Gold benefits from diverse sources of demand: as an investment, a reserve asset, jewellery, and a technology component. It is highly liquid, no one’s liability, carries no credit risk, and is scarce, historically preserving its value over time.
Gold does not directly conform to the majority of the most common valuation methodologies used for equities or bonds. Without a coupon or dividend, typical models based on discounted cash flows, expected earnings, or book-to-value ratios, struggle to provide an appropriate assessment for gold’s underlying value. This presented an opportunity for the World Gold Council to develop a framework to better understand gold valuation.
Returns
Diversification
Liquidity
Portfolio performance
2020 posed unprecedented challenges to investors as the first global pandemic in a century ravaged the world economically and socially.
COVID-19 significantly increased uncertainty by compounding existing risks and creating new ones. The rollout of new vaccines at the end of last year fuelled optimism that the worst was over. Yet the pandemic and the ensuing policy response from governments will likely have unintended consequences for, and create structural changes to, asset allocation strategies.
Global central banks have effectively taken interest rates to zero, driving nearly all sovereign debt to negative real yields. With less opportunity for yield across fixed income assets – especially those of shorter duration or higher quality – investors will likely continue to shift exposure to riskier assets. This has pushed many global stock markets to extreme levels on numerous valuation metrics and – importantly - has also served to increase the risk profile of most investment portfolios.
Additionally, many countries have made it clear they will continue to enact sizeable fiscal policy measures to tackle the economic impact of COVID-19, along with expanding budget deficits and balance sheets.
We believe these actions - in combination with the current environment have made gold increasingly relevant as a strategic asset. Not only could investors benefit from gold’s role as a diversifier amid ballooning budget deficits, inflationary pressures, and potential market corrections from already high equity valuations, but they may also see additional support as gold consumption will likely benefit from the nascent economic recovery, especially in emerging markets (see 2021 Gold Outlook).
Over recent years, investors have increasingly looked to integrate environmental, social and governance (ESG) considerations as part of their investment process. For example, 89% of European investors now take ESG factors into account when they make investment decisions.2 This increased emphasis on ESG reflects increasing pressure for businesses to actively manage ESG risks. It also emphasises that good ESG performance could lead to better long-term financial performance.3 This shift towards a greater integration has important implications for gold, which needs to demonstrate that it is produced and sourced responsibly, as well as the role that gold can play in supporting ESG objectives within a portfolio (Focus 2: Gold as an ESG investment).4
Institutional investors5 have embraced alternatives to traditional stocks and bonds in pursuit of diversification and higher risk-adjusted returns. The share of non-traditional assets, such as hedge funds, private equity funds or commodities, among global pension funds increased from 7% in 1998 to 23% in 2019 – this figure is 30% in the US (Chart 1).6
Gold allocations have been recipients of this shift. Investors increasingly recognise gold as a mainstream investment; global investment demand has grown by an average of 15% per year since 2001 and the gold price has increased almost seven-fold over the same period.7
Our analysis illustrates that adding between 2% and 10% in gold to a hypothetical US pension fund average portfolio over the past decade would have resulted in higher risk-adjusted returns.8
Our analysis shows gold is a clear complement to equities, bonds and broad-based portfolios. A store of wealth and a hedge against systemic risk, currency depreciation and inflation, gold has historically improved portfolios’ risk-adjusted returns, delivered positive returns, and provided liquidity to meet liabilities in times of market stress.
Investors have long considered gold a beneficial asset during periods of uncertainty. Historically, it has generated long-term positive returns in both good and bad economic times. Looking back almost half a century, the price of gold in US dollars has increased by an average of nearly 11% per year since 19719 when the gold standard collapsed.10 Over this period, gold’s long-term return is comparable to equities and higher than bonds.11 Gold has also outperformed many other major asset classes over the past five, 10 and 20 years (Chart 2 and Chart 3).
This duality reflects the diverse sources of demand for gold and differentiates it from other investment assets. Gold is often used to protect and enhance wealth over the long term as it is no one’s liability, and it operates as a means of exchange due to its global recognition.
Gold is also in demand via the jewellery market, valued by consumers across the world. And it is a key component in electronics.12 These diverse sources of demand give gold a particular resilience: the potential to deliver solid returns in various market conditions (Chart 7, p6).
