World Gold Council

10/15/2019 | Press release | Distributed by Public on 10/14/2019 23:54

The relevance of gold as a strategic asset in Japan

15 October, 2019

Gold is a highly liquid yet scarce asset, and it is no one's liability. It is bought as a luxury good as much as an investment. As such, gold can play four fundamental roles in a portfolio:

  • a source of long-term returns
  • a diversifier that can mitigate losses in times of market stress
  • a liquid asset with no credit risk that has outperformed fiat currencies
  • a means to enhance overall portfolio performance.

Our analysis shows that adding 2.5%, 7.5% or 10% in gold over the past decade to the average Japanese pension portfolio would have resulted in higher risk-adjusted returns.

Why gold, why now

Gold is becoming more mainstream. Since 2001, investment demand for gold worldwide has grown, on average, 15% per year. This has been driven in part by the advent of new ways to access the market, such as physical gold-backed exchange-traded funds (ETFs), but also by the expansion of the middle class in Asia and a renewed focus on effective risk management following the 2008-2009 global financial crisis. Additionally, central banks have turned from net sellers to net buyers of gold as part of their foreign reserves, a change of approximately 1,000 tonnes.

Today, gold is more relevant than ever for investors. While central banks in developed markets are moving to normalise monetary policies - leading to higher interest rates - we believe that investors may continue to feel the effects of quantitative easing and the prolonged period of low interest rates for years to come.

These policies may have fundamentally altered what it means to manage portfolio risk and could extend the time needed to meet investment objectives.

In response, institutional investors have embraced alternatives to traditional assets such as stocks and bonds. The share of non-traditional assets among global pension funds has increased from 15% in 2007 to 25% in 2017.1

Many investors are drawn to gold's role as a diversifier due to its low correlation to most mainstream assets and as a hedge against systemic risk and strong stock market pullbacks. Some use it as a store of wealth and as an inflation and currency hedge. In Japan particularly, gold has acted as a safe haven in times of market stress, including periods of heightened uncertainty since the Brexit referendum.

As a strategic asset, gold has historically improved the risk-adjusted returns of portfolios, delivering returns while reducing losses and providing liquidity to meet liabilities in times of market stress (Chart 6).

A source of returns

Gold is not only useful in periods of higher uncertainty. Its price in yen has increased by an average of 8.2% per year since 1971 when gold began to be freely traded following the collapse of Bretton Woods. And gold's long-term returns have been comparable to stocks and higher than bonds or commodities (Chart 1).2

There is a good reason behind gold's price performance: it trades in a large and liquid market, yet it is scarce.

Mine production has increased by an average of 1.4% per year for the past 20 years. At the same time consumers, investors and central banks have contributed to higher demand, and this diversity of demand has become a key strength.3

On the consumer side, the combined share of global gold demand from India and China has grown from 25% in the early 1990s to more than 50% in recent years.4

Our research shows that expansion of wealth is one of the most important drivers of gold demand over the long run. It has had a positive effect on jewellery, technology, and bar and coin demand - the latter in the form of long-term savings.5

Chart 1: Gold has delivered positive returns over the long run, outperforming key asset classes

Chart 1: Gold has delivered positive returns over the long run, outperforming key asset classes

Average annual return of key global assets in yen

Sources: Bloomberg, ICE Benchmark Administration, World Gold Council; Disclaimer

*As of 31 December 2018. Computations in yen of total return indices for JPMorgan Cash Index, JPY 1 Month Index, JPMorgan GBI Japan Unhedged Index, MSCI Japan Total Return, MSCI Kokusai, MSCI Emerging Market Indices, Bloomberg Commodity Index and spot for LBMA Gold Price PM. For compounded annual growth rates see Appendix II.

Additionally, investors have embraced gold-backed ETFs and similar products to get exposure to gold. Gold-backed ETFs amassed more than 2,500 tonnes (t) of gold worth ¥11.8trn since they were first launched in 2003.6

Asian listed gold-backed ETFs holdings grew 48% over the past five years. This represents an increase of 26 tonnes or ¥130bn.

