. This can also benefit gold investment demand and drive up the price of gold. In the Q4 2018 global equity sell-off, for example, the S&P 500 fell 14% and commodities fell 9%, yet gold rose 8%.

Chart 3: Gold, unlike commodities, tends have a positive performance when volatility increases

Performance of stocks, gold, commodities and VIX during periods of systemic risk*

^{**The VIX is available only after January 1990. For events occurring prior to that date, annualised 30-day S&P 500 volatility is used as a proxy. Dates used: Black Monday: 9/1987-11/1987; LTCM: 8/1998; Dot-com: 3/2000-3/2001; September 11: 9/2001; 2002 recession: 3/2002-7/2002; Great recession: 10/2007-2/2009; Sovereign debt crisis I: 1/2010-6/2010; Sovereign debt crisis II: 2/2011-10/2011; 2018 Pullback 10/2018–12/2018. Commodities is the Bloomberg Commodity Index.}

Chart 4: US stocks' correlation to major financial assets during expansions and contractions

Gold is more negatively correlated to the market than Treasuries in periods of contraction*

^{*As of 30 June 2019. Based on monthly returns from January 1987 to June 2019 of the S&P 500, MSCI ACWI ex US, BarCap Treasuries and Corporates, Bloomberg Commodity Index and LBMA Gold Price. Business cycles as defined by the National Bureau of Economic Research (NBER).}

Gold is also a more effective diversifier than other precious metals. While gold’s correlation to silver and platinum was positive during periods of growth, it decreased during market downturns as these other metals depend, to a greater extent, on industrial demand (Chart 5 and Chart 18, Appendix I).

Chart 5: Gold and silver correlation

Correlation between gold, commodities and silver with US stock returns, in various environments of stocks’ performance*

^{*As of 30 June 2019. Correlations computed using weekly returns based on the Bloomberg Commodity Index and the LBMA Gold and Silver Price PM since January 1987.
The middle bar corresponds to the unconditional correlation over the full period. The bottom bar corresponds to the correlation conditional on S&P 500 weekly return falling by more than two standard deviations (or ‘σ’) respectively, while the top bar corresponds to the S&P 500 weekly return increasing by more than two standard deviations. The standard deviation is based on the same weekly returns over the full period.}

Gold and oil prices are not correlated, contrary to popular belief. At times, the two commodities move in the same direction, at others in opposite directions (Chart 6), but there is no consistent relationship between the two. Oil tends to behave more like a risky asset, while gold is widely regarded as a risk-off asset (Chart 19, Appendix I).

Chart 6: Correlation between gold and oil (monthly returns)*

Looking back over the past 45 years, gold’s correlation to oil ranges from -.2 to .55 on a two-year rolling monthly basis.

^{*As of 30 June 2019.
Data is calculated using the rolling two-year correlation of monthly returns of oil and gold. The LBMA PM fix price is used for the price of gold and the oil prices are determined via the Bloomberg Historical Oil Price Index as well as the Bloomberg WTI Crude Oil Sub Index Total Return.}

Low Volatility

Gold is less volatile than most individual commodities and broad commodity indices (Chart 7 and Chart 20, Appendix I). It is also less volatile than equities: from individual stocks to industry sectors, to indices such as the Global MSCI series (Chart 21, Appendix I). As such, gold can enhance portfolio stability and improve risk-adjusted returns.

Chart 7: Gold, precious metals and commodity index volatility

Gold is less volatile than most major commodity indices*

^{*June 2009 to June 2019 annualised daily volatility of various commodities.}

Protecting against inflation

Commodities are often used for diversification during periods of high inflation. While it is true that commodities have performed well during inflationary periods, gold has performed better. And in periods of low inflation, commodities delivered negative nominal returns, while gold posted positive returns, reflecting increased demand when economic conditions are robust (Chart 8).

This behaviour is particularly relevant today. Current inflation expectations are low, so gold should outperform other commodities. Future expectations suggest a growing risk of higher inflation. This should also drive demand for gold.

Chart 8: Gold and commodity returns as a function of inflation

Both work well in high inflation environments but commodities break down in low inflation markets*

^{*Based on y-o-y changes of the LBMA Gold Price, Bloomberg Commodity Index and US CPI between 1971and 2018.}

Gold as store of value

Gold has a long and influential role as a monetary asset. Other metals, including silver and copper, have historically been used as currency but gold’s role in the monetary system is far more extensive. Considered a rare and precious asset for centuries, gold was a logical choice as a currency anchor and performed this role until the US came off the gold standard in 1971. As such, it made an important contribution to global economic architecture and, to this day, is considered a valuable international asset, protecting against currency declines (Chart 22, Appendix I). Prior to 1971, major commodities enjoyed periods of time where their value in gold terms reflected inflation and increased, whilst the price of gold was pegged to the US dollar. After 1971, when the price of gold was able to float, the value of commodities in gold terms fell sharply.