Gold has long been considered a hedge against inflation and the data confirms this. The average annual return of 11% in US dollars over the past 50 years, has outpaced the US and world consumer price indices (CPI).13
Gold also protects investors against high and extreme inflation. In years when inflation was higher than 3%, gold’s price increased 15% per year on average (Chart 4). Over the long term, therefore, gold has not just preserved capital but helped it grow.
Research also shows that gold should do well in periods of deflation.14 Such periods are characterised by low interest rates, reduced consumption and investment, and financial stress, all of which tend to foster gold demand.
Investor demand has been boosted by persistently low interest rates and concerns about the outlook for the dollar, which affect the perceived opportunity cost of holding gold.
Historically, major currencies were pegged to gold. That changed with the unravelling of the US gold standard in 1971 and the eventual collapse of the Bretton Woods system.15 Since then, with few exceptions, gold has significantly outperformed all major currencies and commodities as a means of exchange (Chart 5). This outperformance was particularly marked immediately after the end of the gold standard. A key factor behind this robust performance is that the supply growth of gold has changed little over time – increasing by approximately 1.4% per year over the past 20 years.16
By contrast, fiat money can be printed in unlimited quantities to support monetary policy, as exemplified by the quantitative easing measures in the aftermath of the Global Financial Crisis (GFC).17 In recent years, the rapidly increasing global money supply and a low to negative rate environment have fostered an optimal environment for gold to outperform global sovereign debt, such as US treasuries and to track the global money supply (Chart 6 p6).
The benefits of diversification are widely acknowledged – but it is hard to find effective diversifiers. Many assets become increasingly correlated as market uncertainty rises and volatility is more pronounced, driven in part by risk-on/risk-off investment decisions. As a result, many so-called diversifiers fail to protect portfolios when investors need them most.
Gold is different in that its negative correlation to equities and other risk assets generally increases as these assets sell off (Chart 7). The GFC is a case in point. Equities and other risk assets tumbled in value, as did hedge funds, real estate and most commodities, which were long deemed portfolio diversifiers. Gold, by contrast, held its own and increased in price, rising 21% in US dollars from December 2007 to February 2009.18 And in the most recent sharp equity market pullbacks of 2018 and 2020, gold performance remained positive.19
This robust performance is perhaps not surprising. With few exceptions, gold has been particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses (Chart 8, p7). Importantly too, gold allows investors to meet liabilities when less liquid assets in their portfolio are difficult to sell, or possibly mispriced.
But gold’s correlation does not just work for investors during periods of turmoil. It can also deliver positive correlation with equities and other risk assets in positive markets, making gold a well-rounded efficient hedge
(Chart 9, p7), (see Gold: an efficient hedge).
This dual benefit arises from gold’s dual nature: as both an investment and a consumer good (Chart 18, p13). As such, the long-term performance of gold is supported by income growth. Our analysis bears this out, showing that when equities rally strongly, their correlation to gold can increase. This is most likely driven by a wealth-effect supporting gold consumer demand, as well as demand from investors seeking protection against higher inflation expectations.
Gold has consistently benefited from “flight-to-quality” inflows during periods of heightened risk.
Gold behaves – and is used – as a safe-haven in periods of
systemic risk…
…but also performs well in market recoveries.
The gold market is large, global and highly liquid.
We estimate that physical gold holdings by investors and central banks are worth approximately US$4.8tn, with an additional US$1.1tn in open interest through derivatives traded on exchanges or the over-the-counter (OTC) market (Chart 16a p12).
The gold market is also more liquid than several major financial markets, including US T-bills, euro/yen and the Dow Jones Industrial Average, while trading volumes are similar to those of the S&P 500 (Chart 10). Gold’s trading volumes averaged approximately US$180bn per day in 2020. During that period, OTC spot and derivatives contracts accounted for US$110bn and gold futures traded US$69bn per day across various global exchanges. Gold-backed ETFs (gold ETFs) offer an additional source of liquidity, with the largest US-listed funds trading an average of US$3bn per day (Chart 11).
The scale and depth of the market mean that it can comfortably accommodate large, buy-and-hold institutional investors. In stark contrast to many financial markets, gold’s liquidity does not dry up, even at times of financial stress, making it a much less volatile asset (Chart 12).
