Oc
ctober 2012
Foor professiona
al investors only
Pensio
P
on Sc
cheme Stra
ategies
Gold
G
ffor UK
U Pe
ensio
on Sc
chemes
2011 marke
2
ed the 11th
h consecuttive year off positive rreturns for gold, whicch
shone in a period
p
cha
aracterised by poor performancce for many
y asset
c
classes.
Ho
owever, de
espite its re
ecent track record, th e non-yield
ding nature
e
o gold has led some to argue th
of
hat it should not be cconsidered an
in
nvestment in the trad
ditional sen
nse. This paper addreesses this debate, an
nd
a
asks:
what role, if anyy, should gold play in a pensionn scheme’s
s portfolio?
?
In
n answerin
ng the abovve question
n, we will e
examine go
old from th
he perspecctive of an institutiona
al
in
nvestor, co
onsidering the following areas:
— Wha
at are the characterist
c
tics of gold
d as an inv
vestment and which ffactors affe
ect the pricce
of go
old?
— Wha
at are the benefits
b
of holding go
old as part of a divers
sified portfoolio?
— How
w can a pen
nsion scheme invest in gold?
— Gold
d performance under different sscenarios
What
W
are th
he investm
ment charracteristics
s of gold?
?
Store
S
of value
As
A one of the earliest know
wn currencie
es, gold has long been viewed as a sttore of valuee and a hedge against
in
nflation risk.
To
T a certain e
extent (and over
o
extended
d periods) th
his does appe
ear to be true
e. Comparedd with many other
co
ommodities, the purchassing power off gold has re mained surp
prisingly steady over the yyears. In factt, the
purchasing po
ower of gold in the UK wa
as almost the
e same in 20
010 as it was
s in 15601.
Historically,
H
th
he existence of gold standard2 regime
es ensured that the price of gold remaained in step
p with the
money
m
supplyy, resulting in
n a positive correlation
c
be
etween the price
p
of gold and
a inflation.. In 1971, the
e convertibility
off US dollars into gold was abolished, and with the
e explicit link
k between the
e price of golld and the money supplyy
se
evered, there
e is no longe
er any guaran
ntee that an investment in gold will re
etain its real vvalue over time.
1
Ja
astram, R. (20
009). The Gold
den Constant: The English a
and American
n Experience, 1560 – 2007, with updated material by
J. Leyland
L
(2012
2).
2
A ‘gold standarrd’ is a moneta
ary system in which a unit o
of currency rep
presents a fixe
ed weight of goold. For exam
mple, between
WW
WII and 1971, the price of gold was fixed at USD35/oz.. Historically gold
g
standards
s have inhibiteed inflation by preventing
gov
vernments from printing exccessive amoun
nts of paper c urrency.
Pension Scheme Strategies Gold for UK Pension Schemes
Figure 1: Price of gold versus inflation since 1971
USD per troy oz
1,800
800
1,600
700
1,400
600
1,200
500
1,000
400
800
300
600
400
200
200
100
0
1971
1975
1979
1983
1987
1991
Gold (lhs)
1995
1999
2003
2007
2011
CPI (rhs)
3
Source: Schroders, Datastream, 15 September 2012. Inflation is represented by US CPI rebased to 1 in 1971.
Figure 1 shows that while gold has retained its real value since the collapse of the gold standard, it has not done so
consistently. While the bull market of the 2000s enabled gold to ‘catch up’ with inflation, there was a long period
during the 1990s where the price of gold fell in real terms. Therefore, although one could argue that gold functions
as a store of value in the long term, over the shorter time frames by which investment performance tends to be
measured gold may be a fairly unreliable hedge against inflation.
Figure 2: Real percentage increase in gold price in high inflation environments (CPI ≥5%)
Real % increase in gold price
100%
80%
60%
40%
20%
0%
-20%
-40%
-60%
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1990
High inflation years (CPI≥5%)
Source: Schroders, Datastream, 1971-2011. Inflation is represented by US CPI. Nominal increase in gold price deflated by US
CPI to calculate increase in real terms.