Indeed, while gold no longer plays a direct role in the international monetary system, central banks and governments still hold extensive gold reserves (Table 9, Appendix II) to preserve national wealth and protect against economic instability. Central banks are buying gold at an ever-increasing pace (Chart 27, Appendix II); in 2018 alone they purchased more gold than at any time since the end of the gold standard – and that trend has persisted through the first half of 2019. Today, gold is the third largest reserve asset globally, following US dollar- and euro-denominated assets. Moreover, gold is increasingly used as collateral in financial transactions, much like other high quality, liquid assets such as government debt.

Global liquidity on a physical-linked market

The gold market is robust and highly liquid. On the futures market, daily volumes average US$51bn (Table 4, Appendix I), second only to oil (Chart 9); and on the OTC market, estimated volumes are even higher, at around US$61bn. There is a thriving physical gold-backed ETF market too, with daily volumes averaging US$1bn.² Overall, average daily trading in the global gold market ranges between US$100bn and US$200bn a day (Table 5, Appendix I).

This extensive liquidity allows investors to access gold in a range of ways, particularly when compared to other commodities, and highlights how gold operates within a differentiated market (Focus 1).

Chart 9: Daily volume in gold futures is higher than all commodities except oil

Average daily trading volume in US dollars*

^{*Based on one-year average trading volumes as of June 2019.}

Chart 10: Average daily gold trading volume

Gold futures represent less than half of all gold traded*

^{*As of 30 June 2019.
See details on goldhub.com https://www.gold.org/goldhub/data/trading-volumes}

Chart 11: Global commodity OTC open interest

Gold makes up a significant portion of all global OTC open interest*

^{*As of December 2017.}

Futures and roll costs

As we state above, investors tend to access commodity markets via futures contracts. Because futures contracts are based on expectations of future prices, as well as the costs of carry, storage and interest, investors are exposed to an additional source of variability: the shape of the futures curve. In general, futures curves have less of an impact on gold and other precious metals returns than on most commodities.

Storage costs in particular account for a large portion of the futures cost or cost of carry. The storage costs of physical gold are negligible compared to those of other metals, while investing in commodities such as natural gas incur extremely expensive storage costs.

These costs are typically represented by a futures curve in contango,³ when futures prices are higher than spot prices.

The shape of the curve, combined with the fact that futures contracts are typically rolled over or settled in cash, creates discrepancies between spot price returns and total returns. This difference can be very large in certain commodity markets, yet futures returns are not necessarily higher than spot returns.

The energy market between June 1998 and June 2019 exemplifies this point (Table 6, Appendix I and Chart 12). Cumulative total returns based on spot were 131%: based on the futures markets, they were only 18%. During the same period, gold’s spot return was 156% compared to 146% on futures. In fact, the roll cost has averaged approximately 50bps a year over the past 20 years, compared to 5% for the S&P GSCI. This reflects two important differentials between investments in gold and other commodities. First, the shape of the gold futures curve tends to be flat at the most actively traded front end of the curve. Second, most investors either trade in spot or can potentially take physical delivery of futures contracts (although this can be quite costly and happens rarely). It is worth noting that the Bloomberg Precious Metals Sub-index and gold futures deliver similar performances over the long run, largely because nearly 80% of the Sub-index is comprised of gold futures.

Chart 12: Spot versus total returns for select commodity and commodity indices

Most commodity indices' total return is far less than their spot return

^{As of 30 June 2019.
From December 1998 to June 2019.}

Gold – efficient, effective and under-represented

Despite gold’s unique investment properties that differentiate it from other commodities, investors often cluster it into a commodities bucket that often represents a small allocation within their overall portfolio. Furthermore, the amount of gold allocated to this smaller commodities bucket is usually just a fraction of the bucket itself, further diminishing the weight.

Investors who access commodities via a broad-based index often assume they have an appropriate allocation to gold. In fact, most broad-based commodity indices have a very small allocation to gold. Indices such as the S&P GSCI⁴ or the Bloomberg Commodity Index⁵, for example, typically allocate between 3% and 12% to gold (Table 1 and Table 2). We do not believe such weightings provide an appropriate exposure to gold, particularly as commodities tend to represent a small portion of an investor’s overall portfolio.

Table 1: S&P GSCI sector weights*

Gold is a small component in the S&P GSCI index

Table 2: Bloomberg Commodity Index*

Gold has a more prominent yet small weight in the Bloomberg Commodity Index

Under-allocated to gold: a missed opportunity?

Commodity exposure is generally limited to less than 10% of an investment portfolio. Gold usually accounts for less than 10% of that amount – in other words, a portfolio will have an overall exposure to gold of less than 1%.

Commodity exposure does provide diversification benefits. Our analysis suggests that adding a 5-10% portfolio allocation to commodities increased risk-adjusted returns over the past 20 years. However, gold can do much more. Looking back over the past two decades, replacing or supplementing a commodities allocation with gold provided two key benefits: it increased absolute returns and reduced portfolio volatility when compared to a portfolio with no commodity exposure or with broad-based commodity exposure (Chart 13 and Chart 14).

