Introduction
In our previous white paper on gold 1, we discussed two key reasons investors typically cite as critical decision making factors supporting an investment in gold: as a form of protection against inflation and as a safe haven investment. We showed that current dynamics may support these investment theses over the foreseeable future:
- Expectations for future inflation have become elevated, and may remain so, given a backdrop of easy monetary policies the world over.
- Continued leverage throughout the economy is contributing to uncertainty over the future trajectory of the global economy and likely to result in ongoing heightened levels of volatility.
We believe these dynamics are likely to support ongoing strength in the price of gold over the foreseeable future and consider these to be important considerations in light of the current global economy. We would also propose that an equally important, and complementary, reason for an allocation to gold is its potential portfolio diversification benefit. Indeed, we show that historically, adding a gold allocation provided substantial enhancements to a portfolio’s risk-return profile.
This white paper focuses on the portfolio applications of gold: we analyze the benefits of adding gold to an investment portfolio. Our findings show that the addition of gold into an investment portfolio may significantly improve the overall risk-adjusted performance. Notably, gold may help to minimize downside deviations in the value of an overall portfolio, reduce overall volatility, and enhance returns. For example, in 2008, when the U.S. stock market plummeted 37.0% 2, gold actually appreciated in value during the year, returning 5.8% 3. Additionally, we show that low levels of correlation in movements in the price of gold relative to other asset classes is a primary factor in potentially enhancing overall portfolio performance and a key reason to consider the addition of a gold allocation. Specifically, we find that incorporating a gold allocation into an investment portfolio produces optimal results based upon efficient frontier analysis.
Superior Performance of Gold
Over recent years, gold has performed remarkably well relative to other asset classes, in terms of both absolute performance and risk-adjusted performance. Over the preceding 10 years, an investment in gold would have significantly outperformed a corresponding investment in the S&P 500 Index or U.S. bonds, not to mention international and emerging market equities. Over the past 10 years, gold outperformed U.S. equities by over three times:
As is depicted in the above chart, gold has generated consistently positive returns over this 10-year period. The gold returns and their volatility were favorable compared to other asset classes, especially relative to equity indices, which displayed more sporadic and volatile returns. In fact, on a year-by-year basis, gold has performed very well; outperforming U.S. fixed income over every year analyzed, and frequently in the top tier of asset class returns:
Impressively, and hand-in-hand with its consistent level of performance, gold has exhibited lower levels of volatility relative to the S&P 500 Index and international and emerging market equities, despite a period of unprecedented market volatility, as measured by annualized standard deviation of returns. The table below outlines the annualized standard deviation of returns for gold along with international and domestic equities, through June 30, 2012, over a variety of different time horizons. Notably, since the onset of the financial crisis, gold has exhibited lower levels of volatility relative to domestic and international equity markets, supporting the notion that it may act as a safe haven during times of crisis:
On a risk-adjusted basis, gold has produced superior returns, as measured by the Sharpe ratio 4. Over the 10-year period ended September 30, 2012, gold’s performance generated a Sharpe ratio of 0.85. In comparison, the S&P 500 Index generated a Sharpe ratio of just 0.30, as did international equities. Gold’s Sharpe ratio was nearly as high over the five year period, as it was over the 10-year period ended September 30, 2012, while comparable equity indices produced negative Sharpe ratios 5. In fact, over each time period analyzed, gold outperformed domestic and international equities on a risk-adjusted basis:
Indeed, the risk-return profile of gold over a 10-year period appears very favorable relative to other asset classes, as depicted in the following chart.
Portfolio Benefits of Gold
Given its historic risk-adjusted performance, it stands to reason that adding a gold component to an investment portfolio may help improve the overall risk-adjusted investment profile. For instance, through calendar year 2008, a portfolio comprised 100% of the S&P 500 Index would have lost 37.0% of its value. During the same year, gold performed much better, returning +5.8%. Adding just a 10% gold allocation to a portfolio otherwise comprising the S&P 500 Index would have reduced a 37.0% loss by nearly 5% in 2008, to -32.7% 6. Not only would the addition of gold have helped to improve the absolute performance of such a portfolio, but as we will demonstrate below, the risk profile would also have been improved. This should not suggest gold is a risk-free investment. As a reminder, after soaring from $35 an ounce in the early 1970s to $850 in January 1980, gold fell 65% within a couple of years to $296.75 an ounce in June 1982. So even as we look back as far as 20 years in the analysis below, gold may have periods of extra-ordinary performance, both on the upside and on the downside.
