INVESTING

The pros and cons of gold

Christopher Dhanraj |Jun 27, 2019

Chris explains the pros and cons of holding some gold as part of a multi asset portfolio.

The recent uptick in geopolitical tensions and concerns over a potential growth slowdown has pushed an ancient metal back into the spotlight:  gold.

Global investors have increased their positions in gold exchange traded funds (ETFs) by $4.3 billion from May 14th, one day after the S&P 500 Index’s 2.4% trade tension driven drop, through June 20th. This pushed the year to date total of ETF flows into gold focused products back into positive territory.[1] The Bloomberg Gold Index rallied more than 8% over this time frame. (Source: Bloomberg, BlackRock, as of June 20th, 2019. Notes: Flows are globally listed ETFs.)

Gold’s performance at times of geopolitical volatility underscores its potential value as a portfolio diversifier. However, gold has also performed well amid strong equity markets this year as real interest rates fell, as my colleague Russ Koesterich discussed in March.

But just as there are many “goldbugs” who are enamored by the asset, there are many skeptics who raise legitimate questions about it. We investigate potential merits of adding gold to portfolios below:

From pharaohs to photosynthesis: the industrial and investment case for gold

Interest in gold is as old as civilization itself, with the earliest known usage of the metal dating back to the early Bronze Age (4th millennium BC). Today, demand for the metal continues to come from central banks, investors, jewelers–as well as commercial applications. Scientists have even developed a way of achieving artificial photosynthesis through leveraging gold particles as a catalyst.

Still, a high proportion of annual demand for gold is based solely on investment demand. This can expose the price of the metal to a large amount of speculation. The World Gold Council data suggests that only 59% of demand is for commercial uses; 26% of 2018 gold demand was for investment purposes while another 15% was demanded by central banks. [2]

Three reasons to consider holding gold

Against that backdrop, there are three arguments for holding gold in a portfolio:

  1. Historically, gold has been a diversifying compliment to a traditional stock and bond portfolio throughout market cycles. The below matrix illustrates that the correlation between monthly returns of gold and other asset classes has low or negative correlations to other major asset classes.
  2. Gold’s out-performance in recessions: In the deepest draw-downs of the past three recessions, gold has outperformed all other asset classes, when investors again tend to flock to “safe-haven” assets. While BlackRock continues to see the current late-cycle dynamic persisting, holding gold in a portfolio can provide potential diversification benefits should a recession arise.
  3. Potential inflation hedge: Though the market currently sees little prospect for inflation, investors who wish to add an asset that offers a potential inflation hedge should consider gold. It is important to note that the level of real interest rates – the interest rate after inflation – is a key driver of gold returns.

Risk factors to consider

Several other risk factors to consider when it comes to gold is that the commodity generates no cash flows, no earnings, and requires storage costs.  This has influenced gold’s under-performance of traditional stocks and bonds over the longer term, since dividends and coupon payments are crucial drivers of total returns for stocks and bonds.

Additionally, as a commodity, the physical supply and demand of gold is crucial idiosyncratic driver of the commodity. On the demand side, central bank, investor and consumer preferences for the commodity have been relatively stable overtime, but they are subject to change. On the supply side, an increases in mine production could also weigh on gold.

In the shorter term, gold may face other headwinds. Lack of inflation may reduce its attractiveness and investors may shun the asset class should the market see a strong risk-on rally.

Conclusion

Gold has the potential to shine in times of market and geopolitical volatility. A small allocation to gold may be suitable for investors who are looking to real assets to diversify their portfolio. However, investors should balance the sizing of their position given the lack of yield and low current inflation expectations.

Related iShares Funds

iShares Gold Trust (IAU)

iShares Gold Strategy ETF (IAUF)

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