Should You Own Gold?

00:00 - 00:29

Throughout 2019, markets have exhibited falling interest rates, geopolitical uncertainty, and the possibility of currency wars. Those issues have reignited investor interest in gold. But not everybody thinks that gold is a good investment. While proponents tout its reliability as a store of value, skeptics believe its value is driven primarily by sentiment and occasional mania. So how do we evaluate if an allocation to gold now makes sense?

00:32 - 00:48

Hi, everybody, and welcome to The Pulse, where we cover trends in the economy, markets, and asset allocation for long term investors. I'm Matt Palazzolo and today I'm joined by Vinod, Chathlani, portfolio manager for real assets in our multi asset strategies. So, Vinod, welcome to the show. Thanks for having me.

00:48 - 01:09

So Vinod, lately in client meetings, obviously, as you can imagine, we've been getting a lot of questions about uncertainty in the markets and a lot of anxiety that's been baked in. And during those times, if I look back over history, there have been times when investors have tended to look to gold, as in a portion of their asset allocation. I know you've noted this often.

01:09 - 01:28

When we look back at gold over the long term, its performance results aren't great. What specifically are gold's performance results over the long term? It is indeed the case that performance of gold over very long periods of time has been uninspiring. Gold has returned something like two percent a year over the last 50 years or so.

01:29 - 01:51

That's comparable with bonds. But gold has delivered that with far more volatility than with bonds. And also, you know, one of the volatility is compatible with equities, equities have returned far higher returns. So as a standalone asset for return generation, gold hasn't really been a very useful asset to allocate to. Certainly over a long period of time on average, those results are not comparable.

01:51 - 01:55

And when you do it on a risk adjusted basis, as you did, it's even less inspiring.

01:55 - 02:27

I guess I'm going to come back to this issue around uncertainty. And again, when investors are uncertain or nervous about the markets, they tend to flock into gold, mostly because that's the sentiment at the time. There are these sentiment drivers or factors, if you will, that cause investors to move into that asset class. Talk a little bit about that sentiment aspect. One of the reasons that such a polarized debate around gold as an asset class is because it's very hard to value intrinsically like most other asset classes, because it doesn't generate cash flows that can then be discounted.

02:27 - 02:33

So people just tend to go back to this idea of, well, maybe it's all driven by sentiment. Though that's true to some extent,

02:33 - 03:04

in reality, though, there's a big component of gold that is driven by its relative valuation versus how macroeconomic factors are doing. So gold, as we've spoken in the past, is a little bit like a currency. So what the dollar is doing at a certain point in time is going to be a driver of gold prices. So let's flesh that out, because I think that's important. So looking at not just the sentiment and the uncertainty, but these macroeconomic factors that tend to explain a lot of the returns that gold has driven. Let's talk about those points. So we spoke about the dollar.

03:04 - 03:21

There's also what inflation is doing or what real yields are doing in other parts of the markets, because remember, gold is not an income generating asset. So there's an opportunity cost to allocate to gold. And to the extent real yield are low elsewhere in the world, you would expect that opportunity cost to be lower and to help support gold prices.

03:21 - 03:49

The other factors would just be related to risk and uncertainty in markets, be it either trade or policy related uncertainty or just uncertainty related. The economic environment could also be a factor that drives gold prices, and that's the one that's most tightly coupled with a sentiment point. There's also other specific idiosyncratic drivers, such as the levels of production and the supply in the gold markets and the persistence in the returns of gold, etc. But those are still meaningful drivers, but much smaller.

03:50 - 04:03

They have a much smaller impact than the other macroeconomic factors we spoke about. So when you do your analysis and you look at these macroeconomic factors, is there some way to quantify how much of those issues explain the performance over time?

04:03 - 04:27

Sure. So it's going to be dependent on the horizon. So if you do this on very short horizons, you're not going to find a whole lot because, like to your point, it's going to be driven almost entirely by the sentiment aspect. But over long periods of time, say, for example, in a rolling three-year basis, you would find that a large majority of the variation in price, something like 80, 85 percent would be explained by most of these macroeconomic factors. OK, that's pretty significant.

04:27 - 05:02

And again, investors tend to allocate to gold tactically in order to offset the potential risk that they have in other portions of their portfolio. Now, as a more steady state, investors often use bonds, high-quality bonds as that offset, as that port in the storm, if you will. So... and bonds have done a pretty good job over decades playing that role. So in my mind, I mean, why look elsewhere? Why look outside of fixed income as your diversifier to stock market volatility towards gold or other asset classes?

05:02 - 05:09

Bonds have indeed been a very effective diversifier over the last 40 or 50 years. And frankly, that continues to be the case.

05:09 - 05:30

One thing investors need to keep in mind is that we are now talking about an environment where about 15 trillion of bonds are trading at yields below zero. We are starting to have active debates about the limits of monetary policy and supporting economic growth and also inflation expectations embedded across most asset classes are at one of the lowest points they've been in the last 40 or 50 years.

05:30 - 05:46

So while it's still the case that bonds are an effective diversifier, I think it would be prudent to not be complacent about the effectiveness of that diversifier in the future. So in my mind, it's a completely reasonable thing to start looking for alternatives to bonds as diversifies.

05:46 - 06:10

And I think gold could be one alternative to look at. So I take your point on the challenges that fixed income has in the years ahead and the potential benefit that gold can provide in in an overall well diversified construction. Vinod, you manage a portfolio that is the All Market Real Return Portfolio. So you're investing in assets that are trying to get and provide a return net of inflation, essentially.

