Canada is one of the world’s leading gold investing centres, having the headquarters of the two largest gold producers in the world, Barrick Gold and Goldcorp, many leading gold-specialist firms, and a benchmark stock market index (the S&P/TSX Composite Index) that includes 40 precious metals miners accounting for 14 percent by market weight.

Gold has garnered a great deal of investor attention in recent years as a result of its impressive annualized return of 17.1% over the decade 2000–2010, outperforming all other major asset classes. Adding to its following among mainstream investors is its reputation as an inflation hedge. In this context, many investors are concerned that the expansionary monetary policy of the U.S. Federal Reserve in response to the global financial crisis and economic slowdown will eventually result in a significant rise in inflation. Much has been written about the role of gold in portfolios within the spectrum of investment strategies ranging from a small permanent position for “portfolio insurance” to wide swings in asset allocation based on perceptions of world monetary and political events.

Recently an enlightening new study has been published by one of the Toronto CFA Society’s members, Ghattas Dallal, CFA of CIBC Asset Management, on how strategies for owning gold can be refined to take advantage of its strengths as an asset class while avoiding its weaknesses. The study tests the validity of gold’s effectiveness as an inflation hedge as well as the broader issue of gold’s ability to protect a portfolio during a period of crisis. In addition, it examines the historical risk–return characteristics of gold and suggests the optimal portfolio allocation to gold for various Canadian investor profiles. The Analyst had an opportunity to explore his findings with him:

How would you summarize your analysis of the appropriate role of gold in an investment portfolio?

Ghattas Dallal: Despite the conventional wisdom that gold serves as an effective inflation hedge, our analysis found very limited statistical evidence supporting this claim. Nonetheless, gold still has a place in a portfolio due to its unique role as a diversifier and its strong performance in times of crisis.

A large allocation to gold, as some investors currently appear to be advocating, is not recommended, due to gold’s unattractive long-term risk–return characteristics. However, an allocation of five to 10 percent, depending on the investor’s time horizon and risk tolerance, improves the portfolio’s risk–return trade-off and could provide a measure of protection against substantial loss in a crisis.

What are the findings of your analysis on gold as an inflation hedge?

GD: Contrary to popular belief, historical data do not support a consistent relationship between prevailing rates of inflation and the price of gold. The main reason that this expected relationship fails to hold is that the price of gold does not respond to the actual experience of inflation but rather to inflation expectations. A rise in the price of gold can be viewed as a potential leading indicator of inflation. In fact from 1971 to 2010 the correlation between the actual return on gold in a given year and inflation in the following year was 0.59, which, although still modest, is higher than the correlation on a same-year basis of 0.48.

Applying this analysis to the current situation, the rise in the price of gold over the last decade could indicate that investors are expecting the rate of inflation to rise significantly. If the rate of inflation ultimately proves to be less than expected, the price of gold could decline. If, on the other hand, the result is runaway inflation, the price of gold could rise further.

Although no strong statistical relationship exists between the price of gold and inflation, there is a particular inflation scenario that is positively associated with a rise in the price of gold: double-digit inflation. This has often coincided with a rapid rise in the price of gold. Gold has done extremely well in periods of double-digit inflation, such as the years 1974 and 1979. In periods of double-digit inflation, the average return on gold was 53.5 percent (in U.S. dollars). This was a significant outperformance relative to U.S. equities, as represented by the S&P 500 Index, and relative to U.S. bonds, as represented by the U.S. Long-Term Government Bond, which returned 4.1 percent and a decline of 0.2 percent (in U.S. dollars) in those periods, respectively. This result needs to be interpreted with caution, however, as there were only four such annual periods in the sample of years from 1926 to 2010. Also an analysis of the periods of strong historical returns for gold points to a larger pattern, namely, that gold does very well in times of crisis.

Could you provide some examples of how gold provided protection in times of crisis?

GD: Yes. During the Great Depression, which certainly qualifies as a crisis, gold produced an annualized return of 6.2 percent. In the two periods encompassing the first half of the 1970s (April 1970-June 1973 and July 1973-March 1975), gold produced an annualized return of 44.7 percent and 25.3 percent, respectively. In these periods, the U.S. economy was mired in stagflation amid dramatic spikes in oil prices. The outsized returns for gold continued in the two periods beginning in January 1979 and ending in September 1982. These periods were characterized by the energy crisis as well as the deep economic downturn brought on by the actions of the U.S Federal Reserve, led by Paul Volcker, to rein in inflation by implementing severely tight monetary policy.

