Commodities can be tactically relevant investments, but a strategic gold allocation on its own can supplement or replace a broad-based commodities investment.

Real assets have tended to do well in reflationary periods

Understanding historical asset performance during reflationary periods is relevant for understanding how assets could perform during the current period. We examine the performance of various assets during the last two periods of reflation, i.e. Consumer Price Index (CPI) trough to peak, and compare this to the current environment.²

The results confirm the idea that assets like Real Estate Investment Trusts (REITs) and Treasury Inflation-Protected Securities (TIPS) were solid performers, with commodities and gold performing well. Additionally, it confirms gold’s meaningful outperformance over equities and bonds. 

But what it also suggests is the potential upside in gold compared to how broad commodities have performed during the recent reflationary period. In the previous two periods, gold outperformed broad commodities. However, in the current environment, gold is down 10% compared to commodities, which are up substantially.³

Gold lagged other commodities beginning in May 2020, and has continued through the first half of 2021, but this is not unusual in commodity-led reflationary periods historically, as we addressed in our recent publication, Gold, commodities and reflation. Historically, gold lags initially, but catches up to most major commodity groups by the second and third years of a reflationary period.

Volatility has increased globally, but less so for gold

Volatility increased across major assets and commodities in 2020, driven by COVID-19-induced uncertainty, but less so for gold comparatively (Chart 1). A key reason for gold’s relative stability stems from its role as a diversifier in turbulent markets, as well as stronger left-tail correlation between many other commodities and risk-on assets.

Table 1: Gold historically lagged in commodity-led reflation periods but outperformed over the long run

Most recent reflationary periods in the US*

Gold: not your typical commodity

Gold allocations of 2%–10% in an average institutional portfolio have provided better risk-adjusted returns than those with broad-based commodity allocations.⁷  

Investors have long recognised the benefits of investing in commodities. Over time, they have been shown to improve portfolio risk-adjusted returns, offering diversification, inflation protection, and an element of smoothing across economic cycles. 

Most investors access this asset class via commodity indices, which invariably include gold. 

But gold’s weighting within these indices undervalues its importance as a strategic portfolio component (Focus 1, Table 3 and Table 4). Gold is, of course, a raw material used in the production of manufactured goods – the very definition of a commodity. But gold is much more than that. As both an investment and a consumer good, it is a multi-faceted asset that enjoys diverse supply and demand dynamics that play an important role in gold’s performance (see: Appendices III and IV in the full report), for more information). And as mentioned above, there are six main differentiators between gold and the broader commodities complex.

Better returns, effective diversification

Outperforming commodities

Gold has performed broadly in line with the S&P 500 over the long term, delivering average annual returns of 10.8% since the elimination of the gold standard in 1971 and a compound annual return of 7.9% (Chart 16, Appendix I in the full report).

But when compared to commodities, gold has outperformed not only broad-based indices but sub-indices and most individual commodities too. Nearly all sub-indices have fallen over the past five years. But gold has risen during that time. Gold has also outperformed major commodity sub-indices over the past 10 and 20 years (Chart 3), and outperformed most individual commodities, many of which have delivered negative returns in recent decades.

Diversification that counts

Gold has important diversification properties that come into their own during periods of systemic risk. 

Gold has little to no correlation with many other assets, including commodities (Chart 6 and Chart 20, Chart 21, Table 7, Appendix I in the full report) during times of stress. Crucially, however, the correlation is dynamic, changing across economic cycles to the benefit of investors. 

Like other commodities, gold is positively correlated to stocks during periods of economic growth when equity markets tend to rise. However, gold is also negatively correlated with other assets during risk-off periods, protecting investors against tail risks (Chart 4, and Chart 5), and other events that can have a significant negative impact on capital or wealth – a protection not always present in other commodities.

