The only true money

Category: Asia, Global, U.S.A.
By Paul Mackintosh

Way more risk in not having an allocation to gold than in having one

Whatever else the Trump presidency has done for America, or the world in general, it seems to have done wonders for gold. “Now’s the time for gold”, proclaims content provider Seeking Alpha, instancing the latest resignations and sackings in the White House as though these were market-moving information specifically geared to trigger moves into gold holdings.

Gold bugs have a habit of using exogenous events to reinforce the case for their favourite asset class, waiting for the market cycles to throw up fresh confirmation of a story that has never gone away. Many, in fact, trace that story back far further than the so-called Nixon Shock of 1971, which unilaterally ended the Bretton Woods system of international financial exchange by cancelling the direct convertibility of the US dollar to gold.

Economist Paul Krugman’s celebrated assessment of subsequent US monetary policy and gold states “the current world monetary system assigns no special role to gold”. A certain class of investors, though, takes the completely opposite view. Are they justified, with or without Mr. Trump?

Dominance of gold

Advocates for gold naturally advance more solid arguments than the abstract belief in gold as the true underlying basis of all monetary value. They are compelled to argue that gold is an asset class like any other, with its own characteristics and advantages.

“Gold has three potential benefits that are key reasons why investors should consider including gold in their portfolios,” says Robin Tsui, vice president and ETF gold specialist at State Street Global Advisors.

“Firstly, gold can help to increase portfolio diversification due to its low correlation to most asset classes. A low correlation between the asset classes would lower portfolio volatility and therefore, all else being equal, increase portfolio diversification and enhance the overall risk-adjusted return of the portfolio.”

“Secondly, gold helps to manage tail-risk,” and “lastly, gold helps to manage inflation. Gold also has a long track record of offering some potential preservation of purchasing power in varying inflationary environments.”

Ned Naylor-Leyland, fund manager at Old Mutual Global Investors, advocates a more “direct approach”. In his view, “gold is money, and everything else is credit.” This is not to exclude silver and other specie metals. But, he continues, “silver is money as well. Nothing else is. Gold and silver trade in FX [foreign exchange] markets, so they are money… Silver is like a paddling pool version of the gold swimming pool.”

In other words, silver currency and other specie metals are no argument against the essential dominance of gold, and are more proxies for it. As Mr. Naylor-Leyland points out, “the global super-rich and central bank community and the global poor all hold gold as one of or their actual core asset class… the only band that doesn’t hold gold as a core asset class is the intermediated financial world.”

The financial world currently seems to turn to gold during times of crisis. “History has shown that gold was able to deliver competitive returns and outperformed other asset classes during a number of past ‘black swan’ events,” says Mr. Tsui. “This demonstrated that including gold in a portfolio may provide investors with a means of moderating market volatility and reducing portfolio drawdown.”

This is no surprise, perhaps, when you consider one fundamental characteristic of gold and specie metals. “All the other kinds of money you have are both assets and liabilities,” says Mr. Naylor-Leyland. “Physical money you hold in your hands is free of liability.”

A diversification tool

So, assuming that gold’s qualities do give it a place in a portfolio, what should that place be? And how much? “Investors should consider the merits of including gold in their portfolios as a strategic, long-term investment,” Mr. Tsui recommends. “Our recent research paper has shown that adding a 2%-10% strategic asset allocation to gold in a hypothetical multi-asset portfolio over a 12-year period (2005-16) would have improved risk-adjusted return and reduced maximum drawdown.”

Perhaps predictably, Mr. Naylor-Leyland is even more emphatic on the value of adding gold as a component of a portfolio. “The idea that it’s a component of anything is not right. It’s the core of the entire financial system, from whence this entire system has developed and whither it’s going to return,” he asserts. “The preferred settlement currency of global trade is gold.”

In his perspective, the then US President Richard Nixon’s actions in 1971 dislocated a historic norm, but “we’re returning to that now”. In China, he notes, “the trades are being settled in RMB with gold conversion in the Shanghai Free Trade Zone.” Gold is the only true money, “and we’ve lived through a dislocated paper money credit cycle through the past 45 years which is now ending.”

“We believe that as the size and the number of investable asset classes continue to grow in the future, gold, an asset with historically low and negative correlation with other asset classes, ought to play a more permanent role in a well-diversified portfolio,” according to Mr. Tsui.

Mr. Naylor-Leyland additionally asserts the importance, not only of holding gold, but a large amount of it. “The data looking at modern portfolio theory and back-testing portfolios show that gold is the best decorrelated diversifier you can hold. However, some theories say that you have to hold a very large amount,” he says.

Actual performance

Less committed investors may want to take a closer look at gold’s actual current performance. They are unlikely to be disappointed. “Gold is [up] 12% year-to-date [as of August 10],” Mr. Tsui notes. “Ongoing and escalating geopolitical tensions, weakness in the US dollar, the Trump administration’s inability to push through policies and legislations, and the current low real interest rate environment have all benefited gold.”

Furthermore, Mr. Naylor-Leyland believes that the price and performance of gold suffer from structural impediments, because “since 1980, the gold and silver markets have been smashed into a thousand pieces by the banking system in order to sustain financialisation.” He notes that “the price discovery takes place in a purely paper market, essentially the FX market.”

Additionally, there seems to be no prospect of the ‘black swan’ events stopping any time soon. “We remain bullish on gold in the near term as we believe these factors will continue to support gold prices,” Mr. Tsui says.

There is also the possibility, in some views, of a hike in gold values driven by a shift in the global monetary system. Mr. Naylor-Leyland argues that, “if you look at a chart of US dollar gold versus US dollar real yields, it will show you a perfect inverse correlation.” Gold, in his view, is “inversely correlated to US real yield expectations.” And with only “about 0.5%-1% of actual backing in the system” of gold and precious metals underpinning global currencies, he predicts that “there will be a run on this very meagre cover.”

Investment options

For anyone looking beyond pure bullion, there are plenty of investment options for accessing gold. “There are many ways for investors to gain exposure to gold, ranging from physical gold, gold ETFs [exchange-traded funds], mutual funds, gold futures, and gold mining stocks,” Mr. Tsui says.

Mr. Naylor-Leyland notes that 40 or 50 years ago, gold “would have been a huge proportion” of a typical portfolio, “and now it would be as good as zero.” That said, “for your average investors, the way to access precious metals is to think about it as a cake. The most important part of the cake is the base. That is physical, holding it in your hands, in coins… Some people will have a larger base, some thinner, depending on their net worth.”

However, Mr. Tsui cautions that “investment in physical gold bullion is the most direct way to invest in gold, but it may involve higher ongoing costs for transport, storage and insurance.”

Pursuing his cake metaphor, Mr. Naylor-Leyland advocates a filling of “the best quality gold mining stocks”, potentially including ETFs. “The icing and fireworks that go on top are leveraged assets and derivatives. That is the decoration on a monetary metals cake.”

“Gold mining companies may be influenced by the gold price, but their growth and performance also depend on effective management, production costs, reserves and exploration, among other factors,” Mr. Tsui says.

“Gold futures are widely used by investors looking for exposure to gold and have the benefit of being traded in standardised contracts on exchanges.” However, he adds, “futures do not require full funding up front, which may be preferable to those investors looking for leverage, but the requirement to regularly roll futures contracts to maintain exposure does mean ongoing management of the gold position is required for a longer-term strategic allocation. US-listed mutual funds with a precious metal strategy on average are more expensive than gold ETFs.”

“The key point to understand in this asset class is that there’s way more risk in not having an allocation than in having one,” concludes Mr. Naylor-Leyland.