Long-term returns, liquidity and effective diversification all benefit overall portfolio performance. In combination, they suggest that the addition of gold can materially enhance a portfolio’s risk-adjusted returns.
Our analysis of investment performance over the past five, 10 and 20 years underlines gold’s positive impact on an institutional portfolio. It shows that the US pension fund average portfolio would have achieved higher risk-adjusted returns and lower drawdowns if 2.5%, 5% or 10% were allocated to gold (Chart 13 and Table 1). This positive impact has been particularly marked since the GFC.
In addition to traditional back-testing, a more robust optimisation analysis based on ‘re-sampled efficiency’ 20 suggests that an allocation to gold may result in a material enhancement to portfolio performance. For example, gold allocations between 2% and 10% across well-diversified US dollar-based portfolios with varying levels of risk could result in higher risk-adjusted returns (Chart 14, p10).
The ‘optimal’ amount of gold varies according to individual asset allocation decisions. Broadly speaking, the analysis suggests that the higher the risk in the portfolio – whether in terms of volatility, illiquidity or concentration of assets – the larger the required allocation to gold, within the range in consideration, to offset that risk (Chart 14 p10).
Our analysis also indicates that gold’s optimal weight in these hypothetical portfolios can be statistically significant even if investors assume an annual return for gold of between 2% and 4% – well below long-term historical performance. This works equally for investors who already hold other inflation-hedging assets, such as inflation-linked bonds,21 and for investors who hold alternative assets, such as real estate, private equity and hedge funds.22
Comparison of an hypothetical US pension fund (PF) average portfolio and an equivalent portfolio with 5% gold over the past one, five, 10 and 20 years based on US-dollar returns*
| 20-year | 10-year | 5-year | 1-year | |||||
|---|---|---|---|---|---|---|---|---|
| No gold | 5% gold | No gold | 5% gold | No gold | 5% gold | No gold | 5% gold | |
| Annualised return | 6.77% | 7.02% | 7.95% | 7.79% | 9.12% | 9.36% | 10.33% | 11.18% |
| Annualised volatility | 10.73% | 10.33% | 9.57% | 9.26% | 10.61% | 10.13% | 19.49% | 18.58% |
| Risk-adjusted returns | 0.63 | 0.67 | 0.83 | 0.84 | 0.85 | 0.92 | 0.53 | 0.60 |
| Maximum drawdown | -42.35% | -39.97% | -16.11% | -15.19% | -16.11% | -15.19% | -16.11% | -15.19% |
*As of 31 December 2020. The hypothetical PF average portfolio and weights are based on Willis Towers Watson Global Pension Assets Study 2019 and Global Alternatives Survey 2017 and as described in Chart 13. Risk-adjusted returns are calculated as the annualised return/annualised volatility. Maximum drawdown is calculated as the largest fall in a portfolio before the total value reaches a previous peak.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
Gold is often part of the broad commodity complex: as a component of a commodity index, a holding in an ETF, or a future trading on a commodity exchange. While gold shares some similarities with commodities, there are several important differences:
These attributes set gold apart from the commodity complex. And our research suggests that a distinct allocation to gold could enhance the performance of portfolios with passive commodity exposures.23
Recently, developments in the performance and liquidity of gold have led two major commodity indices (S&P GSCI and Bloomberg Commodity Indices) to increase their weighting of gold for a second year in a row.24 In 2020, gold had the largest individual commodity weight increase in the S&P GSCI Index and will have its highest weight ever in the Bloomberg Commodity Index. Yet, our analysis suggests that allocations to gold in these commodity indices remain below their optimal weight.25
We believe that gold should be considered an ESG-compliant asset. While gold mining is an extractive industry with an impact on the environment, responsible gold miners mitigate risks and contribute heavily to the communities and host countries they operate in, through the likes of direct investments, improvements to infrastructure, access to healthcare and schooling, and much more.
This is demonstrated through the gold mining industry’s contribution to the UN Sustainable Development Goals. Our members are committed to the Responsible Gold Mining Principles (RGMPs), launched by the World Gold Council in 2019. The RGMPs are an ambitious set of 51 individual principles that cover all material aspects of ESG related to gold mining and set clear expectations for the entire gold mining industry. Conformance with these Principles will need to be publicly disclosed, with third-party assurance on this disclosure.
