A lot can change in a year. As global economies begin to reopen in response to wider vaccine distribution, risk assets continue to take center stage among many investor discussions. However, amid this continued bullish sentiment lies a backdrop of certain rising risks — namely, stretched equity market valuations and bond yields remaining below inflation, which have created a potential asymmetrical return profile.
These factors emphasize the importance of diversification, a trait that gold — the original liquid alternative — has historically provided. Gold is one of the oldest financial instruments, dating back thousands of years, and may offer unique risk mitigation and diversification characteristics for portfolios compared to other liquid alternatives.
Following a strong 2020, with gold reaching an all-time high of US$2,067/oz last summer,1 gold performance has remained subdued year to date, as shown below. Some have claimed that other liquid alternatives which have outperformed recently, or even cryptocurrencies such as Bitcoin, should replace gold’s role in portfolios as the preferred diversifier and potential portfolio hedge.
Figure 1: Year-to-Date Performance
Adding liquid alternative asset classes such as real estate investment trusts (REITs), natural resources, global infrastructure, liquid hedge strategies or broad commodities may potentially help investors mitigate risk in a traditional 60/40 portfolio. But gold, the original liquid alternative, has historically shown it may serve portfolios more effectively.
Protecting Portfolios During Tail Events
In a fervent bull market, like the one we find ourselves in now, mitigating risk may not be front of mind. Yet, it remains incredibly important. More so now given the asymmetrical return profile for stocks and bonds that features less of a fundamental backstop (high valuations, low yields) if a correction does occur, even though the reopening of economies will continue to be the driver of growth in the near term.
This aspect of persistent downside risk mitigation is on display in the chart below, illustrating that each time equities dropped more than 10% over the last decade, a 10% portfolio allocation to gold would have reduced portfolio drawdowns by 161 basis points (bps) on average compared to a traditional 60/40 portfolio, while the same allocation to most other liquid alternatives would have had the opposite effect — increasing average drawdowns.
Figure 2: Gold Reduced Drawdowns During Times of Market Stress
A True Alternative to Risk Assets
Gold has not only exhibited a low correlation to global stock/bond portfolios, but exhibited a low beta as well. While correlation showcases directional tendencies in movement of two assets, beta attempts to measure the explanatory power and quantify possible cause and effect.
Gold’s performance is explained by more than just the vicissitudes of global equity and debt markets. Gold is driven by its own market’s fundamentals — gold demand in the form of jewelry, technology, central banks, and investment along with changes in gold supply globally. Compared to gold, other liquid alternatives and Bitcoin have higher betas to global stock/bond portfolios; this shows that their performance is determined by these markets. This may result in a less effective source of portfolio diversification.
Figure 3: Gold Is an Effective Portfolio Diversifier
Volatility Can Lead to Bad Investment Decisions
Understanding the value at risk when adding a liquid alternative investment is important because high volatility can create fear and uncertainty which may lead to irrational investment decisions. Before the emergence of Bitcoin and other cryptocurrencies, investors were sometimes hesitant to allocate to gold due to its potential volatility. Gold can at times exhibit significant volatility but, as shown in the table below, even at its most volatile, gold ranks on par with global equities which, in theory, should be less volatile since it’s a basket of many stocks while gold is a single asset. As expected, Bitcoin’s volatility is much greater than liquid alternatives and nearly five time greater than gold over the last 12 months. While Bitcoin volatility has decreased from 174% to 86% recently, it is still higher than the peak volatility gold and liquid alternatives experienced at the height of the 2008 financial crisis. During this period, REITs were most volatile with a 1-year annualized volatility peaking at 71% in 2009.2 Meanwhile, gold matched global equites in 2009, peaking at 33% rolling 1-year annualized volatility.3
Figure 4: Gold Looks Relatively Tame When Comparing Annualized Volatility
Maintaining Gold for Risks Ahead
After being down as much as 10% this year (driven by rising yields and a stronger US dollar), peak bearishness in gold may have been met. In Q2, gold-backed ETFs experienced positive inflows which could indicate that those investors who opened a gold position in 2020 to only hedge COVID-19 disruptions may have already closed those positions by now. Remaining ETF holders may be a combination of strategic and tactical investors seeking diversification and protection against future market risks, whether it is inflation, a weakening dollar, or monetary policy missteps.
Figure 5: Global Appetite for Gold-backed ETFs Continues to Grow
There are ideally three main portfolio construction goals: capital appreciation, income, and downside risk management. In a bull market, it is sometimes hard to focus on the third. Yet, it is needed and alternative investments should be considered. However, not all alternative assets offer the proper amount of diversification. Overall, whether an investor is considering adding alternatives to their asset allocation, has already done so, or is primarily focused on traditional assets, gold — the original liquid alternative — may be a potentially strong complement to traditional asset allocation models and potentially enhance portfolio performance over time.
1Bloomberg Financial L.P., and State Street Global Advisors. Gold reached all-time high in US-dollar terms on August 6, 2020. 2Bloomberg Financial L.P., and State Street Global Advisors, data as of June 30, 2021. 3Bloomberg Financial L.P., and State Street Global Advisors, data as of June 30, 2021.
Basis Point (bps)
A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
Bloomberg Barclays Global Aggregate Bond Index A benchmark that provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the US Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment-grade 144A securities.
FTSE NAREIT All Equity REITS Total Return Index The index is a free-float-adjusted market capitalization-weighted index that includes all tax-qualified REITs listed in the NYSE, AMEX, and NASDAQ National Market.
HFRX Global Hedge Fund Index The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies, including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset weighted based on the distribution of assets in the hedge fund industry.
MSCI All Country World Index Captures large and mid cap representation across 23 Developed Markets (DM) and 26 Emerging Markets (EM) countries. With 3,050 constituents, the index covers approximately 85% of the global investable equity opportunity set.
S&P GSCI Total Return Index The S&P GSCI Total Return Index in USD is widely recognized as the leading measure of general commodity price movements and inflation in the world economy. The index is calculated primarily on a world production-weighted basis comprised of the principal physical commodities futures contracts.
Spot Gold Price The price in spot markets for gold. In US dollar terms, spot gold is referred to with the symbol “XAU,” which refers to the price of one troy ounce of gold in USD terms.
S&P Global Infrastructure Net Total Return Index The S&P Global Infrastructure Index is designed to track 75 companies from around the world chosen to represent the listed infrastructure industry while maintaining liquidity and tradability. To create diversified exposure, the index includes three distinct infrastructure clusters: energy, transportation, and utilities.
S&P Global Natural Resources Total Return Index The index includes 90 of the largest publicly-traded companies in natural resources and commodities businesses that meet specific investability requirements, offering investors diversified, liquid and investable equity exposure across 3 primary commodity-related sectors: Agribusiness, Energy, and Metals & Mining.
S&P 500® Index The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
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