Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. Any mention of gold in this article shall be seen as a discussion of the commodity as an asset class. No mention of physical gold, funds investing in gold, or its derivatives in this article shall be construed as a recommendation for or against an investment in the asset class (keine Anlageempfehlung). Historical returns are no indicator for future performance.

In my professional career, gold (and other commodities) have only recently started to play a role.

Goldman Sachs’ Investment Strategy Group (“ISG”) - the team responsible for the asset allocation of its wealthy private clients - was not a fan of gold and other commodities. The reason for that was the lack of cashflow, or even more precisely, negative expected cashflow from ‘carry costs’ of those commodities, leading ISG and thus our clients to favor assets with clearer cashflow expectations, most notably equities and bonds, and their private counterparts. At best, they would think about gold exposure through gold miners as a short-term, tactical trade.

That view continued into my first years as a family officer, where I mostly heard of gold not as a portfolio component but more as a crisis hedge. For example, the gold coins or even bars that an affluent client would hide at home, and would be able to take with them in a crisis. Here I was equally sceptical: One, it didn’t really seem practical in a truly bad scenario - shouldn’t you rather have medicine or cigarettes under your bed? And two, such an ‘end of the world’ scenario simply didn’t seem likely to me - as a globally mobile investor, I could likely just move my non-physical assets, like stocks, bonds, and cash, to another jurisdiction.

But admittedly, after many years of well-performing equity markets, that thinking changed in 2022. Amid a year of rapidly rising inflation, paired with substantial interest rate hikes, stocks and seemingly safe government bonds both saw double-digit declines. For the first time ever, I found myself thinking about how I could diversify beyond stocks and bonds, in particular towards assets that could (in theory) perform well in times of higher inflation - but admittedly didn’t find a satisfactory answer yet.

Finding that answer took me another year, when I met my co-founder Markus. Over the prior decade, he had built the investment strategies that are now core to our offering at Cape May - with a strong focus, among other things, on an allocation to assets that could perform well when stocks and bonds don’t. For times of high inflation that includes commodities - but more importantly, gold.

What led Markus - who was also trained by the Goldman ‘school of thinking’ - to include gold in our client portfolios? What benefits, but also risks, does it add to a client portfolio? And what do we think of gold in light of the multi-year rally?

Many of you asked for it, and we oblige: Today, let’s give you the primer on Gold.

Before we speak about the role of Gold in a portfolio, let’s first take a step back and think about how we at Cape May think about portfolio construction.

Most private banks and wealth managers tend to focus on two asset classes - public equities and (regular) bonds. Think about your typical 60/40 portfolio, i.e. 60% public equities, and 40% bonds. (Markus once tried to find out why it’s 60/40 and not 50/50 - the best answer he could find was not an academic one, but that it simply sounds more intellectual than a simple 50/50 split.) As visible in the chart above (a simplified version of the original chart by Bridgewater Associates), those are asset classes that tend to diversify each other well in an environment of low inflation, but either decreasing or increasing economic growth, meaning that public equities tend to do well in a growing economy while bonds provide protection in a less favorable environment.

That combination worked well in the 2010s amid low interest rates and a generally favorable market environment. But as outlined before, it performed terribly in an environment that we saw after COVID, when rapidly rising inflation (and as a reaction by global governments, rising interest rates) had a negative impact on both asset classes. So what can we do to protect ourselves in such an environment?

My colleague Markus was not the first one to have that thought. The most notable person who thought about this challenge was famous hedge fund investor Ray Dalio, who coined the term of the ‘all-weather approach’ - constructing a portfolio that can do well in environments of increasing and decreasing economic growth, but also decreasing and increasing inflation.

We already have the building blocks for a low-interest rate environment - and if we want to find building blocks that also do well in times of rising or high inflation, we can look to two (and of course other) categories: One, inflation-linked bonds, which provide steady income but also an adjustment to offset any inflation-linked losses to their real value. And two, commodities, which not only benefit from rising inflation, but as my colleague Markus likes to say, have historically been  the cause of inflation in roughly 50% of the high-inflation periods of the past century.

In short, we would generally categorize commodities, including gold, as an asset class that should perform well in times of high(er) inflation, but also positive economic growth. With that in mind, let’s move on to gold specifically.

So why would you invest in gold? Of course, it’s because you want its price to go up. But what would you think could cause such an increase?

One, the actual demand for physical gold for industrial purposes, most notably the electronics sector, but also consumer demand, especially for jewelry in India and China. While there is some cyclicality around non-financial gold demand, in particular in the first quarter of the year, we rarely see investors buy gold for its industrial demand.

