How to use gold and other precious metals in a portfolio

As inflationary risks come to the fore of investors’ attentions, understanding the defensive role gold and other precious metals can play in a portfolio is becoming increasingly important.

After reading this article, you will have learned about the different ways to invest in gold, how different fund managers invest in the asset class and how it can be used in a wider portfolio.

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For many years, investors have viewed certain precious metals – primarily gold – as portfolio diversifiers that can provide defensive qualities in different market environments. With stock markets sitting at higher levels in some parts of the world and inflation on the rise, these potentially safer-haven assets may become even more prominent in portfolios over the coming year.

Gold investment options

Gold has dominated the precious metals market. Typically, around half of the gold consumption in the world is in jewellery, owing to its malleability and desirability, while a further 40% is earmarked for investments, and 10% is used for industrial purposes*.

In 2020, the onset of the Covid-19 pandemic bucked this trend. According to the World Gold Council, 1,327 tonnes of the precious metal were used in jewellery making, while 1,773 tonnes were bought by investors. In contrast, 2,138 tonnes were used for jewellery in 2019, far greater than the 1,275 tonnes acquired by investors*.

There are different ways for investors to gain exposure to gold, each with advantages and disadvantages. To leverage gold’s investment properties, choosing the right vehicle is critical.

Related learning: Gold and Silver: where to find it and how to invest

Bullion

Advantages:

• Gold bullion will retain its inherent value, even if the price is continually fluctuating
• The market for gold from the jewellery, manufacturing and electronics industries tends to remain relatively constant during times of economic stability
• Gold has historically performed well during economic recessions, acting as a diversifier against stocks during economic downturns
• Bullion can be valuable in a time of crisis, (for example, if currency were to become worthless)
• Some forms of bullion, such as Gold Britannia coins, are exempt from Capital Gain Tax

Disadvantages:

• Bullion must be physically stored somewhere, whether that be a safety deposit box or an at-home safe
• A custodian or storage facility will incur additional costs
• Bullion does not act as a passive income asset
• Price corrections can lead to losses
• Returns are often lower than stocks or bonds

Funds

Advantages:

• There is no need to pay a premium to store the gold, but investors are still exposed to bullion’s defensive qualities
• Gold funds, especially ETFs, provide a high level of liquidity
• There is no risk of physical theft
• Can be more tax-efficient

Disadvantages:

• Increased exposure to market risks, such as economic downturns
• Fund performance can vary
• Asset managers will demand a fee
• Costs of brokerage and commission
• Liquidity can vary from fund to fund

Equities

Advantages:

• Gold mining stocks correlate more strongly to the stock market than bullion, meaning returns can be greater
• Mining is a well-established and predictable industry
• Lessening supplies can result in a higher price
• Offers different levels of risk depending on the seniority of the mining company

Disadvantages:

• Correlation to the stock market can result in losses
• Lacks the defensive attributes of bullion
• Low demand can result in plummeting prices
• Mining processes are complex and prone to technical, environmental or legislative barriers
• Junior mining companies have a poor track record of long-term success

Why allocate to precious metals

Like any investment, the decision to invest in precious metals is dependent on their performance and risk characteristics, and how they align with the specific objectives of an investor.

In the case of gold, diversification is the primary benefit, according to Adrian Ash, director of research at BullionVault, a gold and silver marketplace.

“Gold tends to do well when other assets do badly, most of all, the stock market. While this has sometimes paid off on short-term shocks, such as 9/11 or the Brexit referendum, gold has typically worked better when investors needed it to, helping offset longer-term losses in equities such as during the dot.com crash and the global financial crisis,” he says.

In this sense, gold can be used to hedge against an unfavourable economic climate.

Gold offers other qualities to investors.

Carlo Alberto De Casa, analyst at Kinesis Money, points towards the metal’s appreciating value, “achieving an average performance of +10.6% per year in the past 50 years.”

Moreover, Adrian says domestic market conditions coupled with a changing global economic landscape play favourably towards an allocation to precious metals. For a UK investor, devaluation is an important factor to consider, he says.

“Cash in the bank hasn’t paid UK savers a positive return after inflation since 2008, and with government debt now so high and economic growth so uncertain, the Bank of England looks sure to keep interest rates below zero in real terms for years to come. Physical gold offers a natural alternative, being rare, tightly supplied and free of default risk,” Adrian says.

While on the global stage, the “decline of Western economic power” relative to the demographic giants of China and India is making precious metals, particularly gold, more attractive.

These two giants of the Asian market, he says, “show a deep, historic love of gold, which shows no sign of ebbing despite changes in fashion and taste.”

“While their consumer demand doesn’t tend to impact gold prices short-term, it accounts for one ounce in every two bought worldwide each year between them. That relentless accumulation means both that there will be less gold available elsewhere over time and that Western investors can join this trend, buying and holding a little of what households across Asia’s powerhouse economies use as a major vehicle for their long-term savings,” explains Adrian.