The relationship between gold prices and inflation is a nuanced one, and the price of gold is influenced by a
number of factors (see below) which may override the impact of inflation. Figure 2 demonstrates this variability in
gold’s performance as a hedge against inflation: while gold did function as an effective insurance asset in some
high inflation years (such as 1973, 1974, and 1980), in others it did not. For example 1982 saw the gold bubble of
the late 1970s and early 1980s burst in spite of high inflation.
3
CPI (the Consumer Price Index) is a widely used measure of inflation based upon the price of a basket of consumer goods and
services.
Pension Scheme Strategies Gold for UK Pension Schemes
Lack of counterparty risk and hedge for economic instability
The lack of counterparties involved in a direct investment in gold mean that it is often perceived to be a hedge
against financial risk. In periods of economic instability, when investors are fearful of default or of counterparties
otherwise failing to meet their obligations, this characteristic is particularly appealing and could lead to increased
demand for gold (although it is important to note that there may still be counterparty risk associated with indirect
investments in gold and gold derivatives).
Also, while governments and central banks may devalue currency by printing money (e.g. to finance debts), gold is
not exposed to this risk, as it is a finite resource and cannot be manufactured. Many investors therefore see gold as
an insurance asset against political risk, with demand increasing when investors lose faith in fiat currencies.
However, in the short term, the price of gold could actually fall during periods of economic crisis. When forced to
sell assets to meet margin requirements, investors may prefer to sell their gold – particularly if gold has performed
well in recent years – than to realise large losses on risk assets. Additionally, investors may be forced to divest
themselves of their gold due to its high liquidity (if they are unable to sell other assets to meet margin calls). This is
a temporary effect which tends to reverse when general risk aversion takes over.
The graph below, which plots the TED Spread4 against the price of gold, demonstrates this effect, with short-term
dips in the price of gold corresponding with periods of illiquidity in 2008 and 2011.
Figure 3: TED Spread versus gold price
USD
per troy oz
2000
400
1800
350
300
1600
250
1400
200
1200
150
1000
100
800
600
Jan 08
50
0
Jul 08
Jan 09
Jul 09
Jan 10
Gold (LHS)
(lhs)
Jul 10
Jan 11
Jul 11
Jan 12
Jul 12
TED Spread (rhs)
Source: Schroders, Bloomberg, Datastream, 28 September 2012.
Non-yielding
Gold is a non-yielding asset, which means that investor returns are linked solely to price increases. This means that
there is an opportunity cost associated with holding gold, which varies according to the risk-free rate of return (that
is, the return investors could earn by investing instead in ‘safe’ assets such as government bonds or the US dollar).
When risk-free interest rates are high, the price return on gold must be greater in order to compensate for the
higher opportunity cost. On the other hand, negative real interest rates eliminate the opportunity cost of holding a
non-yielding asset. One would therefore expect there to be a negative correlation between the price of gold and
interest rates, with gold prices falling as interest rates – and thus opportunity costs – rise and vice versa.
4
The TED Spread is based on the difference in 3-month LIBOR and 3-month T-bill interest rates and is a commonly used
measure of liquidity and perceived credit risk in the market. A larger TED Spread is reflective of higher perceived risk and lower
liquidity.
Pension Scheme Strategies Gold for UK Pension Schemes
Figure 4 demonstrates this effect: during periods in which real interest rates fell below zero (eliminating the
opportunity cost associated with holding a non-yielding asset) the price of gold is shown to have risen substantially.
Figure 4: Real yield versus gold price
USD per troy oz
2000
10%
1800
8%
1600
1400
6%
1200
4%
1000
800
2%
600
0%
400
-2%
200
-4%
0
Gold (LHS)
Real Fed Funds Rate (RHS)
Source: Schroders, Datastream. Data to 31 December 2011. Real yield is represented by the real Fed Funds rate (Fed Funds
rate deflated by CPI).
Supply and demand characteristics
For a commodity, gold is relatively unaffected by supply factors, with movements in gold price instead driven
primarily by demand.
Supply is surprisingly stable in the face of price movements, and mine production has held steady at around 2,500
tonnes per year for several years now*5. The fact that new mines tend to be replacements for defunct mines –
serving to maintain rather than increase global production levels – contributes to this invariability.
