Making a case for “Investing in Gold”
-by Pratik Bajaj & Kunal Shah
“Gold Is Money, Everything Else Is Credit” -JP Morgan of JP Morgan
World’s total above ground gold reserves are estimated at 197,576 tonnes by World Gold Council. Using a $1750/oz spot price, world’s gold worth over $11 trillion while the world stock market capitalization is $90 trillion. Over the last 50 years (from Jan 1972 to Mar 2020), Gold has given an average return of 7.7% per annum while S&P 500 has generated 7% CAGR (if dividends aren’t reinvested) and 10% CAGR (if the dividends are reinvested).
From India’s perspective, the affinity for Gold can be understood from a simple fact that there are more jewellers in India than banks. India demands 23% of the world’s gold, calculated as an average of last 10 years regional gold demand.
Over the years, particularly after Global Financial Crisis (GFC), gold has regained its status of being a safe haven. What’s interesting to know is while it is monikered as a “store of value”, it actually has generated 8.87% CAGR in the last 10 years as compared to that of SENSEX 10.53% for similar time period (2010–2019). Important point to note here is that the stellar returns of gold are calculated without taking into effect-
· the recent price upsurge as investors are flocking to take refuge in gold amidst the coronavirus outbreak, and
· the fact that index is dynamic and changes to include performing stocks and ostracise non-performing ones.
During 2018–2019, gold has in fact outperformed the index generating 15.58% CAGR while the index moved up by an average of only 11.36%.
The increasing significance of gold as an asset class has more to do with the poor global macros. Primary factors behind such growth include-
- Low interest rates-
Fixed income securities have lost all their flavour as yields around the globe have fallen to close to low single digits or to zero in few economies with interest rates going negative. That reduces the opportunity cost of holding gold.
2. High volatility-
Raising uncertainty with tariff wars and overvaluation of stocks, there’s a renewed focus on effective risk management and an appreciation of uncorrelated, highly liquid assets such as gold.
3. Reserves demand-
2008-Financial Crisis has prompted a surge of interest in gold among central banks across the world, commonly used in foreign reserves for safety and diversification. Till 2010, central banks were net sellers of gold with an average of around 350 tonnes per annum over that decade; post 2010, they were net buyers with an average of around 500 tonnes per annum.
4. Eased access-
The launch of gold-backed ETFs has facilitated access to the gold market and materially bolstered interest in gold as a strategic investment, reduced total cost of ownership and increased efficiencies.
Gold as an asset class has multiple importance, namely-
1. Tool for portfolio diversification-
Ray Dalio says, “An ideal portfolio should have good quality uncorrelated asset classes to maximize risk-adjusted returns”. Gold is both an investment as well as a scarce luxury good, which reduces its correlation to other asset classes. Above chart shows correlation between gold and SENSEX for the last 35 years, which is close to zero normally, meaning gold prices are not dependent on movement of the index and can generate return as index progresses. But interestingly in the times when SENSEX ill-performs, the correlation tends to become negative, confirming that Gold generates returns when equities don’t, making it an effective tool for diversification. Surprising enough, when stocks rally strongly, their correlation to gold can increase and become positive, prompting in bold that it’s an all-weather investment.
2. Protector of tail risk-
The negative correlation between gold and equities tends to go deeper as equities fall further, hinting that Gold can protect from tail risks when markets and economy is dwindling. For example, the SENSEX fell by 56% from December 2007 to February 2009. Gold, by contrast, held its own and increased in price, rising 48% in INR terms over the same period.
3. Dollarization of portfolio-
Gold is also an effective way of taking an exposure in USD, as gold prices are determined in terms of dollar (or EURO) and then are multiplied with the spot USD/INR currency exchange rate to convert it into INR. With growing inflation and mounting national debt, money supply in the economy is increasing leading to depreciation of Indian rupees and hence taking dollar exposure can prove to be beneficial. Instead of buying currency futures and rolling over, gold can be used to dollarize the portfolio.
4. Highly liquid safe haven-
Gold has consistently benefited from “flight-to-quality” inflows during periods of heightened systemic risk as it is a safe haven. The supply of gold is balanced, deep and broad, limiting uncertainty and volatility. The gold market is also more liquid than several major Indian financial markets, including bonds and stocks, which is visible in the trading volumes as shown in the chart above. Gold allows investors to meet liabilities when less liquid assets in their portfolio are difficult to sell, undervalued and possibly mispriced.
Direct modes of investing in Gold:
- Physical gold- Bars, jewelry (Direct ownership but high markup and storage cost)
- Gold ETFs (Highly liquid, regulated by SEBI but involves fees)
- Future contracts (Highly levered and time bound)
- Sovereign Gold Bonds (Interest bearing instruments but involves a lock-in period)
According to an extensive analysis by World Gold Council, adding between 6% and 17% of gold to an Indian-rupee based portfolio could make a tangible improvement to performance and boost risk-adjusted returns on a sustainable, long-term basis.
