Why you should invest in gold

Saturday, October 29, 2016 Swati Aggarwal 0 Comments

Why Should You Invest in Gold

Traditional financial advice available for retail investors is almost entirely centered on equities and debt. Most model portfolios have nothing to say about the weights on alternative asset classes such as gold.  Gold in particular is a glaring omission because unlike other alternatives it is quite cheap and easy for retail investors to buy gold – whether in physical format, or through ETFs, mutual funds or sovereign gold bonds. In this article we seek to plug that gap. According to us gold can play a vital insurance/ diversification role in retail portfolios
Recommending gold is fraught with trouble. Many gold-junkies are people who invest in the yellow metal in preparation for some sort of “end-of-the world” event. As a result, “serious” financial investors often scoff at gold. In India, gold has huge (often irrational) cultural significance. As a result “serious” financial investors (and advisors) in India scoff at gold even more. However modern finance, especially work in the area of currencies, can now be used to make some significant arguments in favour of gold. Like so many Indian things, it may just be a case of modern science making us realise that the ancients had it right after all!

Deconstructing the gold price in Indian rupees

While it is natural for us in India to think of the gold price in Indian rupees, this rupee price of gold is actually a derived price with two different components:
  1. 1. What is happening to the gold price in dollars: This portion is affected by various international developments (such as global real interest real rates) and the effect of India-specific factors is actually quite minimal. When global crises occur such as in 2008, then the international gold price moves up due to safe haven demand while Indian equities are tanking. However barring such events, it is difficult to see any clear value that gold price in dollars brings to an Indian equity-bond portfolio.
  2. 2. What is happening to the price of Indian rupee in dollars: This is the interesting part. When people own gold, they are also implicitly holding a position in USDINR. This position will do well every time the rupee weakens and do badly when rupee strengthens – so a very clear India-specific angle.
(In practise the relationship between these 3 may not be exact because there is friction due to govt restrictions on gold imports etc which gives rise to the “Mumbai premium”. But that part is small and can be ignored for this discussion.)

USDINR component of gold gives it interesting hedging properties

USDINR is interesting because it is extremely strongly correlated with Indian equities. The relationship is negative, i.e. (usually) when Indian equities go up (down) then the rupee is also strengthening (weakening) at the same time. Very intuitively this is because all factors that are big negatives for Indian equities (growth crises in the world and/or India and high inflation in India) are all also big negatives for INR. It is obvious why INR will suffer if there is a growth shock or very high inflation in India. But even if there is a big growth shock in the world which has very little to do with India (like 2008), then also INR will suffer because it is perceived as a risky asset in world markets.  Just to give an international perspective, this relationship between equities and currencies is true of almost all high growth emerging markets where currency is not very tightly controlled.
Gold in INR is useful for protecting against the downside in Indian equities because of this USD INR component. Basically gold in INR does well when equities go down not because gold (as measured in USD) is necessarily doing well but because INR is doing poorly and getting weaker. And the fact is that when some big developments are taking place in India, then the volatility in USDINR can overcome the volatility of the gold in USD, so you see the USDINR effect coming through even more strongly.

USDINR and Gold have been up in recent episodes where equities were down by >20%

Gold in INR can give returns when both equities and bonds are falling

Many people think of debt as adding stability to their portfolio. This is true when equities are doing poorly due a slowdown in growth. During such times central banks cut rates to boost growth and hence bonds do well. However both equities and bonds are vulnerable to periods of high inflation. Bonds do badly because the central bank is expected to increase rates to fight inflation. Counter intuitively, equities also do badly, during inflationary episodes even if they may generate inflation-beating returns in the long-run. The case for why equities suffer during inflation in the short-run has been wonderfully articulated by Warren Buffet himself in his 1977 classic article “How inflation swindles the equity investor” and I will leave you to read that. Gold can come to the rescue during such inflationary episodes. High inflation is associated with an eventual depreciation in the Indian rupee which then reflects in increased gold price.
In the developed economies, over the last 20 or so years the problem of inflation has been tamed considerably (that was before the current zero-rate regime). It was mainly slowdowns in growth which were a big concern for equities and which could be countered through bonds. As a result most financial advice in the West talks about equity-bond portfolios. A lot of this advice gets transplanted to India without sufficient attention being paid to the situation prevailing here. In this case, periodic increases in inflation remain a major issue for equities and debt in India and can be countered through gold in INR.

