If the gold asset fits, wear it

The case for gold as a financial asset divides investors and commentators like few other subjects. In one camp, you have those who see gold as the only unprintable currency and therefore an essential hedge against the debasement of fiat currencies. At the other end of the spectrum are those who view gold as just another volatile commodity offering no yield and reliant on the greater fool for price appreciation. In this article, we attempt to sketch out a moderate position in the sparsely populated middle ground between the gold bugs and gold bears.

A unique safe haven?

Gold has played a formal and an informal role in financial systems for millennia, with the first known coins containing gold having been struck in Lydia, Asia Minor, about 600 BC. Gold’s attractions as a currency include its durability, limited industrial use and relative stability of supply (in contrast to other precious metals). The most recent period in which gold had a widespread formal role in currency arrangements was in the post-war period from 1944 to 1971, under the Bretton Woods system, in which the world’s major currencies were pegged to the US dollar – which itself was convertible to gold at a fixed exchange rate. Although gold no longer has a formal role in currency arrangements, many central banks retain large holdings (the US being the most significant holder, with about 8000 tonnes).

A number of current factors arguably make the case for gold more interesting at the moment. Highly indebted governments (particularly in the developed world), the rise of populism and signs of increasing social conflict all point to an environment of heightened political uncertainty and risk. At the same time, financial assets have been inflated by almost a decade of ultra-stimulative monetary policy, leaving investors with few safe havens that are not exposed to the risk of a faster-than-expected unwind of monetary support.

Gold has exhibited attractive diversifying characteristics from both equities and bonds, especially in periods of rising inflation. In particular, in the stagflationary 1970s, gold provided strongly positive real returns; whereas equities and government bonds exhibited negative real returns. In addition, gold has tended to exhibit a negative correlation with equities during market crises; for example, during the financial crisis, the gold price rose by 28 per cent while, over the same period, developed equity markets fell by more than 50 per cent from peak to trough, Thomson Reuters data shows. Furthermore, the correlation between gold and equities tends to move further into negative territory the more extreme the downward move in equities. Therefore, gold is considered by some to be a valuable hedge against tail events and risk-off periods in general.

Or just a volatile commodity?

The primary challenge to gold as a financial asset comes from the absence of any yield or risk premium, making it difficult for many institutional investors to justify a long-term strategic holding. As noted in the 2012 Credit Suisse Global Investment Returns Yearbook, gold has produced low real returns over the very long term (about 1 per cent annually, in sterling terms, from 1900 to 2011).

The gold price is also highly volatile, more so than developed market equities. Further, during periods of low or falling inflation, with decent levels of economic growth, gold has tended to struggle. For example, during the Great Moderation, in which business-cycle volatility and inflation both reduced, the gold price fell by more than 80 per cent in real US dollar terms, Credit Suisse found.


These characteristics – a highly uncertain future return and high volatility – make sizing any allocation to gold challenging. If the allocation is too small, it will have a limited impact on overall risk-return. If the allocation is too large, it may act as a painful drag on returns during periods when the gold price falls. This perhaps supports a case for a tactical approach to gold. However, timing gold poses at least as many challenges as timing other market exposures and perhaps more, given the lack of any fundamental basis for making an assessment of fair value. Few institutional investors are set up to make tactical asset allocation decisions; therefore, we believe such activity is best left to macro and trend-following hedge funds.

Finally, there can be no guarantee that gold will exhibit the same risk-return characteristics it has in the past. The idea that it will relies on a belief that gold will continue to be perceived by a sufficient number of investors as an alternative currency of sorts. A few thousand years of being treated as such clearly provides some comfort, but at a time when digital cryptocurrencies are gaining attention, there can be no certainty that investors will always treat gold as the only unprintable currency.

Finding a role for gold

The investment case for gold will continue to polarise, and it is difficult to make sweeping generalisations about the types of investors for whom a strategic allocation might make sense. However, it is possible to suggest some of the characteristics of investors who are more likely to be open to the merits of gold. These include:

  • Investors highly sensitive to inflationary scenarios, while not being able to access other forms of inflation hedge, such as inflation swaps
  • Investors with a willingness to accept a potential drag on returns in normal scenarios, in order to access some protection against extreme scenarios; for example, one in which investors lose faith in the fiat money system
  • Investors with a willingness to view gold as a risk-management tool in a portfolio context, as opposed to an isolated exposure that is expected to deliver a consistent contribution to the total return.

Investors for whom an allocation to gold is less likely to be suitable include:

  • Investors with nominal liabilities or an alternative approach to hedging inflation risk
  • Investors with an alternative way of plugging any gap that arises from disappointing real returns; for example, a strong sponsor covenant for a pension scheme or other sources of income/support for an individual
  • Investors able to adopt a multi-decade time horizon with flexibility in their long-term liabilities, such that experiencing a decade of disappointing real returns from equities is not catastrophic; for example, a young defined-contribution investor.

Ultimately, consideration of gold will necessarily be an investor-specific decision. However, we believe some investors will find the diversifying characteristics of gold attractive in mitigating the impact of certain extreme scenarios. The views of gold bugs and gold bears will remain entrenched, but investors should aspire to achieve a rational and well-reasoned view on the merits and challenges of this precious metal, in the context of their own circumstances.