06:10 - 06:42

How do you think through your allocation to gold and how should our listeners think about a potential allocation to gold? Should they do it on a tactical basis or more as a permanent evergreen portion of their allocation? The work that we've done in the past on this topic has led us to believe that a small allocation to gold somewhere in the two to five percent range in a broad stock bond portfolio would make sense. And that's the sweet spot, where you trade off the fact that you're giving up returns elsewhere to gain access to this and at the same time picking up a diversifier to the broader portfolio.

06:42 - 06:51

And to be clear, that's on a permanent basis, meaning it's always there, not like it's zero. And then it's two to five percent. Somewhere between two and four percent, I think would be a reasonable long-term allocation.

06:51 - 07:20

And sure, of course, you could move that around as the environment evolves and we can sort of position ourselves to suit the economic environment that we are in. I want to make sure our listeners understand that the reason why that permanent allocation makes sense relative to adding it and then taking it out and then adding it again is because of all of the uncertainty around those macroeconomic factors that you laid out before that tend to drive performance, not even talking about the sentiment factors that tend to drive performance, is that fair?

07:20 - 07:22

Yes, I think that's OK.

07:22 - 07:54

Now, I know gold has from time to time and most recently been linked to cryptocurrencies, right, in the conversation over the last few years about crypto currencies as an alternative to FIAT currency. Is that a fair comparison in your mind? I think it's useful when talking about money is to sort of define what money really is. And in my mind, for something to qualify as money, you need three aspects. So, one, it has to be a store of value, which is another way of saying that there should be a limit to how much supply there is, so it can be a store of value.

07:54 - 08:06

It has to be a medium of exchange that's convenient. And also it has to lend itself to an accounting system of credits and debit. So you could exchange it for products and services in the economy, either as a consumer or as a producer of those services.

08:07 - 08:15

OK, so how does gold stack up against those criteria? Well, all three, I would say FIAT money as well as gold and cryptocurrency. All with, all check the boxes on all of these criteria.

08:15 - 08:44

But it's important to remember there's one distinction between FIAT money and gold and cryptocurrency on the other side. With FIAT money, you're depending on a third party, such as a government or an institution to control the supply of money. And so there's an element of trust involved. With gold and cryptocurrency, the key difference is that there you don't really rely on a third party to control the supply of money, if you will. And that in the case of gold, it's more natural because of geological constraints on how much gold there is under the earth to mine.

08:44 - 09:09

And the case of Bitcoin is driven by an algorithm of how much bitcoins it could mine beyond a point. So I would say that cryptocurrencies do check all the boxes as far as the definition of money goes, but there are important differences. Gold has a history of over thousand years of playing this role of a currency, and at different points in time has proven to be a good alternative to FIAT currency. So it has that element of history behind it.

09:09 - 09:26

And also, I think most cryptocurrency implementations at this point are far too volatile and lacking in scale to be of interest to serious investors. Now, this might change 10 years down the line, but as it stands today, I would think that it's not a comparison that's fair between gold and cryptocurrencies.

09:26 - 09:31

OK, good point. So let me just try and summarize what we've covered to this point, because it's been a lot of information here.

09:31 - 09:58

All of it, I think useful gold tends to be driven by these two main forces, one either being sentiment-driven when investors are nervous about, you know, fill in the blank, or the fundamental factors that are related to the macro economy and the environment that we're in at that moment. Gold can be a good diversifier in certain periods of time, but trying to time those periods of time, like when they're going to occur, is increasingly difficult. That being said, again, they are a good diversifier.

09:58 - 10:12

So having a permanent, flexible but permanent allocation to gold can be an additional arrow in your quiver, if you will, from an overall diversification standpoint, would you agree or and add anything to that summarization? I think that's right, Matt.

10:13 - 10:47

The only thing I would add to that is to remember that the role as a diversifier is particularly interesting in daily events and environments. So these are by definition, events and environments that don't occur as often but... And are unknowable. Yeah, and there are unknowable, exactly. And when they do, they tend to have a large impact on portfolios. So this would be environments, for example, as you know, periods where rising geopolitical risks or periods where inflation is high and rising rapidly and the value of money is being eroded, or during periods of stagnation where growth is below average and inflation is running above average.

10:47 - 11:19

So these are the kind of environments, as, like I mentioned, don't occur too often in history. But when they do, you would find that the gold would probably be a better diversifier than most other assets. Yeah, you get an outsized benefit from owning them. But again, sizing it appropriately is key to not having inordinate amount of volatility because, you know, gold can be volatile in and of itself. You mentioned it has essentially the volatility of stocks, certainly more than stocks than it is bonds. So sizing it appropriately is key in building an overall prudent asset allocation. Vinod, we're going to have to leave it there.

11:19 - 11:24

So I want to thank you for joining us on the show and sharing some of your research insights. Thanks for having me. And thanks to all of you for listening.

11:25 - 11:46

If you'd like to learn more, please see the link to our December Capital Markets Outlook blog, Is Investing in Gold Worth Its Weight, in this episode's description. And if you enjoyed this episode and haven't yet subscribed to our podcast, please go to the iTunes store, Google Play, or wherever you listen to podcasts to subscribe and to rate us.

11:46 - 12:05

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