Even with these favourable conditions, vaccine rollouts and the easing of government restrictions in 2021 meant gold and gold equities declined over the year*.

“This was not unusual after two strong years for gold and gold equities, as economic uncertainty rose before and during the pandemic,” says George Chevely, portfolio manager of Ninety One’s Global Gold fund.

“What was comforting as a gold equity investor was seeing gold companies maintain very strong balance sheets through this period and increase shareholder returns via dividends and buy-backs,” he says.

Finally, gold, being “one of the most liquid asset classes available to investors”, affords investors flexibility and the option to quickly turn holdings into cash – a valuable trait in uncertain times.

Gold in 2022

Markets have recovered on the back of unprecedented financial support from many governments throughout the pandemic, but there is now considerable uncertainty about how markets will react to financial conditions being tightened, says George.

“With inflation still high in many countries, central banks are under pressure to tighten harder, but politicians are eager to maintain growth and to fund decarbonisation infrastructure. This is creating tension in financial markets, as it is not clear how both goals can be achieved,” he says.

Heading deeper into 2022, the role policymakers will play is set to be of increasing importance to investors, says Ned Naylor-Leyland, manager of Jupiter Gold & Silver fund.

He believes the Federal Reserve and the Bank of England may not have a significant influence on inflation rates without unsettling financial markets and global debt levels. A repeat of the Federal Reserve’s 2018 decision to raise interest rates, in his view, would be a mistake.

But for investors and advisers considering gold, paying close attention to real interest rates is key, according to Ned. The real interest rates driver, being separate from the influences of equities or traditional fixed interest, makes gold and silver non-correlating at an overall portfolio level, affording the asset a valuable characteristic amid uncertain times.

“The current presumption is that inflation will start to ease this year and that a series of rate hikes are imminent. The case for owning the metals in 2022 could be that inflation embeds further, especially if oil prices continue higher. The priced-in rate hikes might also, as we have seen before, end up being a policy error needing reversal,” he says.

Additionally, Ned says supply problems are another reason to hold gold. In 2020, a 4% decline in the total gold supply was attributed to disruptions due to the pandemic**.

Lockdowns in Mexico resulted in a Q2 2020 production 62% lower than usual, while in South Africa, production fell by 59%**.

How advisers can use gold

When considering key factors of the gold and silver market, advisers should be aware of how investors are engaging with precious metals, says Carlo Alberto De Casa.

“For example, the separation between the physical or paper markets should be established, in line with the investor’s objectives. It is important to be aware that physical gold presents the advantages of being an inflation hedge and a wealth protection asset. Of course, this is only the case when you own it. However, investors seeking to gain something from the paper markets of gold and silver understand that it can sometimes be cheaper and quicker to buy and sell,” he adds.

Additionally, deciding the appropriate way of investing in gold is important. For some, equities in mining companies may appear attractive. However, Adrian points out that the correlation between the bullion price and equity performance has “become increasingly erratic compared to the portfolio insurance function of gold itself.”

He adds that energy accounts for a “huge proportion of mining costs,” a factor that is likely to “keep a lid on profit margins.” Lower-cost mines are typically in more remote areas in emerging market nations, adding political and environmental risk for shareholders.

Ned echoes this sentiment, stating that individual equities in mining companies may not be the most prudent approach, and instead recommends a fund or index fund, which may “spread [the] risk and volatility budget around better.”

Most important, he says, is to “be selective” and “take counterparty risk seriously in bullion holdings.”

Conversely, George says that gold equities remain “attractive” as they generally have strong balance sheets, high operating margins and “should deliver good returns, even if gold prices remain flat.”

One such investment option is BlackRock World Mining Trust, which has exposure to gold, silver and platinum, as well as some small exposure to palladium and rhodium. Often this exposure is gained by investing in “diversified” miners such as Rio Tinto, Glencore and Vale, which have a range of mining assets, some of which will be precious metals.

Merger and acquisition activity in the space has been strong over recent years, adds George. “As the sector consolidates, we expect this to continue as companies look to increase scale and reduce costs, in particular overheads which have historically been too high.”

When investing in tangible gold, Adrian recommends vaulted bullion, held ready for sale at full value, rather than coins or small bars, where dealer mark-ups “will cost 5-10% in fees.”

*Source: Gold.org, FastMarkets, ICE Benchmark Administration, Thomson Reuters, World Gold Council; Gold price 1 January to 31 December 2021, in US Dollars
**Source: Gold Hub, 28 January 2021

A reminder of the learning objectives

• Demonstrate the role gold and other precious metals play in a balanced portfolio
• Understand the investment vehicles available and their pros and cons
• Explain how to use gold and precious metals strategically
• Build knowledge of the gold market in 2022