This dynamism reflects gold’s dual nature as both a consumer good and an investment. When economic conditions are benign, expenditure tends to increase on items such as jewellery or technological devices, and this works in gold’s favour. During times of systemic risk, however, market participants seek high-quality, liquid assets that preserve capital and minimise losses. This can also benefit gold by boosting investment demand and driving up prices. In the Q4 2018 global equity selloff, for example, the S&P 500 fell 15% and commodities fell 9%, yet gold rose 8%. And in the 2020 COVID selloff, the S&P 500 fell 20%, commodities fell 17%, while gold returned 2%. In both recent cases, gold not only protected portfolio assets but also delivered positive returns, while broader commodities behaved more like a risk-on asset.⁸  

Gold is also a more effective diversifier than other precious metals. While gold’s correlation to silver and platinum has been positive during periods of growth, it has decreased during market downturns as these other metals depend, to a greater extent, on industrial demand. Also, when compared to other metals, gold is much less dependent on the technology/industrial areas of the market in terms of demand, which can be highly cyclical (Chart 24, Appendix II in the full report). 

Gold behaves – and is used – as a safe-haven in periods of systemic risk…

Oil and gold remain largely unrelated

Gold and oil prices are not correlated, contrary to popular belief. Part of this misunderstanding is related to the size and scope of both assets, their global importance, broad commodities grouping, and the fact they are both generally priced in US dollars. At times, the two commodities move in the same direction, at other times in opposite directions (Chart 6), but there is no consistent relationship between the two. Oil tends to behave more like a risky asset, while gold is widely regarded as a risk-off asset (Chart 20, Appendix I in the full report). 

Lower volatility and a store of value in all inflationary periods

Gold is less volatile than most individual commodities and broad commodity indices (Chart 7). It is also less volatile than equities: from individual stocks and industry sectors to indices such as the Global MSCI World Index (Chart 1). As such, gold can enhance portfolio stability and improve risk-adjusted returns. 

Protecting against inflation

Commodities are often used for diversification during periods of high inflation. While it is true that commodities have performed well during inflationary periods, gold has performed better. And in periods of low inflation, commodities delivered negative nominal returns, while gold posted positive returns, reflecting increased demand when economic conditions are robust (Chart 8).  

This behaviour is particularly relevant today. Despite a recent uptick, current inflation expectations are low from a historical perspective, so gold should outperform other commodities. Future expectations suggest a growing risk of higher inflation; this should also drive demand for gold, as it has outperformed commodities in both moderate- and high- inflationary periods.

Gold as a store of value

Gold has a long and influential role as a monetary asset. Other metals, including silver and copper, have historically been used as currency but gold’s role in the monetary system is far more extensive as it has been used for thousands of years. Considered a rare and precious asset for centuries, gold was a logical choice as a currency anchor, and it performed this role until the US came off the gold standard in 1971.⁹ As such, gold made an important contribution to global economic architecture and, to this day, is considered a valuable international asset. Namely, it protects against currency declines and is the only precious metal used as a reserve asset (Chart 18, Appendix I in the full report). Prior to 1971, major commodities enjoyed periods where their value in gold terms reflected inflation and increased, while the price of gold was pegged to the US dollar. After 1971, when the price of gold was able to float, the value of commodities in gold terms fell sharply. 

Although gold no longer plays a direct role in the international monetary system, central banks and governments still hold extensive gold reserves (Table 10) to preserve national wealth and protect against economic instability. Central banks are buying gold at an ever-increasing pace. In 2018 alone, they purchased more gold than at any time since the end of the gold standard – and they have been net buyers for 11 straight years.¹⁰ Today, gold is the third largest reserve asset globally, following US dollar- and euro-denominated assets.

