The Strategic Case for Gold as an Investment

What’s the strategic case for gold as an investment? We posed this question to Juan Carlos Artigas, the head of investment research for the World Gold Council, the market development organization for the gold industry. His responsibilities include managing the global investment research team and providing oversight of research initiatives related to positioning gold as an integral part of investor portfolios. Juan Carlos previously worked for JPMorgan Securities, as a US and emerging markets fixed-income strategist.

CFA Institute: As the market development organization for the gold industry, how does the World Gold Council see the core case for gold as an investment?

Juan Carlos Artigas: The strategic case for gold is centered on risk management and capital preservation. Gold offers investors a liquid asset that lacks credit risk and that provides diversification during good times and bad. During periods of market stress, gold is able to reduce portfolio losses by outperforming most other assets. It is also able to protect investors’ purchasing power through its ability to hedge against high inflation and currency devaluation.

All these characteristics are underpinned by a diverse set of demand and supply drivers. For example, gold uses in jewellery and technology make up almost 60% of annual gold demand; investment demand captures a little over a third; and central banks have turned from net sellers into net buyers over the past few years. In addition, viewed from a geographical perspective, emerging markets account for approximately 70% of gold consumer demand on an annual basis. As such, gold demand is not driven solely by economic uncertainty in developed markets — in the form of investment — but supported by income growth in developing nations which are anticipated to account for the lion’s share of the world’s GDP in less than a decade.

Rather than focus on gold’s qualities in isolation, analysis shows that investors should use — and analyze — gold as a strategic (medium- to long-term) component of their portfolios. In particular, in the latest edition of our quarterly journal, Gold Investor, we show that holding 5% to 6% in gold within a well-balanced 60/40 portfolio — 60% in stocks and risk assets, 40% in cash and bonds — is optimal for helping investors reduce risk and improve risk-adjusted returns.

Gold’s optimal allocation increases when risk in the portfolio increases. The additional risk can come from a larger allocation to stocks or other risk assets, but it also can stem from higher credit risk, inflation risk, or currency risk.

Investors have multiple options for adding gold to their portfolios. These include bars and coins, gold-backed ETFs, gold accounts at bullion banks, mining stocks, futures and options, and over-the-counter solutions. These vehicles have characteristics that may benefit different types of investors. Typically, most investors will find gold-backed ETFs to be fairly cost effective, but they may benefit from having gold exposure in more than one form.

Gold’s price has declined substantially from its highs. What explains the sudden and relatively sustained drop?

There are several factors that contributed to the drop in the gold price. Many investors grew increasingly bearish on the gold price as a result of several macro-economic developments:

• An improving US economy, which led to speculation about the imminent tapering of asset purchases by the Federal Reserve;
• Declining inflation expectations across the world, driven lower by inflation readings;
• A potential slowdown across several emerging markets, particularly China; and
• Speculation around the potential sales of gold reserves by European central banks.

However, while many of these factors guided short-term positioning on gold, long-term global factors such as organic demand growth, retail consumption, and central bank reserve asset management policies, coupled with fairly constrained supply, have already balanced some of the recent price dynamics. Put simply, while Western investment demand is an important component of the gold market, it is by no means the only or most relevant one over the long run.

Is gold price inversely related to the confidence in the global economy?

Gold has several pro-cyclical and counter cyclical drivers. While investment-driven purchases increase during times of contraction, savings- and consumption-related purchases increase during times of expansion. Thus, even though gold is typically inversely related to confidence during times of stress, its relationship changes throughout the business cycle.

As a result of these offsetting factors, gold has a lack of correlation with equities and most other assets investors hold in their portfolios. Consequently, gold’s contribution to portfolio volatility is not only small, but in most instances it helps to significantly contract it; it’s a particularly useful tool to protect purchasing power and preserve capital wealth over time.

The digital currency Bitcoin is being called the digital gold. Do you think that Bitcoin can pose a challenge to gold?

On the surface, there seem to be a few similarities between Bitcoins and gold, including a constrained supply and their use as a unit of exchange. However, similarities end there. Gold is a virtually indestructible, tangible asset that has played an integral part in the monetary system hundreds of years. And this role will continue to grow, especially as the global monetary system morphs into a multi-currency one. Gold forms one of the most liquid markets in the world, comparable to daily trading volumes on major currency pairs such as the US dollar and pound sterling. It trades in transparent, global exchanges with visible pricing mechanisms. Gold is also a high-quality component to central bank foreign reserves, a role that it shares with US Treasuries and other sovereign debt bonds. In fact, it is worth noting that not even silver — a seemingly well-established and fairly accessible alternative currency — plays such an important role. Further, gold is a divisible unit that, beyond its uses as a currency and investment, it is used in sought-after jewellery and high-end electronics around the world. In fact, over half of gold’s demand is linked to global consumption. Consequently, gold provides diversification and wealth preservation to investors’ portfolios in a way that no other asset can, let alone something as speculative as a Bitcoin.

On a different note, what is the role of the World Gold Council in responsible mining, balancing environmental and social issues in gold mining?

The World Gold Council is committed to the development of a truly sustainable gold mining industry. Responsibly undertaken, gold mining and its associated activities can have a transformative effect on socioeconomic development in countries where gold is found. When produced in conformance to high social, environmental, and safety standards, gold provides employment opportunities, improved infrastructure, and tax revenues. It can also drive foreign direct investment and generate foreign exchange. In 2012, the industry made an economic contribution of more than US$78 billion to the top 15 gold-mining economies.

Some of our key activities in this sector include: the developing the Conflict-Free Gold Standard, a common approach by which gold producers can demonstrate that their gold has not supported unlawful armed conflict; the development of the guidance note on all-in costs; and a number of reports that demonstrate economic and social value of gold mining. This body of research covers the impact at both a country and a global level. Our latest two reports, both released in October 2012 are The Direct Economic Impact of Gold (commissioned by the World Gold Council and undertaken by PwC) and Responsible Gold Mining and Value Distribution.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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