In the second of two articles, we help demystify gold as an investable asset class for LGPS funds.
What are other global investors doing – any sign of trends developing?
Central banks have been net buyers of gold for 15 years, with average purchases of around 500 tonnes in the 2010s. The rate of purchasing has doubled since 2022, with central banks diversifying their reserve assets and hedging against uncertainty and inflation.
In 2024, flows into gold-backed Exchange Traded Funds turned positive ending a four-year streak of outflows. This reversal can be attributed to heightened geopolitical tensions, monetary policy easing and the momentum effects of gold's record performance.
Analysis of gold's ownership by global institutional investors relative to their holdings in equities, bonds and other asset classes indicates an under-allocation to gold versus what is calculated to be an optimal allocation level (2.5% - 10%).
Where does gold fit into an asset allocation framework? Where would you take assets from to fund Gold purchases?
Given its unique investment characteristics, gold can typically fit within more than one specific bucket. Many investors include it in within their asset allocation as a risk diversifier. Some treat it as a currency, others a commodity, or even as its own standalone asset class. The common theme is that gold is a versatile asset for institutional portfolio construction and risk management.
How an allocation to gold is funded will typically depend on the overall structure of the purchasing portfolio. Given gold's contribution to improved risk adjusted returns through both increased portfolio returns and lower risk, and rising funding levels resulting from rising gilt yields, LGPS funds may benefit from moving some of their equity allocations to gold as a de-risking strategy.
What is gold's diversification impact on "standard" asset allocation mixes?
Effective diversifiers are not always easy to find. Many assets become increasingly correlated as market uncertainties rise and volatility increases. As a result, many so-called diversifiers fail to protect portfolios when investors need them most.
Gold is different, as its correlation profile changes as equity markets move up and down. When equities are up considerably, gold becomes positively correlated with equities. Conversely, when equities are down considerably, this correlation profile "flips" and gold becomes negatively correlated with equities.
The Global Financial Crisis provides clear evidence of this. Equities and other risk assets tumbled in value, as did hedge funds, real estate and most commodities, which had previously been categorised as portfolio diversifiers. Gold, by contrast, held its own and increased in price, rising 21% in US dollars from December 2007 to February 2009. And in the most recent sharp equity market pullbacks of 2020 and 2022, gold's performance remained positive.
This robust performance is not surprising. With few exceptions, gold has been particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses
And gold's correlation does not just work for investors during periods of turmoil. It can also deliver positive correlation with equities and other risk assets in positive markets, making gold a well-rounded efficient hedge.
How does gold's liquidity perform in times of market turmoil?
The gold market is large, global, and highly liquid. It is estimated that physical gold holdings by investors and central banks are worth approximately US$5.1tn, with an additional US$1.0tn in open interest through derivatives traded on exchanges or the over-the counter (OTC) market. Daily gold trading volumes are similar to those of US T-Bills.
The scale and depth of the gold market means that it can comfortably accommodate large, buy-and-hold institutional investors. It also means that in stark contrast to many financial markets, gold's liquidity does not dry up, even at times of financial stress. Importantly too, gold allows investors to meet cash-flow requirements when less liquid assets in their portfolios are difficult to sell, or become mispriced.
What is the outlook for production? Will more gold be found? Will extra supply inevitably reduce prices?
The estimated above-ground stock of gold is 216,265 tonnes. If brought together in one place this would occupy a physical space barely larger than three Olympic-sized swimming pools.
Over the past 10 years, global mine production has averaged around 3,500 tonnes per year. This means the above ground stock of gold is growing by less than 2% per annum.
There is estimated to be a further 50,000 of proven below-ground gold reserves. Even if large additional deposits are found and mines developed, given time constraints of setting up new mines and capacity constraints for production, they are unlikely to have a substantial impact on gold's ongoing demand/supply profile.
What is gold's carbon footprint? How will owning it impact on progress towards Net Zero?
Research indicates that, while the global gold industry's annual carbon footprint is quite small (roughly, 0.4% of global annual emissions), it is not insignificant. However, analysis of the specific sources of gold sector emissions strongly suggests that there is an achievable and cost-efficient pathway to materially reduce emissions.
Decarbonising the extraction of gold at mine sites will decarbonise gold as an investment. The Kibali mine in the DRC derives most of its energy needs from its three hydropower stations with plans for a solar farm with a battery energy storage system to augment the hydropower supply during the dry season well under way. Following completion of this project, the mine will run entirely on renewable energy for six months of the year. The opportunity for sectoral decarbonisation is clear, concentrated and, compared to many sectors, relatively simple and accessible.
Such characteristics, along with thorough analysis of historic performance, suggest that gold's long-term returns may be more robust than those of many mainstream asset classes in the context of a range of climate scenarios and transition pathways.
How can my Scheme work with the World Gold Council?
- Portfolio analysis: We can analyse the effect an allocation to gold will have on the risk/ return profile of your Scheme.
- Invite us to a meeting: We can provide training, discuss the case for investing in gold, and present our portfolio analysis.
To find out more, get in touch with the World Gold Council's Institutional Investor Relationships team: [email protected].