Figure 5: Global gold mine output (tonnes)
700
3,000
600
2,500
500
2,000
400
1,500
300
1,000
200
500
100
0
0
1988
1990
1992
1994
SA
US
1996
1998
CN
2000
AU
2002
2004
CH
2006
2008
2010
World
Source: MEG, September 2011.
5
GFMS (2011) Gold Survey 2011.
*However, it is worth noting that an increasing proportion of this supply is being provided by China (green bars on Figure 5) who
have thus far shown little inclination to export their gold.
Pension Scheme Strategies Gold for UK Pension Schemes
Around half of global gold demand is driven by jewellery, with only a relatively small amount being used in industry
relative to other precious metals (10% compared to 50% for silver)6. The non-cyclical nature of gold means that it
could be held as a defensive asset, as its price may fall less than that of many other commodities during business
cycle troughs.
Central banks hold a substantial portion of the world’s above-ground gold stocks (17% at the end of 2011)7, and
can exert a significant influence on global supply and demand through the management of their gold reserves.
In the 1990s, following a prolonged period of relative economic stability, demand for safe haven assets fell.
Increasing pressure was placed on reserve managers to generate returns, and combined with falling gold prices
this led many central banks (most of whom still held large quantities of gold as a relic of the gold exchange
standard) to divest themselves of a portion of their gold reserves. Net outflows from central reserves flooded the
markets with gold, placing further downward pressure on prices.
This trend has since reversed, and in the current environment, with the safe haven qualities of gold more highly
valued (and confidence in traditional reserve currencies such as the US dollar and the euro falling in the face of
high government debt burdens), we are seeing net purchases by central banks. Again, this serves to accentuate
the upward trend in gold prices.
Figure 6: Official sector net transactions (tonnes) from 1985 to 2012
400
200
0
-200
-400
-600
-800
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
8
Source: World Gold Council , GFMS.
Denominated in US dollars Because gold is denominated in US dollars its price is likely to be influenced by the value of the US dollar relative
to other currencies – the stronger the dollar, the more expensive (and less attractive) gold will be to foreign
investors, which could push gold prices (denominated in US dollars) down. This results in a negative correlation
between the price of gold and the strength of the US dollar.
The fact that both gold and the US dollar are viewed as ‘safe haven’ investments reinforces this inverse
relationship: a weak US dollar may force investors to seek other safe haven investments, and demand for gold (as
an alternative store of value) may increase.9
6
World Gold Council (2011). Gold: A commodity like no other.
World Gold Council website: http://www.gold.org/investment/why_how_and_where/why_invest/demand_and_supply/
8
Recreated from World Gold Council (2011). Liquidity in the global gold market.
9
Oxford Economics (2011). The Impact of deflation and inflation on the case for gold.
7
Pension Scheme Strategies Gold for UK Pension Schemes
Figure 7: US dollar nominal effective exchange rate versus gold price (log scale)
40
3.5
Weak dollar
60
3.0
80
100
2.5
120
140
2.0
160
1.5
1975
180
1980
Gold (lhs)
1985
1990
1995
2000
2005
Strong dollar
2010
USD Nominal Effective Exchange Rate (Inverted) (rhs)
Source: Schroders, Datastream, 28 September 2012. The graph above demonstrates this negative correlation, with a weakening dollar corresponding with rising gold
prices in the late 1970s and 2000s, and a strengthening dollar with falling gold prices in the late 1990s and (to a
certain extent) early 1980s. One point at which the relationship between gold prices and US dollar strength appears
to have decoupled is in the mid-1980s. This potentially reflected investors’ fears that the high interest rates at that
time10 (which are likely to have contributed to the strong US dollar) would spark a recession, thereby increasing
demand for gold as ‘protection’ against economic instability.
Liquidity
The relatively high liquidity of gold contributes to its status as an alternative currency (or store of value) and – along
with the impressive depth and breadth of the market – means that gold is easily accessible for investors. However,
as discussed previously, the high liquidity of gold also means that it may be one of the first assets to be sold off in a
liquidity crisis, with dips in the gold price historically associated with spikes in illiquidity measures such as the TED
spread (see figure 3).
