Investors have been worried about the volatility in equity markets over the past one year. The first two months of 2016 also saw sharp correction in equities, and then a sharp pullback in March. Asset markets have been volatile and often bring into context the financial crisis of 2008, when equities were badly hit. Gold bucked the trend, and did well during this period. It also did well this year when equities were struggling.
The global financial landscape remains uncertain. While the US economy remains relatively better off, Euro zone and Russia are likely to fall into recession, China is slowing down, and Japan is already in recession. The big issues like economic uncertainties and structural imbalances remain, especially in the older industrialised nations. Private and public debt in advanced economies are still high and rising.
The widening policy divergence among major central banks is going to have a big impact on currencies and create the real potential for a currency war.
Gold tends to perform well during periods of declining confidence. So, while you are framing an appropriate portfolio, remember that gold is an essential diversification tool.
For simplicity sake, we considered two asset classes: equity and gold. For equities, we took investment in S&P BSE Sensex (without dividends), and Indian gold prices (without taxes, duties and levies). We compared different portfolios that are rebalanced yearly. One with 100% equity and no gold, and others with varying gold allocations—5%, 10%, 15%, till 30%—and correspondingly lower levels of equity. Duration was calendar years 1990-2015 (yearly data).
Data shows that an allocation to gold has helped reduce risk without impacting overall returns. For instance, the annualised Sharpe ratio for a portfolio with 100% equity investment was 0.42 (14.3% compounded annual growth rate, CAGR). Sharpe ratio is a way to calculate risk-adjusted returns. In a portfolio with 95% equity and 5% gold, Sharpe ratio was 0.44, and it returned 14.4%. The one with 30% in gold had a Sharpe ratio of 0.57 and CAGR of 14.2%. The point here is risk has been reduced for the overall portfolio without giving up long-term return potential. But your allocation has to depend on factors such as risk tolerance, other investments, cash flows, income, and age.
Generally speaking, allocation should be 10-15% of the portfolio, because beyond this point, returns on the portfolio start diminishing, and incremental risk reduction also reduces. A financial adviser can help you identify the right allocation. (Mint recommends 5-10% allocation.)
Moreover, the newer forms of buying gold are far more price efficient and convenient over the traditional form of physical purchases in the form of gold jewellery or gold coins.
Although the sovereign gold bonds give additional interest income on initial invested capital over and above the gold return, the biggest concern is that of liquidity.
Gold exchange-traded funds (ETFs) have been around for a long time now and are even listed on stock exchanges. Since these are backed by physical gold, they are considered ‘as good as gold’. Gold ETFs do not offer any additional interest but are price efficient as they pass on the wholesale market efficiencies to the retail level even if you are buying as little as units equivalent to 0.5 grams of gold.
So, keep gold as a portfolio diversification tool, but limit your allocations to about 10-15% of the portfolio.
Chirag Mehta is senior fund manager at Quantum Asset Management Company.