Gold has a low correlation with other asset classes, which makes it a good diversifier
Gold appears to have made a remarkable comeback recently. The upcoming festive season might have something to do with it, though it is largely owing to turbulent times in the equity market, as a result of global trade woes and a gloomy economic outlook. Volatility in the market has pushed investors towards the ‘safe haven.’ The yellow metal surged 24 per cent (gold returns calculated from LMBA prices converted to Indian rupees) in the year-ended September 16, 2019, and 20 per cent year-to-date. Historically, too, gold has done well as a safe-haven asset during choppy times in the financial markets. It just confirms the importance of gold as a diversifier in the investment portfolio. This article builds a case for gold and encourages investors to add glitter to their portfolios.
An effective portfolio diversifier
Asset classes perform differently across market phases, as seen in the chart below. Thus, a balanced mix of different assets helps diversify the portfolio. Traditionally, investors have relied on equity and debt as the primary asset classes, but have realised that adding gold to the portfolio can act as an effective diversifier. This was evident in 2016, 2018 and 2019, when equity was mauled by weak sentiments; gold outperformed equity, while giving superlative returns in the latest calendar year.
Dynamic performance of key asset classes
Calendar year point-to-point returns
Gold returns calculated from LBMA prices converted to Indian rupees
Equity returns calculated for Nifty 50 Index
Debt returns calculated for CRISIL Dynamic Gilt Index
*Returns are as on September 16, 2019
A judicious portion of gold not only lends balance to the portfolio but also reduces risk. To verify this hypothesis, we analysed the performance of a diversified portfolio (equity, debt, and gold) as against standard diversification (equity and debt) and standalone asset classes. Our analysis shows that a combination of equity, debt, and gold in the portfolio generated higher risk-adjusted returns (Sharpe ratio) than other combination/standalone classes.
A judicious mix of equity, debt, and gold gave higher risk-adjusted returns
Returns – Average of 10-year CAGR on a daily rolling basis from 1997 to September 16, 2019
Volatility – Standard deviation of 10-year CAGR returns from 1997 to September 16, 2016
Risk adjusted returns denoted by Sharpe ratio computed on the returns and volatility generated above. Risk-free rate of 6.27 per cent used for the analysis, which is the one-year average 91-day T-bill rate for the period ended September 11, 2019
Debt, equity and gold represented by CRISIL Dynamic Gilt Index, Nifty 50 and LBMA gold prices, respectively
* Allocation between equity and debt assumed to be 50:50
^ Allocation between equity, debt and gold assumed to be 45:45:10
Notwithstanding the benefits of adding gold to the portfolio as seen in the chart, investors should invest in the yellow metal judiciously. This is because a higher exposure to gold can heighten the concentration risk of the portfolio, especially since it is a single asset class and investment product, unlike equity and debt, where investments are spread across companies and issuers. Traditionally, a minor exposure to gold, of up to 5-10 per cent of the portfolio, is considered judicious in terms of portfolio diversification. However, investors can chart their own risk-return profile and consult their financial advisor before investing in the asset class.
Investment through paper gold
Here’s another point about gold. Investing in paper gold is better than hoarding it in a physical format – jewellery, coins and bars. Physical gold investments are exposed to the risks of theft, impurity and unfavourable prices. In contrast, paper gold investments offer greater price transparency, purity and negate the risks of storage and theft.
Paper gold options include gold exchange-traded funds (ETFs) and gold fund-of-funds (FoFs). Gold ETFs are similar to traditional units, where investors get units in their demat accounts and buying/ selling of these units is done on the exchanges. Gold FoFs, on the other hand, invest in gold ETFs or foreign gold funds (mother funds); the difference is that investors can buy/sell their units from the fund house. Both these gold mutual fund options are taxed like debt mutual funds. Short-term capital gains (STCG) for a holding period of less than three years is taxed in the hands of the individual as per his / her tax slab, while long-term capital gains (LTCG) tax is 20 per cent with indexation, after three years.
Meanwhile, investors also have the flexibility to invest in the precious metal through sovereign gold bonds (SGBs) issued by the Reserve Bank of India (RBI). An investor earns an interest of 2.5 per cent per annum on the investment. Capital gains arising on redemption of SGBs to an individual have been exempted from tax. Indexation benefits will be provided to LTCG arising on transfer of bonds. Further, investors also have the opportunity of converting physical gold to paper gold, and earning fixed income returns along with tax benefits through the gold monetisation scheme. Investments are locked for pre-defined tenures of up to 15 years, and investors can earn an additional interest rate of 2.25 per cent and 2.20 per cent for medium- and long-term deposits, respectively. There is no tax on capital gains and interest earned.
The cyclical nature of the financial markets necessitates a diversified portfolio to reap optimal returns. The key to diversification is to invest in assets which are not closely correlated with each other. Gold has a low correlation with other asset classes, which makes it a good diversifier. Having said that, allocation to gold should be judicious and based on the investors’ risk-return profile.(The writer is Director, Funds & Fixed Income, CRISIL)The Great Diwali Discount!
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