What are the benefits of holding gold as part of a diversified portfolio?
In the wake of an 11 year bull market11, speculative allocations to gold (with the sole intent of capitalising on price
increases) may seem less appealing. However holding gold as part of a diverisifed portfolio still offers a number of
possible advantages for UK pension schemes. Gold has historically displayed low or negative correlations with
many risk assets, which means the addition of gold to a portfolio could provide relative diversification benefits.
Figure 8: Correlation between gold and other asset classes*
UK Equities
US Equities
Global Equities
Emerging Market Equities
US Treasuries
US Corporates
Global High Yield
Commodities
Hedge Funds
Real Estate
USD Spot
-0.6
-0.4
-0.2
3 year correlation
0
0.2
10 year correlation
0.4
Source: Schroders, Bloomberg. *Correlations based on monthly data over 3 and 10 years to 29 February 2012.
10
11
See Figure 4.
Which peaked in September 2011.
Pension Scheme Strategies Gold for UK Pension Schemes
Pension schemes wishing to protect against downside tail risks may also be interested in gold’s function as a
possible offset against inflation, financial risk, and US dollar depreciation. As an example, the graph below plots the
price of gold against the S&P500 between January 2008 and March 2009 (i.e. the credit crunch).
Figure 9: Price of gold during periods of market crisis – gold versus S&P500 January 2008 to March 2009
USD per troy oz
1150
1450
1350
Credit crunch: gold and equities fall
simultaneously (see Figure 3)
1250
1050
1000
1150
950
1050
900
950
850
850
800
750
750
700
650
Jan 08
1100
Mar 08
May 08
Jul 08
S&P (lhs)
Sep 08
Nov 08
Jan 09
Mar 09
Gold (rhs)
12
Source: World Gold Council , Schroders, Datastream.
Over this period, gold served as an effective offset against equity losses (although there is of course no guarantee
that this relationship would hold in any future crisis).
However investors should be wary of relying too heavily on the potential merit of gold as an insurance asset. There
is a considerable behavioural element to the demand for gold, with market sentiment playing a significant role in
driving price movements. The function of gold as a hedge against inflation or financial risk is somewhat reliant on
the fact that investors perceive it as such: a self-fulfilling cycle exists, with gold performing well during crises partly
because investors expect it to do so. This introduces the potential for sharp falls in value if investors were to
become disillusioned. For example, the gold bubble of the 1970s and early 1980s burst even before the reversal of
the equity bear market.13 12
Recreated from World Gold Council (2010). An investor’s guide to the gold market: UK edition.
Ritter, J. & Warr, R. (2002). The decline of inflation and the bull market of 1982-1999. Journal of Financial and Quantitative
Analysis.
13
Pension Scheme Strategies Gold for UK Pension Schemes
How can a pension scheme invest in gold?
Institutional investors can invest in gold directly (through physical or synthetic investments in gold) or indirectly (for
example by investing in the shares of gold mining companies). The key features, advantages, and disadvantages
of each means of gaining exposure to gold are detailed below:
Direct investment
While a physical investment in gold may be the most direct approach to obtaining exposure to this asset class,
there are a number of disadvantages. Investors in physical gold incur costs associated with storage and insurance,
as well as transportation to and from the storage location.
Gold Exchange Traded Funds (ETFs) are an alternative to a physical investment in gold. A gold ETF holds a large
quantity of physical gold, and investors can purchase shares in the ETF through a stock exchange. The advantage
of obtaining exposure to gold through an ETF is that shares are highly liquid and closely track the price of gold,
while enabling investors to avoid many of the issues associated with physical ownership.
Indirect investment
Investors can also achieve exposure to gold indirectly, through investment in gold mutual funds, or by purchasing
shares in firms whose performance is positively correlated to the price of gold (such as gold mining companies).
Gold mutual funds tend to invest in companies involved in various stages in the gold production process (and may
also invest directly in gold itself, using the methods discussed above). Because the mutual fund invests in a
number of different companies, a fair portion of the specific risk of individual companies is diversified away.
