An old investment saying confounds the bulls and other market optimists: “Buy gold and hope it is the worst-performing investment in your portfolio.”
Why would any investor buy an asset and hope it underperforms? Because if gold is falling, the chances are that key global equity market indices are doing okay. Or, if US dollar-denominated gold is rising, it is a good bet that equity market volatility is rising and investors want shelter.
Gold’s status as a safe haven or form of insurance is well known, although too few investors, in my experience, understand gold’s role in portfolios and act. Often they equate gold to speculation as “gold bugs” punt on unknown junior explorers.
The case to increase gold allocation in portfolios is strengthening. Equity market volatility in October is a taste of what’s to come during the next 12 to 18 months. Adding gold and cash to portfolios in the next few months to make them more defensive is prudent.
I am not suggesting markets are about to tank, or that investors should take profits and run. The global economy, although likely to slow by 2020, is in good shape. Our economy, judging by Reserve Bank comments this week, has at least two years of solid growth ahead.
Focus on portfolio weightings
Ultimately, expectations of a recession spark bear markets and it is hard to see one in Australia any time soon, unless the property market has a harder-than-expected landing. The US economy is going gangbusters and global economic growth has a solid footing.
Moreover, I am not recommending investors load up on gold. For most, a weighting of 1% to 5% of the total portfolio makes sense; at the high end when market volatility is expected to rise and the lower end in the earlier stages of bull markets.
Conservative investors who live off their portfolio may have no gold allocation because the physical metal does not pay income. But for the most part, investors should have a small allocation to gold bullion – perhaps $100,000 or less in a $2 million portfolio.
Note that I say gold bullion. Too many investors mistakenly view gold equities as a proxy. Gold stocks have their place and can provide terrific leverage to the gold price if management is increasing reserves and production, lowering costs or doing deals. But gold equities should be considered within the portfolio’s equities component.
Make no mistake, if global share markets tumble, gold stocks will fall with them; perhaps less than other sectors, but enough to thump your portfolio. When buying gold stocks, investors assume market and company risk, in addition to commodity risk.
Stick to gold bullion if you want to use the metal as a form of insurance. Gold has a lower correlation with global equity markets, meaning it can rise as share markets fall. Gold did its job in the October equities sell off, moving from US$1,186 an ounce when markets fell to US$1,227. As often happens, investors bought gold during heightened market volatility.
Currencies are another factor. Gold historically has a negative correlation with the greenback: it rises when the greenback falls and vice-versa, although the relationship is not always clear-cut. Market expectations of further US interest rate rises and a higher greenback have weighed on the US-dollar gold price this year.
Contrasting views
The market has mixed views on gold. US banking giant Wells Fargo this week predicted gold’s recent rally would continue in 2019 and gave a 12-month price target of US$1300 – about 7% higher than the current price. “We suspect that gold could very well continue to rally as we exit 2018 and enter 2019, even if stocks do, too,” the bank wrote.
In contrast, a Macquarie Group analysis this week from London indicated that gold prices would average US$1,219 an ounce in 2019, noting a lack of catalysts to drive a larger re-rating. “Our concern increasingly is about [gold’s] fundamentals, which are often overlooked, but we think are tending towards market surpluses, meaning investor flows have to work even harder to push prices higher,” they wrote.
What strikes me about these and other bank forecasts is not the price targets; the bullish view on gold – a 7% cent gain over 12 months – is relatively tame. It is that the banks expect gold to do okay, even if global equity markets or the US dollar rise as US interest rates rise.
If those forecasts are correct, gold should have less downside risk in 2019 while still performing its role as a safe haven if equity market volatility spikes. The US midterm elections this week and Federal and State elections in Australia this year and next just add to uncertainty. Then there’s emerging-markets risk, a rising oil price and the US-China trade war.
A 7% return in gold bullion (possibly more in Australian dollar terms) over 12 months, while adding portfolio insurance, looks a reasonable trade-off between return and risk.
Gaining exposure
I favour exchange-traded funds (ETFs) for gold bullion exposure. Bought and sold like a share, gold ETFs are a simple, low-cost tool to add gold bullion exposure to portfolios.
The largest of them (and one of the market’s largest ETFs overall) is the ETFS Physical Gold ETF (ASX Code: GOLD). The ETF rises when the gold price rises (assuming constant currencies) and vice-versa. As the chart below shows, GOLD rallied in October when equity markets fell.
The ETF is unhedged for currency movements, so changes in the Australian dollar affect returns. GOLD’s annual fee of 40 basis points is competitive for a commodity ETF.
Chart 1: ETFS Physical Gold ETF
Source: ASX
Investors seeking pure exposure to gold bullion, without currency risk that can greatly influence returns, could consider the BetaShares Gold Bullion ETF (QAU).
The ETF tracks the price of gold bullion but, unlike the ETF Securities ETF, is hedged against currency movements in the Australian dollar/US dollar exchange rate.
QAU costs 59 basis points annually, a little more than the ETFS ETF because of currency hedging.
Chart 2: BetaShares Gold Bullion ETF
Source: ASX
The Perth Mint Physical Gold ETF, which recently debuted on the New York Stock Exchange (NYSE: AAAU), is the first of its kind backed by pure gold that is backed by a sovereign entity and offers shares that are redeemable for physical gold. The Western Australian Government guarantees all gold held on behalf of AAAU.
A key feature of AAAU is that investors may at any time exchange their shares for delivery of physical gold. Shareholders can select from a suite of premium bullion bars and coins available from The Perth Mint, which is also one of the largest suppliers of gold coins to the US market.
The Perth Mint ETF is an interesting idea for investors who like the extra comfort of a sovereign entity backing the gold and the ability to turn their ETF into physical gold. I can see the ETF appealing to self-managed superannuation funds, some of which hold physical gold bullion.
Chart 3: Perth Mint Physical Gold ETF
Source: Yahoo Finance
On balance, I favour the GOLD ETF. The BetaShares ETF has its place for investors who seek pure gold exposure and want to eliminate currency risk. But GOLD’s currency exposure works in its favour right now because I expect a modestly lower Australian dollar in the next 12 months.
The Australian dollar can be a shock absorber when global equity markets slump. If I’m right and we see higher-than-average volatility in equity markets next year, a lower Australian dollar and higher Australian-dollar gold price would be good news for GOLD investors.
Our lower currency has helped GOLD in relative terms: it returned 2.34% over one year compared with minus 5.88% for BetaShares’ unhedged QAU.
Rising US interest rates and a rising US dollar will limit the gains (in Australian dollar gold terms), but there is enough to suggest a reasonable return from gold over 12 months and, just as important, a much-needed portfolio tool when investors have to run for cover.
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs.
Before acting on information in this article, consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 6 November 2018.