Some encouraging statistics on Gold...

Given the discussion on gold so far, it should not come as a surprise that the monthly correlation of gold in INR with the Nifty and the 10-yr Government bond is -11% and -12% i.e. there is a lot of scope for diversification by adding gold to the portfolio.
But what about returns? Just looking at the past 15 years, gold returns have been extremely good at 14.5% p.a.  with a volatility of 16%. As a result the risk-adjusted return of gold, as measured through the Sharpe ratio has been same as that of equities and much better than 10-yr Government bonds.

Statistics for Nifty, 10-year Government bonds and Gold (2001-2016)


The implication of these two results is that if we just went by historical experience alone then there is significant value-add of adding gold to an equity/bond portfolio. Suppose we start with a 50-50 equity bond portfolio, then the chart below shows the impact of adding gold (in different proportions)to this portfolio over the last 15 years. The 50-50 equities/bond portfolio had returns of 13% p.a.  By adding gold, we would have succeeded in increasing the returns of this portfolio. Further look at volatility (which is a measure of the distribution of returns around the mean), that also comes down with an increase in the percentage of gold. This means that not only would adding gold have increased returns, it would also have made returns more stable around this average. This is reflected in the risk-adjusted returns, measured by the Sharpe ratio. The Sharpe ratio goes up with an increase in the percentage of gold in the portfolio and finally peaks around a level of 40%. Hence just historical analysis would suggest that adding 40% of gold to a 50-50 equity bond portfolio would have worked best.

Adding gold to a 50-50 equity bond portfolio – historical results (2001-2016)


...But with a few caveats

The biggest question in financial analysis is to what extent past performance can be projected forward. In this respect, two important observations can be made with respect to gold:

  1. 1. We can more or less expect the diversification angle to continue going forward since there is a strong fundamental rationale for it.
  2. 2. Whether gold returns will be as strong going forward is less clear. As we discussed earlier gold returns in INR, can be decomposed into gold returns in USD and USD INR returns. Even if we assume that the periodic bouts of high inflation will continue in India and hence the USDINR depreciation can be projected going forward, it is difficult to say that gold in USD will repeat its past performance. In the past 15 years, international developments have been in favour if gold. For the 20 years before that (1980-2000) gold in USD was in a big bear market. Going forward, the trend in gold will be determined by international developments which may have little or no relation to what is happening in India. Hence we cannot expect gold to repeat its stellar performance even if inflation remains a problem in India.
In many ways the problem here is that having to buy gold just so that you can buy USD and sell INR is inefficient – why should you take gold risk, just buy USDINR. But that is easier said than done by retail Indian investors. Gold is a cheaper and easier way of accessing similar risk.
Finally apart from this, gold unlike debt is a high volatility asset and does not provide regular coupon income.

So what role should Gold play in your portfolio?

Given the diversification that gold can provide, it definitely deserves a place in your portfolio. If the role of debt in a portfolio is to provide regular income and equities is to provide returns, then gold can provide insurance and diversification especially during high inflation periods. This helps to stabilise the year on year variation in equity returns.
In fact from our discussion we can develop a few principles about how gold should feature in your portfolio:
  1. 1. If you are investing for the very short-term (say emergency funds etc.) or need regular income then the role of gold should be minimal in your portfolio. This is because it does not provide regular income and returns can show significant variation over short-periods just like equities
  2. 2. If you are investing for the very long-term then also gold may have a somewhat limited role relative to equities. This is because if you are a long-term investor and willing to live with substantial volatility in the meantime, then long horizons give sufficient time for equities to recover and provide high returns, reducing the need for diversification.
  3. 3. The true value-add for gold comes in the medium term portfolios, say for a 3-8 year horizon and/or if you would like to avoid significant volatility in portfolio returns. In such portfolios, gold can provide returns when equities and bonds are not doing well, increasing your probability of ending up with good positive returns.
In our view, a 5-20% allocation to gold can be useful in most portfolios.You can check ORO's goal based advisory for more details on how we treat gold in our model portfolios.

Data source: We have used the following sources for calculation returns - Equities: Nifty total return index; Gold : MCX Gold; 10-yr Gilts: Computed from generic yields and Risk-free rate: RBI repo rate.


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