And since 2010 central banks have been net buyers of gold in order to expand their foreign reserves as a means of diversification and safety.

Well above inflation

During the Gold Standard, and subsequently the Bretton Woods system, when the US dollar was backed by and pegged to the price of gold, there was a close link between gold and US inflation. But when gold became free floating inflation was no longer its main price driver.

Sure enough, gold returns have outpaced the Japanese consumer price index (CPI) over the long run due to gold's many sources of demand. Gold has not just preserved capital; it has helped it grow.

Gold has also protected investors against extreme inflation. In years when inflation has been higher than 3%, gold's price has increased by 16% in real terms on average (Chart 2). Additionally, research by Oxford Economics shows that gold should do well in periods of deflation.7

Chart 2: Gold has historically rallied in periods of high inflation

Chart 2: Gold has historically rallied in periods of high inflation

Gold returns in yen as a function of annual inflation*

Sources: Bloomberg, World Gold Council; Disclaimer

*Based on y-o-y changes of the LBMA Gold Price and Japan CPI between 1989 and 2018.
**For each year on the sample, real return = (1+nominal return)/(1+inflation)-1.

A high-quality, hard currency

Over the past century, gold has greatly outperformed all major currencies as a store of value (Chart 3). This includes instances when major economies defaulted, sending their currencies spiraling down, as well as after the end of the Gold Standard. One of the reasons for this robust performance is that the available above-ground supply of gold has changed little over time - over the past two decades increasing approximately 1.6% per year through mine production.8 By contrast, fiat money can be printed in unlimited quantities to support monetary policies.

Chart 3: Gold has outperformed all major fiat currencies over time

Chart 3: Gold has outperformed all major fiat currencies over time

Relative value between major currencies and gold since 1900*

Sources: Bloomberg, Harold Marcuse - UC Santa Barbara, World Gold Council; Disclaimer

*As of 31 December 2018. Based on the annual average price of a currency relative to the gold price.
**The 'Mark' was the currency of the late German Empire. It was originally known as the Goldmark and backed by gold until 1914. It was known as the Papermark thereafter.

Diversification that works

Although most investors agree about the relevance of diversification, effective diversifiers are not easy to find. Correlations tend to increase as market uncertainty (and volatility) rises, driven in part by risk-on/risk-off investment decisions. Consequently, many so-called diversifiers fail to protect portfolios when investors need them most.

For example, during the 2008-2009 financial crisis, hedge funds, broad commodities and real estate, long deemed portfolio diversifiers, sold off alongside stocks and other risk assets. This was not the case with gold.

Gold historically benefits from flight-to-quality inflows during periods of heightened risk. By providing positive returns and reducing portfolio losses, gold has been especially effective during times of systemic crisis when investors tend to withdraw from stocks. Gold has also allowed investors to meet liabilities while less liquid assets in their portfolio were undervalued and possibly mispriced.

The greater a downturn in stocks and other risk assets, the more negative gold's correlation to these assets becomes (Chart 4). But gold's correlation doesn't only work for investors during periods of turmoil.

Due to its dual nature as a luxury good and an investment, gold's long-term price trend is supported by income growth. As such, our research shows that when stocks rally strongly their correlation to gold can increase, driven by the wealth effect and, sometimes, by higher inflation expectations.

Chart 4: The price of gold tends to increase more when stocks pull down sharply

Chart 4: The price of gold tends to increase more when stocks pull down sharply

Conditional correlation between gold and the TOPIX relative to the magnitude of the stock pullback*

Sources: Bloomberg, World Gold Council; Disclaimer

*Based on weekly returns in yen between January 1987 and December 2018.

The top bar corresponds to the unconditional correlation over the full period. The middle bar corresponds to the correlation conditional on the TOPIX Index weekly return falling by more than two standard deviations (or 'σ'), respectively.

The bottom bar corresponds to the correlation conditional on the TOPIX Index weekly return falling by more than three standard deviations (or 'σ'), respectively.

A deep and liquid market

For large buy-and-hold institutional investors, size and liquidity are important factors when establishing a strategic holding.

