What role can gold play in a diversified portfolio?

What role can gold play in a portfolio?

Gold has traditionally been used as a portfolio hedge, rising in response to higher inflation, to a declining US dollar and to sharp reversals in riskier assets. This negative correlation is attractive from a diversification standpoint, helping to dampen overall portfolio volatility. Gold also has a limited supply and various demand sources—from jewellery production to industrial applications and as an investment. Despite these positive characteristics, gold has its critics, most notably Warren Buffet, who decried gold’s lack of return drivers. Gold does not produce anything and has costs associated with its storage. Gold has also experienced extreme price volatility and prolonged periods of negative returns, making expected future returns difficult to forecast.

What is a reasonable return expectation for gold?

Gold differs from most other investments as it is a real asset which does not have an internal rate of return. So, we are forced to look to history as a guide to potential future returns. This is problematic as the price of gold has been particularly volatile through time, and the overall return varies greatly depending on the time period selected.

What is the best way to implement gold?

For those wishing to invest in gold, the method of implementation is a key consideration. Holding the asset physically, via an exchange-traded fund (ETF) or investing in listed gold mining companies are the three obvious choices, and there are advantages and disadvantages to each.

Physical—The purest form of gold ownership is simply to purchase gold bullion, however there are a number of complications which impact this option. The largest consideration is that the gold must be stored, and this comes with a cost. There are also question marks over security and whether the gold is segregated or comingled with other owner’s holdings.

ETFs—A more straightforward option than physical ownership is to purchase an ETF. This is fairly intuitive for most investors who would typically already buy and sell equities in the same way. Synthetic offerings use derivatives to replicate gold price movements, whereas physically-backed products actually hold the gold to back the investment. Both options come with costs, but the risk of price movements deviating from the gold price and of counterparty default make synthetic options less attractive than physically-backed ETFs.

Gold miners—Another common way to gain gold exposure is to invest in the listed equities of gold mining companies. The fortunes of these stocks are obviously heavily reliant on the price of gold, but additional factors are at play, making this type of exposure much more complicated. One notable downside is that, while the price of gold and the performance of gold miners tend to be highly correlated over the long term, there can be short-term divergence—for example, during a stock market crash when sentiment drives the whole market lower. This may reduce the diversification benefits for those holding mining stocks instead of physical gold (either directly or via an ETF). Individual mining companies are also subject to operational considerations, which could have a material impact on stock price, regardless of the price of gold.