In addition, we believe gold can play an important role as a climate-risk mitigating asset within an investment portfolio. Our analysis suggests that gold has the potential to perform better than most mainstream asset classes under various long-term climate scenarios.
Gold may lower the carbon footprint of an investment portfolio over time, as carbon emissions associated with holding physical gold are minimal. Our research suggests that, unlike many other commodities, over 99% of greenhouse gas emissions associated with gold occur during the mining and milling process; and significant progress is already being made to remove greenhouse gas emissions from these processes, with opportunities to further de-carbonise.28
Perceptions of gold have changed substantially over the past two decades, reflecting increased wealth in the East and a growing worldwide appreciation of gold’s role within an institutional investment portfolio.
Gold’s unique attributes as a scarce, highly liquid, and un-correlated asset demonstrate that it can act as a diversifier over the long term. Gold’s position as an investment and a luxury good has allowed it to deliver average returns of nearly 11% over the past 50 years, comparable to equities and more than bonds and commodities.26, 27
Gold’s traditional role as a safe-haven asset means it comes into its own during times of high risk. But gold’s dual appeal as an investment and a consumer good means it can generate positive returns in good times too. This dynamic is likely to continue, reflecting ongoing political and economic uncertainty, persistently low interest rates and economic concerns surrounding equity and bond markets.
Overall, extensive analysis suggests that adding between 2% and 10% of gold to a US-dollar-based portfolio can make a tangible improvement to performance and boost risk-adjusted returns on a sustainable, long-term basis.29
1Oxford Economics is a leader in global forecasting and quantitative analysis and a specialist in modelling. Visit QaurumSM for important disclosures about Oxford Economics’ data, as well as a detailed description of the available scenarios; the assumptions underlying and data used for each scenario; and its respective hypothetical impact on gold demand, supply and performance.
2Mercer European Asset Allocation Insights 2020, August 2020
3Refinitiv, How do ESG scores relate to financial returns, August 2020.
4Gold and climate change: Current and future impacts, October 2019
5An institutional investor holds and/or manages assets for clients in larger, pooled portfolios often represented as mutual funds, banks, brokerages, hedge funds, etc.
6Willis Towers Watson, Global Pension Assets Study 2021, February 2021 and Global Alternatives Survey 2017, July 2017.
731 December 2000 to 31 December 2020.
8See Chart 13 on p9 for more details behind the composition of the hypothetical US pension fund average portfolio. Based on 2000 – 2020. In addition, refer to important disclaimers and disclosures at the end of this report.
9January 1971 – December 2020.
10During the gold standard, the US dollar was backed by gold, and the foreign currency exchange rates were dictated by the Bretton Woods System. In August 1971, the Nixon Administration announced the halt of the free conversion between the US dollar and gold catalysing the collapse of the gold standard and, subsequently, the Bretton Woods system.
11For other return metrics and performance see Appendix II on page 17.
13Based on average annual CPI changes for the US (3.9%) and world (9.3%) as measured by the IMF from December 1971 – December 2020.
14Oxford Economics, The impact of inflation and deflation on the case for gold, July 2011.
15Ibid footnote 9.
16From December 2001 – December 2020. See the Demand and Supply section at Goldhub.com.
17For more information please see The impact of monetary policy on gold and It may be time to replace bonds with gold.
18Based on the LBMA Gold Price PM from 1 December 2007 to 27 February 2009.
19Based on the LBMA Gold Price PM from 1 October 2018 to 27 December 2018 and from 31 January 2020 to 31 March 2020.
20Re-sampled efficiency is a methodology developed by Richard and Robert Michaud and praised as a robust alternative to traditional mean-variance optimisation. See Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Oxford University Press, January 2008.
21Gold as a tactical inflation hedge and long-term strategic asset, July 2009, July 2009.
22Enhancing the performance of alternatives with gold, February 2018.
23See: Gold: the most effective commodity investment, and Gold: metal by design, currency by nature, Gold Investor, Volume 6, June 2014.
24For more information on the gold weight increases see: Major commodity indices will increase gold weightings for a second year in a row.
25Gold: the most effective commodity investment, September 2019.
26Average annualised returns in US dollars from January 1971to December 2020.
28The Greenhouse Gas Protocol, Ecoinvent database. Please see Gold and climate change: Current and future impacts and Gold and climate change: An introduction.
