Gold’s Time to Shine?

A gold allocation can increase diversification and reduce portfolio drawdowns without sacrificing long-term performance.
November 2019

As a macro asset influenced by investor sentiment, gold has a place in investment portfolios. We compare alternative portfolios to a 60-40 balanced benchmark and show that gold allocations benefit from lower beta and positive convexity, paying off more on sharp negative moves in stock-market prices. A gold allocation can increase diversification and reduce portfolio drawdowns without sacrificing long-term performance.

Looking ahead, gold may also perform well in shorter time horizons relative to historical norms. Heightened late-cycle concerns, policy uncertainty, low neutral interest rates and rising negative-yielding debt will make gold increasingly attractive. A turn in the U.S. dollar’s dominance will also benefit gold.

Gold can be an optimal strategic allocation of up to 10% in a 60-40 balanced portfolio, with compelling tactical considerations going forward as well.

“Gold makes the ugly beautiful.”


Why gold?

Betting against gold is like betting against 6,000 years of recorded human history. Gold was first mined by Egyptians in 3600 B.C. for its desirability as a commodity before becoming the first international currency in 564 B.C. Today, gold wears many hats, serving as a commodity (a consumer and an investment good) and as a macro asset, where investor sentiment is a bigger influence than physical demand and supply conditions.

Investors like gold also because of its dual function as a safe-haven hedge and portfolio diversifier. Traditionally, gold has been viewed as an inflation hedge, most notably during times of war-driven high inflation episodes. But there are other more important attributes. Gold has demonstrated low to negligible correlation with other financial assets thanks to both cyclical and counter-cyclical sources of demand. Gold can therefore reduce risk, or beta, of a portfolio. For example, gold has low correlations with bonds and equities and a relatively high negative correlation with the U.S. dollar (Figure 1).

Figure 1: Low Historical Correlations Provides Diversification

In addition, gold is a safe-haven hedge by outperforming in times of high volatility and large equity-market drawdowns. This implies positive convexity which enhances a portfolio’s downside protection. Convexity, or the gamma of an option, measures the dynamic risk of an asset’s performance during significant swings in prices. An asset exhibits positive convexity if it outperforms in high volatility environments.  By contrast, stocks or carry strategies have a negative convexity profile by selling off sharply after long periods of modest gains.

Finally, because gold is a zero-yielding asset, there is an opportunity cost to holding gold, in addition to a small storage cost. As a result, gold tends to outperform when real interest rates fall.

Portfolio Performance and Stress Scenarios

We examine how gold can enhance downside protection and portfolio performance. Research suggests an optimal allocation to gold of up to 10%. For purpose of illustrating the impact of defensive portfolio allocations on long-term performance, we use a 10% allocation in the context of a balanced benchmark portfolio (60% equities, 40% bonds). The benchmark and alternative portfolios are described in Table 1.

Table 1: Benchmark and Alternative Portfolios

Alternative portfolios 1 and 2 add gold allocations relative to benchmark by reducing exposure to either fixed income or equities. The remaining portfolios are meant to compare the defense properties of bonds and low-volatility (low-vol) stocks to those of gold. Portfolio 3 raises exposure to bonds while 4 and 5 allocate to low-vol equities, with no exposure to gold.

Both gold portfolios have lower betas relative to the bond and low-vol portfolios, reinforcing the argument that gold provides diversification. Next, we find that gamma (convexity) is positive and greater in magnitude in the gold portfolios, meaning that gold increases its payout more when equity-market volatility spikes. Relative to bonds, gold also more consistently exhibits positive convexity over time.

Figure 2: Historical Drawdowns – Gold Often Shines When It Rains

Sources: BMO Global Asset Management, Bloomberg.

These findings suggest that gold portfolios raise downside protection during significant equity-market downturns. To confirm this, we show that historical drawdowns are indeed reduced (Figure 2). Long-term returns are also smoother across time and, importantly, are not sacrificed (Figure 3).

Figure 3: Historical Returns – Gold Brings Diversification to Long-Term Investors

Finally, we find strong asymmetry across gold returns during volatile episodes, e.g. when equities move +/- 5% or when bonds move +/- 30bps within a given month (Figure 4). What is most striking is that gold returns are more pronounced during risk-off episodes compared to risk-on events. This asymmetry further strengthens the case for downside protection.

Figure 4: Gold Performance on Large Market Movements

Tactical vs Strategic Considerations

In sum, gold has key investment attributes (lower beta and positive convexity) that raise a portfolio’s downside protection without limiting long-term performance. These even raise its attractiveness relative to bonds for long-term investors. There are a few caveats, however. In shorter time periods (3-5 years) gold often underperforms partly because episodes of financial stress are infrequent. Tactically owning gold is therefore far more challenging for investors, and we believe the strategic benefits of owning gold far exceed the tactical opportunities it offers, which are highly uncertain. For these reasons, we think 60-40 balanced solutions would benefit by allocating no more than 10% of their portfolio to gold, funded by reducing their fixed-income holding.

Following an extended bull run from 2001 to 2012, gold has seen renewed strength in the past year with notable outperformance since October 2018 (+25% vs +6% for the S&P 500). The onset of trade wars, political uncertainty and late cycle concerns have revived interest in gold. The steady rise in the share of negative-yielding debt amid the start of the global central-bank easing cycle has also contributed (Figure 5).

Figure 5: Gold Prices Increase with Negative Yielding Debt

What also matters is the U.S. dollar, given its strong negative correlation to gold. The loss in the dollar’s dominance, led by a drop in the U.S. yield advantage and a pickup in global growth, will influence diversification toward gold. Rising twin deficits in the U.S. and dollar weaponization from President Trump also threaten the dollar’s reserve status. Indeed, official sector demand has picked up with emerging-market central banks resuming purchases for the first time in years. Furthermore, an emerging threat heading into the next decade as global debt soars is inflation, which gold has been proven to hedge against. All in all, tactical considerations are becoming increasingly compelling even considering the significant returns gold has achieved in the past year.

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This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

This commentary has been prepared by BMO Asset Management Inc. the portfolio manager. This update represents their assessment of the markets at the time of publication. Those views are subject to change without notice as markets change over time.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms.

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