Chart 13: Performance of a hypothetical pension portfolio with and without commodities or gold*

Gold allocations improved absolute and risk-adjusted returns more than commodities over the past 20 years

^{*Risk-adjusted return defined as portfolio return divided by annualised volatility and based on the total return indices and benchmarks listed below using data from June 1999 to June 2019 assuming monthly rebalancing.
A 0% allocation denotes an average pension fund portfolio and is based on Willis Towers Watson Global Pension Assets Study 2017 and Global Alternatives Survey 2016. It includes a 60% allocation to stocks (35% Russell 3000, 20% MSCI ACWI ex US, 5% FTSE REITs Index) and a 40% allocation to fixed income (30% Barclays US Aggregate, 5% Barclays Global Aggregate ex US, and 5% short-term Treasuries). The other mix of weights include either 5% of gold or commodities or 10% of gold or commodities and this allocation to commodities or gold comes from proportionally reducing all assets.}

Chart 14: Performance of a hypothetical pension portfolio with and without commodities or gold*

Gold improves absolute and risk-adjusted returns

^{*As of 30 June 2019.
Based on monthly data from June 1999 to June 2019 assuming quarterly rebalancing.
The average PF portfolio is based on Willis Towers Watson Global Pension Assets Study 2017 and Global Alternatives Survey 2016. It includes a 60% allocation to stocks (35% Russell 3000, 20% MSCI ACWI ex US, 5% FTSE REITs Index) and a 40% allocation to fixed income (30% Barclays US Aggregate, 5% Barclays Global Aggregate ex US, and 5% short-term Treasuries). The allocation to commodities or gold comes from proportionally reducing all assets.}

Gold improves risk-adjusted returns across portfolio structures

To determine the optimum allocation to gold it is useful not only to compare gold with other commodities, but also to consider the broader impact that gold can have on portfolios. The World Gold Council has conducted analysis, based on typical US investment portfolio allocations of varying risks, and back-tested the ideal allocations of gold for each (Chart 24, Appendix I). This analysis indicates that US dollar-based investors can meaningfully improve the performance of a well-diversified portfolio by allocating between 2% and 10% to gold (Chart 15).

Broadly speaking, the higher the risk in the portfolio – whether in terms of volatility, illiquidity or concentration of assets – the larger the required allocation to gold to offset that risk.

Chart 15: Gold can significantly improve risk-adjusted returns of hypothetical portfolios across various levels of risk

Range of gold allocations and the allocation that delivers the maximum risk-adjusted return for each hypothetical portfolio mix*

^{*Based on monthly total returns from June 1999 to June 2019 of ICE 3-month Treasury, Bloomberg Barclays US Bond Aggregate, Bloomberg Barclays Global Bond Aggregate ex US, MSCI US, EAFE and EM indices, FTSE Nareit Equity REITs Index, Bloomberg Commodity Index and spot returns of LBMA Gold Price PM. Each hypothetical portfolio composition reflects a percentage in stock and alternative assets relative to cash and bonds. For example: 60/40 is a portfolio with 60% in stocks, commodities, REITs and gold, and 40% in cash and bonds. Analysis based on New Frontier Advisors Resampled Efficiency. For more information see Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Oxford University Press, January 2008.}

Conclusion

A commodity is defined as an economic good, which is valued and useful and has little or no difference in composition or quality regardless of the place of production. While gold fits this definition, its market dynamics and the diversity of its application make it very different from other commodities.

This difference is underlined by gold’s robust performance profile in terms of returns, volatility and correlation. Taken together, gold’s investment characteristics produce a more diversified portfolio than one with a simple, broad-based commodities exposure.

Looking at other commodities, some can be considered luxury goods, some have technological applications, and some are basic, everyday products. Some are used to hedge against inflation, some protect against currency devaluation and all of them provide a degree of diversification in an investment portfolio. Uniquely however, gold as an investment performs all these functions.

Indices such as the S&P GSCI or the Bloomberg Commodity Index are widely used by investors as benchmarks for their allocations when investing in commodities. However, gold’s weighting within these indices is small. More importantly, we find that under these conditions, an investor who only holds gold via a diversified commodities index will not achieve optimal returns (per unit of risk) or minimise expected losses.

Implementing an outright or supplemental position to gold reduces risk without diminishing long-term expected returns. In particular, strategic allocations ranging from 2% to 10% can significantly improve and protect the performance of an investment portfolio, while providing the exposure desired by investing in commodities.

Notes

<sup>1The average PF portfolio is based on Willis Towers Watson Global Pension Assets Study 2017 and Global Alternatives Survey 2016. It includes a 60% allocation to stocks (35% Russell 3000, 20% MSCI ACWI ex US, 5% FTSE REITs Index), 40% allocation to fixed income (30% Barclays US Aggregate, 5% Barclays Global Aggregate ex US, and 5% short-term Treasuries).

2See details on goldhub.com https://www.gold.org/goldhub/data/trading-volumes

3Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time. This results in an upward sloping forward curve, which can increase the cost of maintaining exposure to a particular asset.

4S&P GDCI is a world production-weighted commodity index based on the average of the previous five years.

5Determinants and weights in the Bloomberg Commodity Index include economic significance, diversification, continuity and liquidity.</sup>

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