Gold is one of the most commonly traded commodities. It is mostly known for its use as a safe-haven asset at times of market uncertainty and declining yields. I will break down my argument for gold here into two parts: a micro argument and a macro argument. After that, I will prove to you why GLD in specific is the best security to buy for exposure to gold.
On the micro side, gold has very favorable demand factors. For one thing, foreign banks have been increasing their purchasing of gold, especially banks of developing countries. Examples here include Thailand, Indonesia, India, Philippines and Egypt, which just bought gold for the firm time since 1978. There is a 193-tonnes increase in gold buying in the first half of 2018, an 8% increase from the 178 tonnes bought in the same period last year. The reason why central banks buy gold are not for value or inflationary reasons; rather, it’s to diversify away from USD reserves, especially as the world seems to gradually drift to a multi-polar reserve system. While central banks are not the sole demanders of gold, an increase in central bank demand is still a positive sign. Secondly, gold is underpriced relative to the money supply. Growth in money supply, namely M2, is correlated to increases in gold prices. Gold and M2 historically approach a long-term average ratio of around 1. The current ratio is 0.87, clearly under the average. When mean-reversion happens, as it historically does, gold is expected to gain in price. Thirdly and as mentioned above, gold is a safe-haven asset. At times of market volatility, investors usually sell risk-on assets such as U.S. equities and buy risk-off assets like gold in a flight to safety. The unsettled global issue of trade wars is expected to generate volatility in the market, and that volatility will be a positive driver for gold. On average, following months of high-volatility, gold returns 15% in the next year. Lastly, the expected lower aggression in interest rate hikes, as recently revealed by Fed chairman Powell, should help gold prices. This is because increases in interest rates in theory increase the opportunity cost of buying gold: when rates are high, yields are high and thus yield-generating investments are more attractive than commodities that don’t pay interest or dividends. However, given Powell’s recent statement, rates are not expected to significantly rise in the future, thus eliminating much of the risk associated with value loss due to alternative options of investment.
Despite all micro market conditions, gold is always a good investment for portfolio diversification, especially for equity-heavy portfolios. Gold is uncorrelated to equity over the long run, and its 6-month and 1-year rolling correlations with equity are also quite low. According to portfolio theory, adding an uncorrelated asset to an existing portfolio would lower the overall portfolio risk. Not only that, but increasing the allocation to gold, given its uncorrelated status to all asset classes, actually lowers portfolio drawdown. This means that portfolios that are diversified with gold exposure have a quicker recovery after market declines. Lastly, having a small allocation to gold in an equity portfolio actually increases the overall portfolio’s risk-adjusted return. To show this effect, one can compare the returns of the S&P 500 on the one side, and then an adjusted portfolio of 95% S&P 500 and a mere 5% allocation to gold using historical data since 1968. Data shows that an adjusted portfolio with a small gold allocation always yields a marginally higher return. So not only does gold reduce overall portfolio risk, it also increases the portfolio’s Sharpe ratio.
Gold ETFs are the best market securities for gold exposure due to two main reasons. First, buying an ETF is easier than owning physical amounts of gold, as the latter is expensive in terms of storage. Secondly, the alternative of buying gold companies is riskier because companies are subject to equity risk. Having market risk means that gold companies lose value at times of systemic market downtowns. All assets with systemic risk usually approach a correlation 1 with other asset classes at times of recession. Gold and gold ETFs, on the other hand, lack equity risk. Matter of fact, gold gains in value at times of recessions due to its safe-haven status. They are many gold ETFs out there, the two most prominent of those are the Ishares Gold Trust (IAU) and the SPDR Goldshares (GLD). Both of the aforementioned gold ETFs are comparable. The reason I pitch GLD as slightly superior is because it is traded more, so it is more liquid.
The SPDR Gold Trust (GLD) holds physical amounts of gold. In 2017, the trust held over 26.5 million ounce of gold. Shares provide ownership of the fund, whose only asset is gold. The best part about this gold ETF is that it not only tracks the actual gold price with about 1% tracking error, but it is also very inexpensive. The fees total only 0.4% annually.
In conclusion, microeconomic market conditions make investing in gold quite opportune. Regardless of all market conditions, however, buying gold is almost always a good idea for the health of the overall portfolio as it not only reduces portfolio risks, but also marginally amplifies returns given gold’s diversification benefits. In my opinion, best exposure to gold comes from an ETF that very closely tracks the actual commodity price and is both liquid and cheap. That is why I bought GLD, and why I strongly believe that equity-heavy portfolio managers could strongly benefit from doing so themselves.