Gold is liquid and less impacted by futures storage and roll costs

Global liquidity on a physical-linked market

The gold market is robust and highly liquid. On the futures markets, daily volumes average US$69bn (Chart 22 and Table 8, Appendix II in the full report), second only to oil on US exchanges over the past 10 years (Table 9, Appendix II in the full report and Chart 9). It is worth noting that in 2020, amid significant market volatility, gold traded more each day in the US (at US$54bn) than either WTI Crude oil (US$42bn) or Brent Crude oil (US$36bn). On the over-the-counter (OTC) market, estimated volumes are even higher, at around US$110bn.¹¹ There is a thriving physical gold-backed ETF market too, with daily volumes averaging US$1bn. Overall, average daily trading in the global gold market ranges between US$140bn and US$200bn (Chart 10, Table 8, Appendix II in the full report).

This extensive liquidity allows investors to access gold in a range of ways – which are particularly important when compared to other commodities – and highlights how gold operates within a differentiated market (Focus 2). 
 

Storage costs hurt many commodity futures returns, but only slightly for gold

Many investors access commodity markets via futures contracts. Because futures contracts are based on the expected price at a certain point down the road, as well as the costs of carry, storage, and interest, investors are exposed to an additional source of variability: the shape of the futures curve. 

In general, futures curves have less of an impact on gold and other precious metals returns relative to most other commodities. Storage costs in particular account for a large proportion of the futures cost or cost of carry. But the storage costs of physical gold are negligible compared to those of other metals, while commodities such as natural gas incur extremely expensive storage costs, with most of those securities not settling for physical delivery. These costs are typically represented by a futures curve in contango, when futures prices are higher than spot prices.^{12, 13}

The shape of the curve, combined with the fact that futures contracts are typically rolled over or settled in cash, creates discrepancies between spot price returns and total returns. This difference can be very large in certain commodity markets, yet futures returns are not necessarily higher than spot returns. 

The oil market between June 2001 and June 2021 exemplifies this point (Chart 12, Table 6, Appendix I in the full report). Cumulative total returns based on spot were 88%; based on the futures markets, they were -111%, a by-product of the continuous rolling costs of maintaining a position.¹⁴  During the same period, gold’s spot return was 194% and the futures return was 189%. In fact, the roll cost has averaged approximately 25bps a year over the past 20 years, compared to 6% for the S&P GSCI. This reflects two important differentials between gold and other commodities. First, the shape of the gold futures curve tends to be flat at the most actively traded front end of the curve. Second, most investors either trade in spot or can potentially take physical delivery of futures contracts (although this can be quite costly and happens rarely). It is worth noting that the Bloomberg Precious Metals Sub-index and gold futures deliver similar performances over the long run, largely because nearly 82% of the Sub-index is comprised of gold futures.

Gold – efficient, effective, and under-represented

Despite gold’s unique and differentiating properties, investors often cluster it into a commodities bucket that frequently represents a small allocation within their overall portfolio. Furthermore, the amount of gold allocated to this smaller commodities bucket is usually just a fraction of the bucket itself, further diminishing the weight. 

Investors who access commodities via a broad-based index often assume they have an appropriate allocation to gold. In fact, most broad-based commodity indices have a very small allocation to gold. Indices such as the S&P GSCI or BCOM typically allocate between 6% and 15% to gold (Table 2, Table 3, and Table 4).¹⁵ While we previously noted that these allocations are trending higher, we do not believe such weightings provide an appropriate exposure to gold, particularly as commodities tend to represent a small portion of an investor’s overall portfolio.

Table 3: Gold is a small component in the S&P GSCI Index

S&P GSCI sector weights*

Table 4: Gold has a more prominent yet still small weight in the Bloomberg Commodity Index

Bloomberg Commodity Index sector weights*

Under-allocated to gold: a missed opportunity?

Commodity exposure is generally limited to less than 10% of an investment portfolio, and in many cases this is much lower.¹⁶ Gold usually accounts for less than 10% of that amount – in other words, most portfolios will have less than 1% exposure to gold. 

