The idea that gold is the rich man’s currency, unavailable to us poor plebs in the street, is one we absorb through fairy tales and history alike. Imagery of Ebenezer Scrooge counting his gold in a dingy London shop window spring to mind.
In recent years gold has grown in popularity, with many ordinary investors building up substantial holdings in the metal rather than buying equities or bonds.
There were even gold vending machines unveiled in London shopping centre a couple of years ago, as the fever for the metal hit its peak.
The price of gold soared following the financial crisis, making 163 per cent between January 2008 and its peak in September 2009.
However, the metal has been on a downward slope since then, with many retail investors having their fingers burned this year in particular.
Highly regarded managers such as Sebastian Lyon of the immensely popular Personal Assets Trust, and FE Alpha Manager Steve Russell of the Ruffer Investment Company have stuck vehemently to their gold holdings despite the commodity’s recent troubles.
Many other investors have started to wobble on gold, however, given alarming falls in the price of the metal – 19.78 per cent in the year-to-date according to data from FE Analytics.
Performance of gold spot price in 2013
Source: FE Analytics
This makes it a good time to re-examine your reasons for holding gold in your portfolio.
Legendary investor Warren Buffett is well-known for his scathing attitude to gold, which he describes as working on the "greater fool" mechanism – as long as there is someone else foolish enough to pay more, the price goes up.
So have investors merely been engaged in a self-perpetuating bubble, an unintentional Ponzi scheme that is ready to burst?
FE Trustnet examines the evidence.
Gold is not a hedge against inflation
A lot of the advocates of gold claim that the metal is a store of wealth when the value of money falls and the cost of goods rise – a situation known as inflation.
This has been one of the key reasons for holding gold for a number of high-profile investors, including US hedge fund manager John Paulson, whose gold fund has suffered falls of more than 60 per cent this year.
Inflation is often predicted to be the consequence of the sort of quantitative easing – or money printing – in which many governments have been engaged, which has made hundreds of professionals, as well as do-it-yourself investors, keen to find something to protect themselves against this threat.
The argument from many of these has been that only inflation can reduce the high debt levels in the West, and inflation leads to a rise in the gold price.
However, academic research by Claude B Erb and Campbell R Harvey, both of Duke University and the National Bureau of Economic Research, suggests this may not be the case.
In a paper titled The Golden Dilemma, the pair argue that gold is not a hedge against unexpected inflation in either the short- or long-term.
Erb and Harvey used the US consumer price index to produce a predicted price of gold over the period from 1975 to the present day.
Their figures show that the real price of gold fluctuates wildly around the prediction, both above and below, and if the relation held, the price of gold should currently be $780 an ounce. It is $1,250.
To see whether the metal was a successful hedge, they looked at the nominal price of the gold futures contract and the value of the CPI index, both measured at the end of each month.
If gold was a short-term hedge against inflation, the ratio between the two figures should remain constant; however, this is far from the case.
In January 1975 the ratio was 3.36. In the preceding time it has averaged 3.2, reached a low of 1.46 in March 2001 and a high of 8.73 in January 1980. It currently stands at 7.31.
The results show that the volatility of the real price of gold – the inflation-adjusted price – is high.
"In fact, the volatility of the real price of gold has been basically the same as the volatility of the nominal price of gold, and the real price of gold tends to mean revert over a time period of about 10 years," the authors concluded.
"The variability of the real price of gold suggests that gold has been a poor short-term inflation hedge."
The authors also show that gold is not a hedge against unexpected inflation, by plotting the change in the price of gold in a year to the level of unexpected (i.e. not forecasted) inflation. There is no correlation.
Gold does not protect against a fall in the pound, dollar or peso
Often investors believe that buying gold will protect them from a fall in the value of their own currency, caused by money printing.
In reality, this is only a form of the gold-as-inflation argument, the researchers point out, although it can be dispatched on its own terms.
The researchers analysed the relationship of the price of gold to the price of various currencies in dollars over the same time period.
If a currency’s price in dollars was perfectly hedged, it would have a beta of -1.0 to the gold price, which would tell you to expect the metal to add 1 per cent in value when gold lost 1 per cent and vice-versa.
The beta of gold against sterling was -0.15, -0.15 against the Australian dollar and -0.24 against the Swiss franc, to take three examples. The average was -0.15.
The currency negative correlations are thus very small, and not large enough to protect as investors want them to.
Technically, Erb and Harvey note, this low figure is the result of low correlations between gold and the currencies and much higher volatility of the gold price.
"The change in the real price of gold seems to be largely independent of the change in currency values," they said.
"Furthermore, since the real price of gold seems to move in unison across currency perspectives, it is unlikely that currency movements help in explaining why the real price of gold fluctuates."
Gold is not a hedge against long-term interest rates
Many people use inflation-linked gilts as a safe-haven, low-risk investment, leaving them with a dilemma when yields are so low that they will lose money on them.
The gold price has risen in recent years as the yields on inflation linkers have fallen, so does this mean gold is a hedge against low returns on other safe haven assets?
In other words, would buying gold be a sensible alternative to buying inflation-linkers?
In the UK, where the securities have been traded since the early 1980s, the correlation is just -0.31, which means that the movement in inflation-linkers explains just 9 per cent of the movement in the price of gold. That’s a no, then.
Gold is not a safe haven
Perhaps most controversially, Erb and Harvey discard the argument that gold offers protection against tail-risks, that is to say it preserves wealth in the worse-case scenarios of economic collapse.
First, their figures show that gold performs badly at times of general market stress.
The researchers divided the monthly returns on gold and the S&P since 1975 into four quadrants: periods when the S&P did well and gold did well, periods when one did well and the other did not, and periods when both did badly.
They note that in 17 per cent of all months, the S&P 500 did badly and so did gold. If gold was a haven from market stress, there should be very few, if any, such events.
But what about total economic collapse, such as the hyperinflation that hit the Weimar Republic in the 1920s?
Erb and Harvey use the example of Brazil to show this is not the case. From 1980 to 2000, the country had an average annual inflation rate of 250 per cent, yet the real price of gold fell by 70 per cent during that time, meaning that gold had only 30 per cent of its 1980 purchasing power at the end of the period.
This is about the same as the fall in real gold prices experienced by a US gold investor over the same period.
"A key takeaway…is that even though countries such as the US or Brazil may experience very different inflation experiences, their real gold return experiences will probably be similar and there is no reason to expect that the real gold return will be positive when a specific country experiences hyperinflation," the researchers concluded.
Looking at 56 cases of hyperinflation found by researchers Hanke and Krus, Erb and Harvey show that there is no pattern between the incidences and gold maintaining its pricing power.
Gold is a strange asset and it is not clear why it has value outside of certain limited technological uses.
While no academic research is final, Erb and Harvey’s results should make investors wary of taking for granted the received wisdom on gold.
If the cynics such as Buffett are right and gold is driven by irrational sentiment, then once that sentiment turns, investors could be in for serious losses.
