Can Gold Play a Role in an SMSF?

_The following article was written in early September, and was originally written for Cuffelinks, one of Australia’s leading investment newsletter services. The article can be found on the Cuffelinks website here, and has also been carried by AMP here.

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Physical gold has been one of the best performing assets this year, up some 20%, with the price currently sitting just below AUD $1,750 per troy ounce. This continues a strong run that dates back to the turn of the century, with gold prices returning close to 9% per annum over this time period.

Despite the solid returns, gold is still barely on the radar of most investors, with global pension funds holding less than 0.50% of total assets in gold.

In Australia, demand from SMSF trustees is rising, though it’s coming off a low base, with ATO data, as well as recent asset allocation data from Super Concepts, indicating that less than 1% of SMSF assets are in “other” assets, of which physical gold is just one component.

With prices near their highs in AUD, some investors feel that they’ve missed their opportunity to profit from this cycle, though banks like UBS are upgrading price forecasts, whilst JP Morgan stated that the yellow metal had entered “a new bull market” earlier this year.

No one can be sure how long it will last, though investors may be interested to know that, according to the World Gold Council, the average bull market in gold has lasted just over 5 years, with average gains of 385%.

Isn’t it Hard to Trade and to Store?
There are a few myths about gold investing, including the supposed difficulty of trading and storing it. In reality, physical gold can be bought and sold 24 hours a day, with trading premiums of less than 1% of the value of the metal, depending on which products and volumes an investor chooses, and the bullion dealer you buy and sell through.

For SMSF trustees, it is best practice to stick to investment grade cast bars, rather than coins and tablets, which come with higher trading costs.

Storage can be done in one of three ways.

• Pool allocated metal: In this situation, the investors buy a claim on a pool of physical gold managed by the bullion dealer on behalf of all investors. There are no storage costs in this situation.

• Secure storage: In this situation, the investor buys an actual physical bar (or bars) that they own. Annual costs for this range from 0.75% to 1% of the value of the metal.

• Private vaulting: In this scenario, physical bars the investor has purchased are stored in the investor’s own vault. This can be done for as little as AUD $252 per year, which works out at just 0.25% on a $100,000 investment.

What About the Volatility and the Lack of Income?
Price volatility and the lack of income are legitimate concerns that any potential gold investor has to be comfortable with. The volatility of annual returns for Australian dollar gold over the last 15 years has been around 12%, higher than that of traditional defensive assets like bonds, though lower than the volatility that equity market investors have endured over the same time period.

As for income, whilst it’s true that gold will never provide this, frustration with record low interest rates is a sad reality forcing all Australian investors to look at alternative assets.

There are no guarantees, but if history is any guide, gold is one of those alternatives that should be considered, as prices tend to rise fastest in low ‘real’ interest rate environments, like the one we are in today. Note that the ‘real’ rate of interest is calculated by subtracting the inflation rate from the official overnight cash rate set by the RBA, and is currently sitting at just 0.5% in Australia (1.5% RBA rate minus a 1% CPI rate as at end June 2016).

Since 1971 (when gold prices became free floating), the yellow metal has recorded average annual price gains in excess of 20% in years when the ‘real’ rate of interest was below 2%, outperforming both stocks and bonds in the process.

This can be seen in the table below, though investors should be aware that the below table highlights nominal, not ‘real’ gains for all the asset classes shown, with inflation itself averaging close to 7% in these years.

Source: IRESS, Global Financial Data

Whilst no one can be certain where rates will head next, cash futures suggest at least one more rate cut this year, whilst many economists see rates hitting 1% in this cycle.

Indeed the bond market suggests low to negative ‘real’ rates will be a feature of our economic landscape for up to a decade, an issue that is particularly confronting for retirees and SMSF trustees with large cash holdings.

A Simple Hedge against Equities
Another factor that could be of interest to Australian investors regarding gold is its historically strong performance whenever the ASX is going through periods of volatility.

In our book, Gold for Australian Investors, we analyzed market returns for a variety of asset classes over a more than 40-year period, again starting in 1971. That study (inspired by a Q3 2015 research piece from AQR Capital Management, titled “Good Strategies for Tough Times”) found that physical gold was the best performing liquid asset in the ten worst performing quarters for global equity markets.

This is captured in the chart below, which highlights the average performance for gold, as well as the average performance of Australian stocks, bonds and cash in those calendar quarters where global equity markets fell most. 

Source: Gold for Australian Investors, Global Financial Data.

Obviously no one wants their shares to fall, but it does makes sense to have insurance against it happening, especially in an uncertain economic environment.

Whether or not gold remains the highest performing ‘risk off’ asset in the years to come remains to be seen, though we think it’s at least an even money bet that it will, given the paucity of ‘real’ yields on offer in many of the more traditional defensive assets.

Central Banks and Emerging Markets
As a final point, SMSF trustees should be aware that the gold story is not all about rising demand from Western investors seeking a hedge against equities, or a cash alternative due to low ‘real’ rates.

Gold prices will also benefit should consumers in emerging markets continue buying, with demand from these regions highly correlated to rising disposable incomes.

Central banks, who are now buying more than 500 tonnes of gold a year, are also worth watching. To this day, developing market central banks still hold less than 5% of their foreign exchange reserves in gold, versus a near-20% average for their advanced market counterparts (see chart below).

Source: World Gold Council, IMF

No one can be sure what central banks will do next, but with over USD $13 trillion in negative yielding sovereign debt, gold could become more attractive to emerging market central banks in the years ahead. Indeed, Ken Rogoff, ex-chief economist for the IMF, stated in May 2016 that emerging market nations should increase their pace of gold accumulation, as the metal is both “highly liquid” and “low risk” – key criterion for reserve asset managers.

As such, whilst physical gold won’t provide income, and can be volatile in the short-term, it does have a number of positive attributes, not least of which are the fact that it is a tangible, highly liquid, zero-credit risk investment, and one that will benefit from any increase in emerging market demand.

Furthermore, gold is an asset that has historically been:

• The best performing asset in low ‘real’ rate environments

• The best performing asset whenever the ASX is volatile

This is no guarantee of price gains going forward, but it is safe to say that no other single asset class brings all those potential benefits to an Australian investor’s portfolio.

Until next time,
Jordan Eliseo

Disclaimer
This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.