Gold benefits from its large, global market. We estimate that physical gold holdings by investors and central banks are worth approximately ¥336trn, with an additional ¥86trn in open interest through derivatives traded on exchanges or over-the-counter.

In addition, the gold market is liquid (Chart 5). Gold trades between ¥5.7trn and ¥8.5trn per day through spot and derivatives contracts over-the-counter. Gold futures trade ¥3.5trn and ¥5.7trn per day across various global exchanges. Gold-backed ETFs offer an additional source of liquidity, with the largest Japanese-listed funds trading an average of ¥500mn per day.

Chart 5: Gold trades more than many other major financial assets

Chart 5: Gold trades more than many other major financial assets

Average daily trading volumes in yen*

Sources: Bloomberg, Bank for International Settlements, UK Debt Management Office (DMO), Germany Finance Agency, Japan Securities Dealers Association, London Bullion Market Association, World Gold Council; Disclaimer

*Based on one-year average trading volumes as of December 2018, except for currencies that correspond to full-year 2016 volumes due to data availability.
**Gold liquidity includes estimates on over-the-counter (OTC) transactions, published statistics on futures exchanges, and gold-backed exchange-traded products. For methodology details visit the liquidity section at Goldhub.com.

Gold is a highly liquid yet scarce asset, and it is no one's liability.

Enhancing portfolio performance

The combination of all these factors means that adding gold to a portfolio can enhance risk-adjusted returns.

Over the past decade, Japanese investors with an asset allocation equivalent to an average private investor portfolio would have benefitted from including gold in their portfolio. Adding 2.5%, 7.5% or 10% in gold would have resulted in higher risk-adjusted returns (Chart 6).

Chart 6: Gold increased the risk-adjusted returns of a hypothetical average pension fund portfolio

Chart 6: Gold increased the risk-adjusted returns of a hypothetical average pension fund portfolio

Risk adjusted return of a hypothetical pension portfolio with various allocations to gold*

Sources: Bloomberg, ICE Benchmark Administration, World Gold Council; Disclaimer

*Risk adjusted return defined as portfolio return divided by annualised volatility and based on the total return indices in yen and benchmarks listed below using data from December 1998 to December 2018. The portfolio is rebalanced yearly. The composition of the hypothetical average portfolio is based on a survey conducted by the Pension Fund Association on 18 January 2019 (for data as of FY2017). It includes total returns in yen for a 35% allocation to stocks (20% MSCI Kokusai, 15% MSCI Japan), 55% allocation to fixed income (30% JPMorgan GBI Japan Corporate Bonds, 20% Barclays Global Aggregate Corporate Bonds, 5% JPMorgan Japan Cash Index), and 10% alternative assets (6% Hedge Fund Research Absolute Return Index, 2% Tokyo Stock Exchange TOPIC Real Estate Index, 2% S&P Listed Private Equity Index). Gold's performance is based on the LBMA Gold price in yen and the respective 2.5%, 7.5% and 10% portfolio allocations come from proportionally reducing all assets. As of 31 December 2018.

But studying only simulated past performance of a hypothetical average portfolio does not allow us to evaluate how much gold investors should add to a portfolio to achieve the maximum benefit.

Asset allocation analysis indicates that, for Japanese yen-based investors, holding 2.5% to 12.5% in gold as part of a well-diversified portfolio can improve performance even more (Chart 7).9 Broadly speaking, the higher the risk in the portfolio - whether in terms of volatility, illiquidity or concentration of assets - the larger the required allocation to gold, within the range in consideration, to offset that risk.

The analysis shows that gold's optimal weight in hypothetical portfolios is statistically significant even if investors assume an annual return for gold between 2% and 4% - well below its actual long-term historical performance (Chart 7).

Our research shows that this is also the case for investors who already hold other inflation-hedging assets, such as inflation-linked bonds,10as well as for investors who hold alternative assets (e.g., real estate and hedge funds).11

Gold goes beyond commodities

Gold is often lumped together with the commodity complex by investors and investment practitioners alike. Whether as a component in a commodity index (e.g. S&P Goldman Sachs Commodity Index, Bloomberg Commodity Index), one of the securities in an ETF, or as a future trading on a commodity exchange, gold is viewed as a part of this complex.

