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Protect and diversify your portfolio with gold

Kris Walesby
Thursday, August 11, 2016

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By Kris Walesby

Gold has always been considered an integral part of Australia’s society and economy. It partly explains why we enjoy such a high quality of life, even among the most developed nations. So it seems unusual that more Australian investors don’t make meaningful allocations to gold in their portfolios. Given the rally in the gold price in recent years, and the volatility we’ve seen this year in global markets, I believe these investors are missing a useful opportunity to do two things. First, to create a more diversified portfolio better able to withstand market falls, and secondly, to build in protection from the effects of inflation.


We all know that typical Australian investors who manage their own accounts have a “home bias” towards Australian equities and tend to allocate an overly high proportion of their portfolios to them. It’s understandable in some respects, because the companies are often large, well-known names, have no currency risk, and best of all, in a low return environment they pay dividends which offer the benefit of franking credits. But the reality for many is that there is substantial risk embedded in these portfolios.

Conventional financial theory (and in practice) suggests that if you hold less than 30 different companies in your portfolio, you won’t get the full benefit of diversification. This is where portfolio risk is reduced because it is spread across enough companies so that a single company’s ups and downs will only have a limited effect on the rest of your portfolio. In reality, many Australians only hold between seven and 15 companies.

Additionally, if you only hold shares, you’re ignoring other asset classes such as bonds. Shares have a much higher chance of financial gain than bonds, but equally, they have a much higher chance of loss. A portfolio without any bonds is likely to have periods of substantial losses.

You only have to look at the constant flow of new products, particularly in the Exchange Traded Fund (ETF) space, to know there are many options for investors wanting to diversify their portfolios. Global equities, specific country exposure and government or corporate bonds are just some of them. All are valid options. But let’s look at gold itself in more detail.

The general view of gold is that it is “de-correlated” from other asset classes. This means that its price movements are not related to events in the equity or bond markets and are unlikely to follow your shares and bonds down in negative markets. Furthermore, in strongly negative markets, gold can become “negatively correlated”, meaning that it does more or less the opposite of what your shares are doing. That’s a feature any investor should be looking to factor in to their portfolio.

Inflation Protection

Gold also offers effective protection against inflation. Right now, many economists believe the Federal Reserve has taken too long to raise rates and this is causing inflation to build in the US market which will then flow outward to the rest of the world.

Core CPI, one of the key indicators that all central banks look at, is increasing for the developed and emerging economies and energy prices have rebounded significantly from their lows.

While inflation is increasing, real rates of return - what your money is worth - is decreasing. Physical gold acts as a key hedge against this devaluation. This is illustrated in the chart below that shows how gold responds in a negative interest rate environment which the US is in right now and Australia is slowly heading towards.

Buying physical gold is not the same as buying miners

So why not just buy gold mining stocks if you want gold exposure? While miners have their place within a portfolio at different times, they should never be considered a substitute for physical gold.

In reality, there is often very little relationship between physical gold and gold miners. That’s because gold miners are exposed to all the vagaries of trying to keep a mining company profitable – such as exploration and extraction – while gold itself has a simpler supply and demand chain that dictates its price. Looking at the performance chart below, you can see that over a longer period, gold significantly outperforms miners and one of the main reasons for this is the “equity” effect that can negatively affect a miners’ value.

Investors in other countries appear to be wiser to the benefits of gold in their portfolios. More and more SMSF equivalent portfolios (401K in the US and SIPPs in the UK) hold 1% – 5% of their value in gold, depending on whether they see the market as being in growth or in decline. It may not sound like much, but it’s enough to provide more than a marginal benefit in most markets and a material benefit in strongly negative ones.

In the year to date, more than US$20 billion has been allocated to ETFs in America and Europe, helping to boost the overall global ETF market to more than US$3 trillion. Driving these inflows is investors’ search for better returns in a low (and negative in some countries) interest rate environment and a desire to protect themselves against continued market instability.

The reason ETFs are popular is that they’re a simple and low-cost way to buy physical gold. ANZ ETFS’ Physical Gold ETF (ZGOL), for example, gives investors the ability to buy physical gold that is stored in a vault in Singapore. The ETF units have a direct, allocated claim to the gold in the vault. This is as close to holding gold as you can get without actually physically storing it yourself, but without the hassle or cost. With a bid/offer spread very close to institutional levels at between 0.05%-0.15%, investors can also buy or sell without incurring high transaction fees and there are no premiums or discounts.

ETFs offer a very simple mechanism to get access to physical gold for even the smallest size (currently one unit is $17.40 per unit) at wholesale prices. Australian investors have not traditionally been big holders of gold, but there are good reasons why this is likely to change. Having a gold allocation should be at least considered by all investors, and using ETFs is a very easy way to gain exposure.

Published: Thursday, August 11, 2016

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