Uncovering the truth about investing in gold

Gold has been treasured by people for thousands of years, whether as a means for bartering or as a symbol of wealth, but questions are still being asked particularly around its investment characteristics. Is gold an inflation hedge? Is it suitable for ESG investors? And where does it fit in a diversified portfolio?

Today, gold is held by a range of investors for a variety of reasons, from central banks wanting to diversify their reserves to individuals wanting physical assets that may retain value over time. Gold held by retail and institutional investors has increased substantially over the past 20 years, due mainly to gold-backed exchange-traded products making it easier for them to gain exposure. 

As investors are adding gold to their portfolios, they naturally want to know more. Here we look at five of the most asked questions and provide insight to understand the truth.
 

Q1: How good is gold as an inflation hedge?

Gold can be useful in times of high and rising inflation, particularly when other factors such as economic slowdown or uncertainty also support risk-off assets.

Since 1971, gold has returned an average of 15% per annum when inflation has been above 3%, compared to a 6% annual return when inflation has been below 3%¹. Of course, the answer is not so simple. Gold tends to be less desirable by investors when inflation pressures come from demand “pulling” prices higher, as the market prices in an expectation that central banks, particularly the Federal Reserve, will control rising costs through conventional monetary policy. A strong US Dollar and rising bond yields – both often accompany rising interest rates – are also generally seen as headwinds to gold because the former makes it more expensive for non-US buyers and the latter increases the opportunity cost of holding non-yielding assets such as gold.

However, when inflation is “pushed” higher, for instance from a sudden unexpected event or crisis, gold tends to be a more effective hedge. We saw this in the ‘70s when oil prices spiked, and wage growth and other inflation pressures meant simply raising interest rates was less effective. This and again in the early ‘80s were the only periods over the past 50 years when inflation was at the sort of levels we’re now experiencing, albeit we’re still a little way off those double-digit highs.

Over these past 50 years, gold has produced positive real and nominal growth during periods of high inflation, stagflation and recession, as well as small positive returns in more balanced growth phases.

It’s worth highlighting from this analysis that the greatest real returns for gold have been during times of stagflation, which is the most worrying economic scenario for most investors in the current market climate. The prospects for gold in 2022 will depend largely on the impact of Fed tightening (which is currently estimated to take the Fed Funds rate to upwards of  3.5% by the end of the year²) on inflation, unemployment and economic growth. Recession and stagflation risks are real concerns.

Q2: Is gold an ethical investment?

The question is whether ethics can be safeguarded across the entire gold supply chain, from mine to vault in the case of bullion held on behalf of physical gold exchange-traded products.

The gold mining and refining industries are focused on improving sustainability, accountability and transparency. The goal is to provide investors and consumers with more clarity and confidence that the gold they are buying has been sourced and processed according to a high set of standards. As a provider of one of the largest physical gold ETCs in Europe³, we aim to ensure all the bullion stored in the custodian’s vault on behalf of the ETC meets those industry standards.  The biggest concern for most investors until around a decade ago was stopping the amount of gold used to fund or support unlawful armed conflict, particularly involving oppressive regimes in frontier economies. The World Gold Council launched the Conflict-Free Gold Standard (SFGS) in 2012, putting in place processes for mining companies to guard against this risk. The CFGS has now been incorporated in the Council’s more comprehensive Responsible Gold Mining Principles, issued in 2019, for its 32 member firms (mining companies). This framework establishes what constitutes responsible gold mining.

Likewise, the London Bullion Market Association (LBMA) has a mandatory Responsible Sourcing programme for any refiner wanting to trade with the London Bullion market. The LBMA issued its Responsible Gold Guidance in 2012 and has updated the document multiple times since then to incorporate incrementally improving guidelines and auditing guidance around relevant issues. They continue working with mining companies to develop best practices across the industry.

The World Gold Council and LBMA have been issuing separate guidance to their members since 2012 and are now working together on a combined framework, trialling a blockchain solution for tracking gold from the mine all the way through the supply chain. We will comment as details are released, and on critical areas such as recycled gold and artisanal and small-scale mining (ASM).

Q3: What is gold’s impact on the environment?

Mining is an energy-intensive process that often impacts the local ecology and, while it may never be totally environmentally neutral, improvements can be made to reduce the negative impact.

The source of the power generation will make an enormous difference in the environmental impact of a particular mine, from low if hydro power is available to high if the mine relies on a coal-fired power plant. The overall impact of the mining industry should improve over time if countries transition to more sustainable energy sources. Responsible mining companies are also required to monitor and report on the management of tailings to ensure the local ecology is not compromised.

At Invesco, these environmental issues are generally top of our agenda when we engage with the senior management of the mining companies in which we have equity holdings. We seek to better understand their views, steps they are taking to mitigate risks and reduce their carbon footprint.

Mining companies must also have plans for restoring the ecology at the end of the mine’s lifetime. Ethics extend beyond the environment, of course, and mining companies can make a positive impact on addressing socio-economic issues. Given that a productive mine may be in operation for many decades, mining companies will often help develop local housing, transportation, schools and medical infrastructure. This can have long-term material benefits for emerging economies.   

Find out more about what we’re doing to make gold more sustainable and responsible.

Q4: Does gold have intrinsic value?

Gold has tangible value, although many investors point to it being a non-yielding asset and, therefore, difficult to assign fair value by conventional methods.

While much of gold’s value is linked to its investment characteristics and cultural significance in major jewellery markets such as India and China, gold’s physical properties also make the precious metal valuable for use in a range of high-end technology applications including from the medical and aerospace industries.

Total demand from this sector accounts for just under 10% of annual gold demand, but the amount used has been fairly steady over the past decade, according to data published by the World Gold Council. The electronics sector consumes around 80% of this demand, with gold a critical element in the manufacture of semiconductor chips. In health care, gold nanoparticles are used in many of the diagnostic testing kits such as those relied on throughout the covid pandemic.    

Q5: What role can gold play in a portfolio?

Gold has low correlation with many of the riskier assets you’re likely to have in your portfolio, meaning it could be a useful diversifier.

Some investors consider gold to be like an insurance policy. Although it offers no guarantees and can go down even when you expect it to behave differently, gold historically has held up well during sharp equity market downturns.

As shown in the correlation matrix, the gold price tends to move more in line with other defensive assets, particularly US Treasuries, but the low correlation with risk assets make it more useful to include in portfolios with significant equity exposure. Investors may typically allocate up to 5% to gold, often as a ‘cushion’ for the rest of the portfolio.