To further understand the potential portfolio benefits of gold, we analyzed its impact using a variety of efficient frontiers. We considered gold’s impact over five-year, 10-year and 20-year periods ended September 30, 2012. But as we shall see below, even over a 20-year period, when the S&P 500 Index outperformed gold, investors may benefit from adding gold to their portfolio. Firstly, we assessed gold’s impact over a five-year horizon on a portfolio comprised 100% S&P 500 on one hand, and 100% gold on the other.
The results were quite remarkable. As the above efficient frontier chart depicts, a portfolio comprised 100% gold (top right end of efficient frontier) would have returned 18.9% on an annualized basis, with a standard deviation of returns of 21.9%. In comparison, the S&P 500 returned a much lower 0.8% annualized, but a higher standard deviation of returns of 26.5% (lower right end of efficient frontier). Each point along the efficient frontier depicted above represents a 5.0% incremental change in the make-up of a hypothetical portfolio comprised of the S&P 500 and gold 7. Despite the S&P 500 significantly underperforming gold, the efficient frontier depicts an optimal risky portfolio having a blend of the two assets. In other words, a portfolio comprised both the S&P 500 and gold would produce superior risk-adjusted returns when combined with a risk free asset compared to a portfolio made up solely of gold, or solely the S&P 500, for the five-year period ended September 30, 2012.
The improvements in the efficient frontier by adding a gold component are due to two factors: the superior riskadjusted returns produced by gold itself, and the low level of correlation between gold and the S&P 500 over time. It is this low level of correlation that is important in understanding why a blend of the two assets is superior to one asset alone. When asset classes exhibit low levels of correlation to one another, it is less likely that they will move in tandem. The example of 2008, given above, is evidence that holding low correlated assets may help protect against downside movements in the value of an investment portfolio. Adding a gold component may reduce overall portfolio volatility. With monetary policy makers increasingly active in managing the economy, we have seen many correlations across asset classes approaching one. In such an environment, it is increasingly difficult for investors to find uncorrelated returns. Gold may fulfill this requirement.
Extending our efficient frontier analysis, we found similar results when analyzing the addition of gold to a portfolio comprised of the S&P 500 over 10-year and 20-year time horizons. In both cases, the optimal portfolio was a blend of the two asset classes:
Gold Shines even when Under-performing
Note that even during time periods when gold underperforms other asset classes, as it did during the 20-year time period analyzed above, the addition of a gold component improves the overall risk-adjusted return profile of a risky portfolio. We consider this to be largely driven by the low levels of correlation between the two assets and thus the positive impact it has on the volatility profile of the hypothetical portfolio above. For example, we find that a portfolio comprised 50% gold and 50% the S&P 500 would have exhibited an annualized standard deviation of returns of 12.7% over the 20-year period ended September 30, 2012. This is a significant reduction to the annualized standard deviation of returns exhibited by a portfolio comprised 100% the S&P 500, which was 19.2% over the same timeframe.
Gold Enhances Balanced Portfolios
fixed income (a 60%/40% mix, respectively). The results were very similar to the above analysis. We found the optimal portfolio composition over both a five-year and 10-year period was a mix of equities, fixed income and gold. Similar to its relationship to the S&P 500, gold exhibited very low levels of correlation of returns to the equity/fixed income index used in our analysis. For instance, over the five-year period ended September 30, 2012, we found the correlation of returns to be just 0.05. Such a small correlation is a key contributing factor in why gold may improve the risk-adjusted returns of these portfolios.
The following charts clearly highlight how the addition of a gold component can potentially enhance the riskadjusted return profile of an investment portfolio:
Through the above analysis, we have found that adding a gold component may create a more optimal investment portfolio composition. Specifically, gold’s superior performance and low correlation to other asset classes may enhance the risk-adjusted returns of an overall investment portfolio.
Conclusion
As our analysis has shown, the portfolio benefits of an investment in gold are compelling. Gold has shown superior performance over a variety of different timeframes, while maintaining a more contained risk profile relative to other asset classes. As evidenced by using an efficient frontier analysis, we demonstrated that the addition of gold may increase overall portfolio returns, while concurrently reducing the overall volatility of a portfolio. In particular, the low level of correlation in the price of gold relative to other assets may generate superior portfolio diversification benefits. These attributes, unique to gold, are critical in increasing risk-adjusted performance, which we have shown to be higher in portfolios with an allocation to gold relative to those without. Overall, we consider our analysis supports the notion that investment portfolios may benefit from the addition of a gold allocation.