Finally, from January 2008 to December 2010, the financial crisis generated unprecedented uncertainty in the solvency of major financial institutions. Even after the most immediate issues were addressed by dramatically expansive monetary and fiscal policy, the crisis left in its wake a global regime beset by sovereign debt issues and persistently high unemployment and sluggish growth. This suggests a powerful argument for maintaining a strategic allocation to gold in a portfolio, since gold serves to protect the portfolio from severe losses during times of crisis.

Gold also acts as a diversifier due to its low correlation with other asset classes. Despite the large weighting of gold companies within the TSX Composite Index, the correlation of gold with the stock market is low due to the fact that the share prices of gold companies do not move in tandem with gold prices. The returns of gold companies are impacted by more than just the commodity price. The efficient frontier constructed with the addition of gold as an available asset class is superior to the efficient frontier constructed in the absence of gold.

So including gold in a portfolio can improve the risk–return characteristics and provide protection in times of crisis.

GD: Yes, but only a modest allocation to gold should be maintained within the portfolio. As the allocation to gold is increased, the drawbacks begin to outweigh the benefits, as gold has displayed inferior risk–return attributes as a standalone investment, particularly relative to equities in the past 61 years. Unlike equities, gold provides no income and does not benefit from an increase in economic growth and corporate profits. Worse, gold has displayed a much higher volatility, as it is prone to large price swings resulting from speculation by investors. Between 1950 and 2010, gold generated an average annual return of 6.4 percent (in Canadian dollars) with a volatility, measured by standard deviation, of 19.6 percent. Canadian equities, on the other hand, as represented by the S&P/TSX Index, generated a superior return of 10.3 percent, with a lower standard deviation of 16.5 percent. As a result, an overly large allocation to gold in a portfolio would detract from the portfolio’s expected return, likely negating any potential benefits of the allocation to gold. On the other hand, a modest allocation for a long-term investor can provide benefits.

The optimal allocation for a conservative portfolio designed for investors with a shorter time horizon contains only a five percent allocation to gold. At the other end of the risk–return spectrum, the optimal allocation for aggressive growth-oriented investors with a long time horizon contains an allocation of up to 10 percent.

Given the large increase in the price of gold in the last decade, should we not expect that production, and hence supply, will increase significantly?

GD: Interestingly, this has not been the case, historically. Production reached a bottom in 2008 and then began increasing, surpassing its 2001 high only in 2010. Despite this increase in supply, gold is still trading at four times the price level of 2001. Although gold producers are expected to further increase production over the next three years, the experience of the last decade has shown that the demand side has the dominant influence on gold prices.

Turning then to the potential for future crises, as you know, there are some investors who are saying that there are fatal flaws in the fiat monetary system of the past century and that one needs to protect oneself from the effects of this system’s inevitable dissolution by holding gold and silver, the most time-tested forms of money. Is five to 10 percent enough for a portfolio seeking that kind of protection?

GD: If we knew with certainty the direction of markets or gold prices, we would not need an asset allocation strategy. However, the reality is that there is no certainty in investing, and history has shown us that timing the market could impede investors from achieving their long-term financial goals. Investors are well-advised to look at the risk–return trade-off, rather than risks or returns in isolation. Gold has displayed a much higher volatility than bonds and equity, as it is prone to large price swings resulting from speculation by investors. Also, gold has an intrinsic weakness compared to equities, which is the absence of any income return. However, gold remains a very good diversifier due its low correlation with other asset classes and its relatively strong performance in times of crisis.

Remaining diversified and maintaining an asset allocation to bonds, cash, gold, Canadian and global equity is highly effective in down markets. The allocation to bonds, cash, gold, and equities should be determined based on the investor’s individual goals and risk tolerance, time horizon, financial situation, income needs, liquidity, tax considerations, unique circumstances, and attitude toward global investing. The optimal allocation, which provides the best risk–return characteristics based on the past 61 years of market data, includes an allocation to gold of between five and 10 percent, depending on the investor’s risk tolerance. In summary, adding a modest allocation to gold in addition to the conventional asset classes improves the risk–return characteristics for conventional portfolios.

So five to 10 percent should be investors’ golden rule! Thank you for your very interesting insights.