Most stick to stocks and bonds and call it a day, but by sprinkling in a little bit of gold or related exchange traded funds, long-term investors can diversify holdings, enhance risk-adjusted returns and diminish drawdowns during down markets for a smoother ride over the long haul.
“We saw in our case study that adding a 2% to 10% strategic asset allocation to GLD in a hypothetical multi-asset portfolio between January 1, 2005 and December 31, 2016 would have improved risk-adjusted return and reduced maximum drawdown compared to the portfolio without any exposure to gold-backed investments,” State Street Global Advisors’ SPDR ETF strategists, led by George Milling-Stanley, said in a research note, revering to the popular gold ETF play, SPDR Gold Shares (NYSEArca: GLD).
With the advent of easy-to-use ETFs that track various asset classes, many are re-evaluating the the balanced stock-and-bond funds of the past. Since the global financial downturn, more have realized the benefits of holding a truly diversified multi-asset portfolio with alternative assets like gold, which has historically low or negative correlation with most other asset classes. The yellow metal has helped investors counter volatility, especially during periods of uncertainty, to help smooth out the ride.
The SPDR strategists identified three potential benefits of gold that are key reasons why multi-asset investors consider holding gold in their portfolios, including increased portfolio diversification, tail risk hedging and inflation protection.
Gold is seen as a portfolio diversifier largely because of it usually does not respond to external stimuli that would normally affect equities and fixed-income assets. A lower correlation between the asset classes would lower overall portfolio volatility and therefore increase portfolio diversification and enhance the overall risk-adjusted return of a portfolio. For example, from January 2000 through the end of 2016, gold has exhibited a 0.12 correlation to global equities, 0 correlation to U.S. equities, 0.28 correlation to U.S. Aggregate Bonds and 0.22 correlation to U.S. Treasuries.
Gold has historically been used to provide tail risk mitigation during times of market stress, rising during periods of stock market pullbacks, notably so-called black swan events like most recent financial depression. This ability to act as a tail risk hedger provides investors with a means of diminishing market volatility and reducing the magnitude of potential drawdowns within a portfolio.
Lastly, gold has traditionally acted as an inflation hedge, with a long track record of offering protection of purchasing power in varying inflationary environments. Since 1970, gold prices have increased at an average 6.7% rate when the annual rate of inflation in the U.S. has been below 2%. During periods of moderate inflation of 2% to 5%, gold has increased at an average rate of 7.4% per year. When inflation spikes persists at 5% a year, gold returned an average annual rate of 15.2%.