Gold undoubtedly shares some similarities with commodities. But a detailed look at the make-up of supply and demand proves that differences outnumber similarities:

  • the supply of gold is balanced, deep and broad, helping to quell uncertainty and volatility
  • because gold is not consumed like typical commodities, its above-ground stocks are available for continuous utilisation
  • gold is used for many purposes and purchased all around the world, reducing its correlation to other assets
  • gold is both a luxury good and an investment, resulting in more effective downside portfolio protection.

Gold's unique attributes set it apart from the commodity complex. From an empirical perspective, including a distinct allocation to gold has improved the performance of portfolios with passive commodity exposures.12

Chart 7a: Gold can significantly improve risk-adjusted returns of hypothetical portfolios across various levels of risk

Chart 7a: Gold can significantly improve risk-adjusted returns of hypothetical portfolios across various levels of risk

(a) Long-run optimal allocations based on asset mix*

Sources: World Gold Council; Disclaimer

* Based on monthly total returns in yen from December 1998 to December 2018 of MSCI Kokusai, MSCI Japan, JPMorgan GBI Japan Corporate Bonds, Barclays Global Aggregate Corporate Bonds, JPMorgan Japan Cash Index, Hedge Fund Research Absolute Return Index, Tokyo Stock Exchange, TOPIX Real Estate Index, S&P Listed Private Equity Index and LBMA PM gold price Each hypothetical portfolio composition reflects a percentage in stock and alternative assets relative to cash and bonds. For example: 40/60 is a portfolio with 40% in stocks, commodities, hedge funds, REITs and gold, and 60% in cash and bonds. Analysis based on New Frontier Advisors Resampled Efficiency. For more information see Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Oxford University Press, January 2008.

Chart 7b: Gold can significantly improve risk-adjusted returns of hypothetical portfolios across various levels of risk

Chart 7b: Gold can significantly improve risk-adjusted returns of hypothetical portfolios across various levels of risk

(b) Range of gold allocations and the allocation that delivers the maximum risk-adjusted return for each hypothetical portfolio mix*

Sources: World Gold Council; Disclaimer

* Based on monthly total returns in yen from December 1998 to December 2018 of MSCI Kokusai, MSCI Japan, JPMorgan GBI Japan Corporate Bonds, Barclays Global Aggregate Corporate Bonds, JPMorgan Japan Cash Index, Hedge Fund Research Absolute Return Index, Tokyo Stock Exchange, TOPIX Real Estate Index, S&P Listed Private Equity Index and LBMA PM gold price Each hypothetical portfolio composition reflects a percentage in stock and alternative assets relative to cash and bonds. For example: 40/60 is a portfolio with 40% in stocks, commodities, hedge funds, REITs and gold, and 60% in cash and bonds. Analysis based on New Frontier Advisors Resampled Efficiency. For more information see Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Oxford University Press, January 2008.

Footnotes

1Willis Towers Watson, Global Pension Assets Study 2018, February 2018 and Global Alternatives Survey 2017, July 2017.

2For other return metrics and y-o-y performance see Appendix II.

3See Appendix I as well as the demand and supply section of Goldhub.com.

4Ibid.

5Ibid.

6As of 31 December 2018. For more information visit Goldub.com.

7Oxford Economics, The impact of inflation and deflation on the case for gold, July 2011.

8See Appendix I as well as the demand and supply section at Goldhub.com.

9Analysis based on the re-sampled efficiency methodology developed by Richard and Robert Michaud and praised as a robust alternative to traditional mean-variance optimisation. See Efficient Asset Management: A Practical Guide to Stock Portfolio Optimisation and Asset Allocation, Oxford University Press, January 2008.

10Gold as a tactical inflation hedge and long-term strategic asset, July 2009.

11How gold improves alternative asset performance, Gold Investor, Volume 6, June 2014.

12See Gold: A commodity like no other, April 2011, and Gold: metal by design, currency by nature, Gold Investor, Volume 6, June 2014.

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