Is Gold A ‘PERFECT Investment Choice?
The current upsurge in the price of gold may tempt many an existing or potential investor to assume that gold, from among all the other asset classes, makes for the most secured and profitable investment option. However, that is not truth, as this article points out.
Gold is an integral part of Indian society. It is ingrained into our culture in a way that it encourages us to keep buying gold periodically, especially during festive and auspicious occasions. And even though there are now several other financial schemes that one can invest in, gold continues to be the biggest attraction when it comes to security. This makes India the second-largest consumer of gold in the world, after China. This has been further vindicated by the superb returns generated by this yellow metal in the last one year. For the one-year period ending May 8, 2020 the price of the gold in the Indian market has increased by 44.4 per cent. Gold prices in India have increased from Rs32,850 per 10 gram at the end of May 8, 2019 to Rs 47,435 per 10 gram at the end of May 7, 2020. This return has helped gold to be one of the best performing asset classes. In the same period, for instance, equity has generated negative return.
The ‘Shine’ Factors
Whether it is an exception that gold has generated superb returns in the last one year or it is actually a good asset class is a question overlooked by many investors due to different reasons. To gain more insights, we analysed the price movement of gold in India since 1979. Our analysis shows that gold has generated better risk-adjusted returns than many other asset classes in this period. For the 41-year period ending May 14, 2020 the annualised return generated by gold is 10.55 per cent. This means that every Rs 1 lakh invested in gold 41 years back is now worth Rs 70.81 lakhs. But here is the flip side of the coin. The equity represented by Sensex in the same period generated returns one and half times better than gold. Hence, the return offered by gold may not look tempting for many equity investors who saw such returns generated by many stocks in less than one-fourth of that time.
The problem is identifying those stocks and sticking with them. For every such single stock you will find 4-5 stocks that actually eroded your investment value. The return generated should always be seen in conjunction with the risk taken to generate such returns. The annual volatility generated by equity is 25.3 per cent compared to 20.6 per cent generated by gold. Gold is less volatile than equity calculated on the basis of standard deviation of returns. Now, let us check the other measures through which we can calculate risk i.e. drawdown risk.
In simple terms, it measures the value by which your investment goes below its previous peak.
The table clearly shows that the drawdown in gold is much shallower than equity. However, it takes a longer duration to reach its previous peak. The largest drawdown in case of equity is 60.91 per cent but for gold it is 57.81 per cent. Nonetheless, beyond that it has never lost more than 50 per cent in its value from the peak. In the case of equity there were other two incidences when their value dropped by more than 50 per cent from the recent peak.
Hedging Strategy
The interesting aspect of the above table is that there is hardly any overlap in the drawdown dates except for a brief period of 2008. This single fact changes the entire narrative of investment in gold. Instead of either gold or equity it gives us an idea of investing in both. Since the drawdown period for gold and equity are different it gives an investor an opportunity to diversify his investment to gold so that it reduces the overall volatility in a portfolio.
The graph above clearly shows the performance of gold during major equity drawdowns. Without any exception it has always generated positive return in all these periods. The best performance was during the great financial crisis when the price of gold jumped by 141 per cent between January 2008 and March 2009. During the same period equity was down by 61 per cent and hence overall gold outperformed equity by more than 100 per cent.
Historically, we have seen that gold prices have not increased as rapidly as equity in normal situations. However, in tail events that we are going through now, it performs better than others. Gold can provide liquidity and protection in risk-off scenarios, especially during so-called systemic events that affect multiple regions and industries. When stock markets sell off quickly, correlation across risk and assets can increase and portfolios that were thought to be diversified could experience unexpected free fall at the same time, forcing margin calls and lower funding ratios. In these circumstances investors often rely on selling highly liquid assets like gold, which can sometimes lead to temporary fall in its prices, as seen in the recent pandemic-driven selloff.
While correlation for most major asset classes, including gold, increased meaningfully during the most recent stock market selloff, gold’s correlation to the stock market remained flat to slightly negative. During the great financial crisis the correlation between equity and gold return was negative 0.19. Even in the current selloff till March 23, 2020 the correlation stood at negative 0.025. This is the reason why gold has consistently benefited from ‘flight-to-quality’ inflows during periods of heightened risk. It is particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses.