However, the question remains as to how closely investments in gold mining companies actually follow gold
prices. Due to the fixed costs of the underlying companies, shares in gold-focused firms represent a ‘leveraged
play’ on gold, and returns may be substantially more volatile than the price of gold itself.
Purchasing the shares of gold mining companies exposes investors to substantially more stock specific risk than
investing in gold mutual funds. Investors will therefore need to carefully consider the fundamentals of the individual
company as well as the outlook for gold in planning their investment.
It is also possible to obtain exposure to gold through investments in multi-asset mutual funds, many of which make
both strategic and tactical allocations to gold in response to long and short-term capital market expectations.
Gold performance under different scenarios
Scenario 1 – Period of deleveraging, low growth, relatively low inflation
A period of deleveraging (in response to the unsustainably high levels of government debt in developed markets)
would be likely to be accompanied by slow growth and weak and volatile stock market returns.
If other asset classes were underperfoming, or if investors believed that they were likely to underperfom in the
future, this could increase the appetite for gold. In light of poor growth expectations, central banks would be
expected to take a dovish stance. In the absence of deflation, very low interest rates would result in a negative real
interest rate environment; and with no opportunity cost associated with holding a non-yielding asset, increased
demand for gold could ensue.
With central banks focused on encouraging growth rather than meeting their inflation target – for example by
combining Quantitative Easing policies with very low interest rates – there is also a possibility that we could enter a
period of higher inflation. In this eventuality, one could expect demand for gold to increase.
Pension Scheme Strategies Gold for UK Pension Schemes
Scenario 2 – Deflation
A global financial crisis would be accompanied by high levels of risk aversion, large losses on risk assets, and
possibly deflation (in response to non-existent or negative economic growth and high unemployment).
If we were to enter a period of deflation, we could see gold prices fall. As well as decreasing demand for gold as an
inflation hedge, deflation would counteract the effect of low interest rates, increasing real rates and thus the
opportunity costs of holding gold. However demand for gold as a hedge against financial instability could
overshadow this effect.
Scenario 3 – Sustained recovery, moderate inflation
In the event of economic recovery, we would expect to see stronger growth, with an increased appetite for risk and
commensurate good performance of risk assets (and potentially reduced demand for gold).
With a strong recovery, central banks could raise interest rates without fear of inhibiting economic growth, and in
this scenario increased opportunity costs would be expected to reduce investor’s appetite for gold.
On the other hand, if the economy were to overheat, inflation fears could cause demand for gold to rise.
Conclusion
It is almost impossible to accurately predict the direction of gold price movements because demand for gold is
affected by a number of (often conflicting) factors, including:
— Inflation
— Macro-economic environment
— Interest rates
— US dollar strength
Despite the difficulties associated with forecasting price movements, an allocation to gold can provide the following
benefits:
— Low correlation with other assets (diversification benefits)
— Non-cyclical demand
— Potential value as an insurance asset against inflation and financial instability
A long-term strategic allocation to gold, combined with short-term tactical adjustments to this exposure, could
therefore prove advantageous to a UK pension scheme. This exposure could be achieved through direct
investments in gold itself, or through indirect investments via shares in gold-mining companies, gold mutual funds,
or multi-asset mutual funds with allocations to gold.
If you would like to discuss any of the topics in this paper, please contact a member of the UK Strategic
Solutions team www.schroders.com/ukstrategicsolutions
Pension Scheme Strategies Gold for UK Pension Schemes
Important information
The views and opinions contained herein are those of the UK Strategic Solutions team at Schroders, and may not
necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be
for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an
offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not
be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable
but Schroder Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility
can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its
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Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed
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Past performance is not a guide to future performance and may not be repeated. The value of investments and the income
from them may go down as well as up and investors may not get back the amount originally invested.
General Forecast Risk Warning
The forecasts stated in the document are the result of statistical modelling, based on a number of assumptions. Forecasts are
subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance.
The forecasts are provided to you for information purposes as at today's date. Our assumptions may change materially with
changes in underlying assumptions that may occur, among other things, as economic and market conditions change. We
assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions,
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