In fact, the share of nontraditional assets among global pension funds reached 26% in December 2018 from 7% in 1998, according to Willis Towers Watson. In the United States, it’s 30%.
Gold has been a recipient of this shift. Increasingly recognized as a mainstream investment vehicle, global investment demand for gold has grown by an average of 14% per year since 2001 while the price of gold has increased by almost six-fold over the same period through Dec. 31, 2019, according to the World Gold Council.
And for pension plan sponsors, an allocation to gold can pay off in performance.
“Our analysis illustrates that adding between 2% and 10% in gold to a hypothetical U.S. pension fund average portfolio over the past decade would have resulted in higher risk-adjusted returns,” said John Reade, Chief Market Strategist at World Gold Council.
“Gold can play a strategic role in almost all portfolios almost all the time,” Reade said. “It can be valuable in long-term strategy and to weather short-term storms.” He added that in addition to improving risk-adjusted returns, gold can provide diversification and improve a portfolio’s liquidity profile.
The inflation hedge
Historically, gold has been viewed as a major hedge against inflation, and for good reason.
Since the gold standard was abolished in 1971, gold’s average annual return has been 10%, outpacing the U.S. consumer price index. Gold has also proven to protect investors against extreme inflation. In years when inflation was higher than 3% gold’s price increased 15% on average.
“Over the long term, gold has not just preserved capital but helped it grow,” Reade said. “Notably, research by Oxford Economics has found that gold should do well in periods of deflation. Such periods are characterized by low interest rates, reduced consumption and investment, and financial stress, all of which tend to foster demand for gold.
“Today, we are witnessing some of those exact conditions,” he said, adding that most economic recovery scenarios that he and his team have run suggest that investment demand for gold will remain strong in coming years, offsetting weaker consumer demand from slower economic activity.
Reade said that although the COVID-19 pandemic impacted consumer demand for gold in the first half of this year, five factors are likely to combine to keep growth solid over the near term. Those factors include:
Emerging market growth. The pandemic hit consumer demand in the first half of the year, particularly in India and China, two countries that had doubled their gold market share in less than two decades. But across emerging markets, economic expansion has driven increasing demand for gold fairly steadily since the early 2000s. Over the longer term, economic growth-driven demand for gold in emerging markets is likely to resume.
Market access. If the pandemic curtailed consumer demand for gold, it conversely provided support for investment. In the first half of 2020, inflows into gold-backed exchange-traded funds hit a record 734 tonnes. This surge of interest highlighted how the launch of gold-backed ETFs in 2003 facilitated access to the gold market for institutional and retail investors, and materially bolstered interest in gold as a strategic investment, reduced total cost of ownership and increased pricing efficiencies.
Market risk. The global financial crisis of 2008-2009 prompted a renewed focus on effective risk management and an appreciation of uncorrelated, highly liquid assets such as gold. Today, those features remain in focus as trade tensions, the growth of populist politics and concerns about the economic and political outlook have combined to keep investors on edge.
Monetary policy. Persistently low interest rates reduce the opportunity cost of holding gold and highlight its attributes as a source of genuine, long-term returns, particularly when compared to historically high levels of global negative-yielding debt.
Central bank demand. Gold is commonly used in foreign reserves for safety and diversification, and over the last 10 years, central bank demand reserve managers have primarily been net buyers of gold since. More recently, they have purchased multi-decade record amounts of gold, using the asset to diversify their foreign reserves. Here again, emerging market countries have led central bank demand.
Diversification is always critical
With their long-term time horizons, institutional investors are well aware of the importance of diversification but it can be hard to find effective diversifiers, particularly in a market environment that features as many headwinds as today’s. Many assets are increasingly correlated as market uncertainty rises and volatility is more pronounced, driven in part by risk-on/ risk-off investment decisions. Earlier this year, for example, when market volatility spiked due to the pandemic, asset class correlations converged.
According to Reade, however, gold’s negative correlation to equities and other risk assets increases as those assets sell off. The 2008-2009 global financial crisis is a case in point. Stocks and other risk assets tumbled in value, as did hedge funds, real estate and most commodities, which were long deemed portfolio diversifiers. Gold, by contrast, held its own and increased in price, rising 51% from December 2008 to December 2009.
“Gold has consistently benefited from flight-to-quality inflows during periods of heightened risk,” Reade said. “It is particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses. Importantly too, gold allows investors to meet liabilities when less liquid assets in their portfolio are difficult to sell, undervalued and possibly mispriced.”
Reade added that because of gold’s dual nature as an investment and a luxury good, it can also deliver positive correlation with stocks and other risk assets when those markets are rising.
“As such, the long-term price of gold is supported by income growth,” he said. “Our analysis bears this out, showing that when stocks rally strongly, their correlation to gold can increase, likely driven by a wealth-effect that supports gold consumer demand as well as demand from investors seeking protection against higher inflation expectations.”
Long-term returns, liquidity and effective diversification benefit overall portfolio performance and gold can provide a lift in all three of these areas for institutional investors such as pension plan sponsors seeking to meet investment performance targets, improve funded status or pay out benefits.
“Our analysis of investment performance over the past five, 10 and 20 years underlines gold’s positive impact on an institutional portfolio,” Reade said. “It shows that the average U.S. pension fund would have achieved higher risk-adjusted returns if 2.5%, 5% or 10% of the portfolio were allocated to gold.”
He added that while the amount any institutional investor should allocate gold varies, according to individual asset allocation decisions. Broadly speaking, the higher the risk in the portfolio — whether in terms of volatility, illiquidity or concentration of assets — the larger the required allocation to gold, within the range in consideration, to offset that risk.
“Gold’s optimal weight in hypothetical portfolios is statistically significant even if investors assume an annual return for gold of between 2% and 4% — well below its actual long-term historical performance,” Reade said.