While commodity exposure does provide diversification benefits from a lower volatility perspective, our analysis suggests that adding a 2%–10% portfolio allocation to commodities decreased risk-adjusted returns over the past 20 years. However, gold can do much more. Looking back over the past two decades, replacing or supplementing a commodities allocation with gold provided two key benefits: it increased absolute returns and reduced portfolio volatility when compared to a portfolio with no commodity exposure or with only broad-based commodity exposure (Chart 13 and Chart 14).

¹“Rethink, Rebalance, Reset: Institutional Portfolio Strategies for the Post-Pandemic Period”, July 2021, Coalition Greenwich (formerly Greenwich Associates)

¹“Rethink, Rebalance, Reset: Institutional Portfolio Strategies for the Post-Pandemic Period”, July 2021, Coalition Greenwich (formerly Greenwich Associates)

²Using National Bureau of Economic Research (NBER) recession index (USRINDEX) via Bloomberg to determine analysis starting points. In our analysis, a reflation begins during the last month of the NBER recession and is loosely characterised as an environment of resurgent economic growth twinned with rising inflation and interest rates.

³31 August 2020 to 30 June 2021.

⁴Total returns for the S&P GSCI and Bloomberg Commodity Index for 2020, respectively.

⁵S&P GSCI is a world production-weighted commodity index based on the average of the previous five years.

⁶Analysis based on New Frontier Advisors Resampled Efficiency, including individual and sub-index commodities. For more information see Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Oxford University Press, January 2008.

⁷The average hypothetical average institutional portfolio is based on market data from JP Morgan Asset Management and Coalition Greenwich (formerly Greenwich Associates). It includes a 58% allocation to stocks (30% Russell 3000, 19% MSCI ACWI ex US, 9% FTSE Nareit REITs Index), 28% allocation to fixed income (20% Bloomberg Barclays US Aggregate, 5% S&P/LSTA Leveraged Loan Index, and 3% Bloomberg Barclays US Corporate High Yield Index), 14% allocation to alternatives (10% S&P Listed Private Equity Index, 4% Hedge Fund HFRI Index).

⁸2018 pullback: 1 October 2018–31 December 2018; 2020 pullback: 31 January 2020–31 March 2020.

⁹During the gold standard, the US dollar was backed by gold, and the foreign currency exchange rates were dictated by the Bretton Woods System. In August 1971, the Nixon Administration announced the halt of the free conversion between the US dollar and gold catalysing the collapse of the gold standard and, subsequently, the Bretton Woods system.

¹⁰On Goldhub.com see: Gold supply and demand statistics.

¹¹Note that these estimates are subject to periodical historical revisions as more data becomes available. See details Gold trading volumes on goldhub.com for methodology

¹²Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time. This results in an upward sloping forward curve, which can increase the cost of maintaining exposure to a particular asset.

¹³The spot price is the current price an investor would pay to acquire a commodity immediately. Spot price is frequently used with commodities because most commodities trade both on the ‘spot market’ and ‘futures market’.

¹⁴An investor is able to lose more than 100% of the initial investment—in this case 111% -- because futures positions do not effectively allow for a buy-and-hold strategy, forcing frequent rebalances where additional money inflows are required to maintain the same investment size.

¹⁵Determinants and weights in the Bloomberg Commodity Index include economic significance, diversification, continuity, and liquidity.

¹⁶A recent study by Coalition Greenwich (formerly Greenwich Associates), in conjunction with the World Gold Council, found that institutional investors expected to allocate 2% to commodities in their portfolios.

¹⁷Expected returns/volatility from Blackrock by asset class: Russell 3000: 5.1%/15.4%; MSCI ACWI ex US: 6.6%/15.4%; FTSE Nareit REITs Index: 5.0%/17%; Bloomberg Barclays US Aggregate: 1.1%/4.3%; S&P/LSTA Leveraged Loan Index: 7.0%/7.0%; Bloomberg Barclays US Corporate High Yield Index: 3.0%/8.9%; S&P Listed Private Equity Index: 12%/10%; Hedge Fund HFRI Index: 5%/6%; LBMA Gold Price PM: 5%/17%.