Gold Prices: Way Forward
India, despite being the second-largest consumer of gold is a price-taker and not price-maker. Domestic gold price is mostly determined by the movement of US dollar against Indian rupee and also by the prevailing geo-political as well as economic condition globally. The current pace of appreciation in gold prices in India is primarily due to the slowing economic growth, coupled with depreciation of Indian currency against US dollar. Nevertheless, what accentuated its rise is the economic uncertainty on account of the pandemic. Globally, the pandemic has led to a sharp downturn in economic activity and underperformance of other asset classes. As discussed above, in these uncertain times gold outperforms.
We believe that the appreciation in gold prices is likely to continue on the back of higher liquidity injection from central banks around the world. Major economies such as USA will continue printing money as well as undertake massive expansion of fiscal deficits that will lead to a further depreciation in the value of paper currencies. These are ideal situations for gold prices to rally. There are other reasons to believe that the price of gold will continue to soar. Although the price of gold in Indian rupee is at an all-time high, internationally it is still 10 per cent below its all-time high. Therefore, there is enough room for gold prices to rise further. Besides, there is a substantial growing demand for gold from central banks across the globe and also by ETFs in recent years.
According to a report released by Goldhub, “Globally, goldbacked ETFs added 170 tons of net inflows of USD 9.3 billion in April, boosting holdings to a new all-time high of 3,355 tons. Inflows have been strong and consistent in recent months but not unprecedented. The rolling 12-month inflows of 879 tons just surpassed those of 2009 and 2016, while the rolling six-month inflows are less than two-thirds of 457 tons of inflows in the comparable time periods of 2009 and 2016.” The current price strength of gold is very similar to the global financial crisis of 2008-2009. At that time it rallied back, following the initial quantitative easing (QE) program in US, which propelled gold over 141 per cent higher during the Indian equity market drawdown.
Quantum of Investment
The above analysis clearly shows the importance of gold and why we expect its price to grow further. Does this mean that you should shift your entire portfolio to gold? The simple answer to this question is NO. This is because despite the equity market currently going through one of the worst phases, it is still better placed than gold to generate better returns in the longer duration. Historically, we have seen gold has performed in patches; nevertheless, most of the time its performance has remained very lacklustre. For example, between 2012 and 2016, gold could generate only 1.1 per cent. This was a huge opportunity loss for an investor. It could not even beat the inflation index and hence it actually eroded wealth in actual terms.
Therefore, the weightage of gold in your portfolio should be such that it does not drag your overall portfolio performance and at the same time also helps you to shield your returns in turbulent times. To understand what an ideal portfolio should look like and what percentage of gold should be part of your portfolio, we have added debt in the form of gilt. After that we calculated the monthly return of the three asset classes i.e. equity, debt (gilt fund) and gold. We divided the corpus equally into equity and debt and varied the portion to gold from 5 per cent to 15 per cent. We further made a portfolio which was rebalanced annually while the other was left with its original asset allocation. The following graph shows the performance of these different portfolios since the start of 1999.
"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value."
— Alan Greenspan
The returns are very identical in case where the portfolio is balanced annually with marginal difference in the end value. Nevertheless, the clear-cut loser is the portfolio that is not rebalanced periodically. Therefore, gold should be part of your portfolio but the actual weightage may vary from 5 per cent to 10 per cent. You can use gold to achieve certain goals such as making jewellery for a child’s wedding.
Best Ways to Invest in Gold
There are various ways you can invest in gold. Investing in physical gold is not new to Indians. You can invest in the form of jewellery or coins or bars. Now you can also invest in gold using the electronic media. Buying gold in electronic form offers you more liquidity and less emotional attachment and therefore you can benefit from the rise in gold prices. Even among the electronic form there are a few distinct ways of buying gold such as gold ETF or gold funds. Both these aim to track the domestic physical gold price.
Gold ETFs (exchange traded funds) can be bought and sold on the stock exchange platforms. Gold ETF units are backed by physical gold of the highest purity. When you sell an ETF you don’t get gold but the cash equivalent. In addition, you can also buy gold fund of funds which further invest in gold ETFs, but you can buy them just like you buy other mutual funds.
The sovereign gold bond scheme is another kind of investment in gold in paper form. These bonds are issued by the RBI and have sovereign (government) guarantee attached. The value of these bonds is linked to the price of gold. Capital gains on SGBs are exempted if held till maturity, i.e. eight years. Also, in between if you require liquidity you can start trading it on stock exchanges within a fortnight of the issuance or date notified by the RBI. The best thing about SGBs is the interest payment attached to it as investors stand to get 2.5 per cent interest on the initial investment. Therefore, as an investor you can buy gold as part of your portfolio, not exceeding 15 per cent, and the mode you can choose to invest is SGB.