There have been many studies regarding the potential institutional role for gold, often with contradictory conclusions. What we have found is that the inconsistent findings are attributable to differences in the time periods examined and the assumed investment horizon.
Over the past few months, investors have been inquiring about how gold behaves around volatility spikes and also whether investing in spot gold versus gold miners may lead to different outcomes.
Does reviewing historical records provide a compass for future volatility events?
Using a research framework developed in 2018 by PGIM IAS, we examined the performance of stocks and bonds before, during and after sharp increases in equity market volatility. We define a volatility spike month as one where average daily equity volatility for the month increases by at least 50 per cent over the average daily volatility two months earlier. For example, March 2020 is labelled a volatility spike month as the average volatility level increased by more than 50 per cent in comparison to the average volatility in January. In our study the two-month period, February and March 2020, is defined as the volatility event.
More generally, we studied gold performance around 15 volatility events for the period from 1 February 1973 to 30 April 2020. We noted that spot gold had better cumulative returns than US equities, on average, during a volatility event, highlighting gold’s defensive properties. Second, gold bullion on average had a cumulative total return of 27.9 per cent for the 21-month post-spike period, gold miner equities had a cumulative return of 37.1 per cent, while the S&P 500 had a 26.7 per cent cumulative return(1).
After the April 1978 volatility spike event, spot gold enjoyed a 280.9 per cent cumulative return in the 21-month post-spike period, a high inflation period, from 1 May 1978 to 31 January 1980. However, even in today’s low inflation period, we have seen high gold returns. During the recent two-month COVID-19 volatility spike event, spot gold returned 1.6 per cent while the S&P 500 was down 19.6 per cent (as of 31 March 2020).
Does it matter how an investor obtains exposure to gold?
The performance of gold miner equity shares not only includes exposure to the spot gold price, but also exposure to firm-level idiosyncratic characteristics like production costs, exploration and development, management expertise, financial leverage and hedging strategy. These characteristics help differentiate mining companies and may become more important when gold prices are relatively high, or low.
In a 2019 study conducted by PGIM IAS, we found that from January 1978 to January 2019 monthly total returns for gold miner equities were more correlated with spot gold returns than with US equity returns (correlation of 0.7 vs. 0.2). However, despite the high correlation between spot gold and gold miners, the volatility of miner returns was double that of spot gold (36.4 per cent vs. 18.8 per cent). And, despite the higher volatility, gold miner equities had average annual returns that were only slightly higher than spot gold (6.5 per cent vs. 5.2 per cent).
This year some institutional investors have also invested in gold royalty and streaming agreements. In return for an upfront payment to a miner, a royalty agreement gives the investor an interest in the mine’s future production. Streaming agreements are metal purchase agreements that provide, in exchange for an upfront investment, the right to purchase at a preset price all, or a portion, of a mine’s annual production.
In our 2019 study referred to above, we suggest that the performance of such investments may be comparable to a strategy of investing in gold royalty and streaming companies. These companies have unique traits such as a low debt-to-equity ratio, high gross profit margins, and high revenue per employee that can be grouped more broadly as “high earnings quality.” Some royalty companies can also have a direct ownership interest in mining operations and, so, may also be broadly considered as gold miners. Consequently, an investor could consider a high earnings-quality gold miner equity portfolio as a proxy for royalty agreements.
As of 13 May 2020, since 1995, high earnings-quality gold miner equities (8.4 per cent) have performed better than low earnings-quality miner equities (-1.6 per cent). The volatility of high-quality gold miners during the period was also lower (33.6 per cent vs. 38.7 per cent). YTD, high-quality gold miners returned 21.7 per cent whereas low-quality gold miners returned -13.9 per cent, a difference of 35.6 percentage points. This relative performance differential is also observed in the broader equity market.
As the risk-off environment continued this year, higher earnings-quality equities did better than low earnings-quality equities except for the industries in severe stress such as oil and gas, airlines and hotels and gaming. However, the equity market and industry-level performance may remain volatile depending on the market expectations around post-pandemic recovery.
Uncertainty or not, gold-related assets may find their place in investors’ portfolios.
(1) Gold miner equities (Datastream G12 Gold Mining Index) performance is available from 1 Feb. 1973. So that we can also compare gold miner equity performance, we analyse performance for the period from 1 Feb. 1973, to 30 April 2020. Member nations of the London Gold Pool formed a two-tiered gold market system only in March 1968, after which the spot gold prices could fluctuate in a free market.
This material reflects the opinions of the author as of 29/07/2020 and has been provided for informational or educational purposes only.
Harsh Parikh, principal at PGIM Institutional Advisory & Solutions (IAS)
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