Which brings us to the second reason why investors tend to buy gold: As a fallback asset. Gold is perceived by many market participants as a true source of price stability in light of inflation. Here we can refer to the aforementioned Ray Dalio, who has spent a lot of time and effort researching Gold’s long-term purpose:

As you can see, most currencies have seen a long-term decline in their real value against the gold price, although with some time of stability from the late 40s (with the establishment of the Gold Standard and a fixed exchange rate of dollars to gold) until the early 70s (with the fall of the Gold Standard and the subsequent ‘floating’ of currency prices against gold rather than a fixed peg). As a result, many investors, including Dalio, see Gold as a long-term hedge against the fluctuation (or as visible here, potential decline) in the real value of currencies. This is (unsurprisingly) talked more about in times where there’s a perceived increase (or lack of repayment) in government debt, as we can for example see these days in the US, but also other regions such as parts of Europe or Japan.

The key word here is long-term. As you can see above, Gold has had phases where it actually became less expensive relative to the currencies shown here, despite the fact that the long-term trend clearly has been in favor of Gold. Gold actually tends to be much more volatile than it generally described (more on that in the next section).

But how about short-term, ‘defensive’ benefits of gold? That brings us to the metal’s third and final perceived role: A hedge in times of market turmoil. Once again, we can look to a chart by Dalio’s Bridgewater, showing the return of equities, bonds, and gold/commodities in times of market turmoil:

As you can see, gold did mostly fulfill its role as a hedge and diversifier against equity market declines, either seeing relatively smaller declines (i.e. -10% vs. -20-40% for equities and bonds in 2022 amid rapid interest rate hikes) or even seeing positive returns during an equity drawdown (i.e. in the tech bubble or the GFC). However, it didn’t always fulfill this role, especially in 1980-1982, when it saw a whopping 78% (!) decline, or in more recent corrections like the tech bubble, the GFC, the Eurozone crisis, or COVID, when bonds actually proved to be relatively better-performing ‘hedges’. Lastly, there were also times when Gold actually saw negative returns while equity markets performed well - but more on that in the next section.

Sounds good so far, no? Don’t forget that in investing, there are no free lunches. While often portrayed otherwise, gold does also have a number of (underconsidered) risk factors.

While gold might be a good diversifier, and can perhaps even be a hedge sometimes, it’s important to note that gold is not a stable asset, such as bonds or cash. The price of gold fluctuates substantially, as visible in its volatility. Compared to other asset classes, we can see that it is not stable like ‘safer’ asset classes like investment grade fixed income, but more volatile than most developed market equities, with a risk profile akin to emerging markets equities:

While returns of certain asset classes can fluctuate substantially over time, the risk (as portrayed by volatility) of asset classes tends to be somewhat more stable over long timeframes. This means that gold will likely remain a riskier, more volatile asset for the foreseeable future - despite its long-term benefits of inflation protection and also some potential protection in market corrections. If that is what you are looking for, great, but if you really want a reliable, short-term source of price stability, gold might not be the asset for you.

Which brings us to another important point: That gold has had many periods where it didn’t just see lower, relative performance, but actually saw negative performance. At least one such recent period also traces back to gold’s industrial demand, as the metal (as well as many other commodities) saw a substantial decline at the end of what is often described as the 2000s commodities boom. 

Or in other words: While gold is clearly a diversifier, especially in your typical 60/40 portfolio, it has had (and will likely have) periods during which it sees a decline in value while other asset classes such as equities see positive returns.

Lastly, a point that is particularly relevant to investors focused on sustainability: Gold is often not considered a sustainable investment. As with other industrial metals, it involves mining with substantial ecological impact. While there are some Gold ETFs and ETCs that offer traceability to where it was mined and what CO2 footprint was created in doing so, at least one of our clients has shared her concerns given the ecological consequences.

Before we dive into how you can invest in gold, let’s summarize our position: 

Gold is generally considered to be an investment offering long-term inflation protection, as well as an ability to hedge relative to public equities in certain phases of market correction. However, it is not an asset offering short-term stability, historically having shown substantial volatility. Lastly, there are certain phases of market correction where gold actually has not been the ideal hedge. Nevertheless, we see gold (and other commodities, but that’s for another time) to be a great ‘diversifier’ and source of positive inflation sensitivity for client portfolios.

So let’s say that it is a convincing argument to you. How can you invest in gold?

You can achieve that in different ways: One, buying physical gold directly, such as coins or bars stored in a bank vault or even at home if you so desire. Two, the indirect route through funds, meaning financial instruments that represent a direct claim to physical gold, such as an ETF investing in gold or so-called exchange-traded commodities (ETC). Some of these even give you the option to have the underlying physical gold delivered to you. And of course, there are literal and figurative derivatives of gold, such as buying synthetic derivatives based on the gold price, or gold miners which you’d also expect to increase in share price if gold does well. (For this article, we will not focus on this last category but only on the gold as the commodity, whether held directly or indirectly.)

What should you consider when choosing between physical and synthetic gold?

First, holding physical gold outright. 

Many of the affluent investors we work with like physical gold for its tangibility. To them, it fits the requirements of the ‘crisis hedge’ as I outlined in the introductory paragraphs: Coins or even bars that they can store at home in a vault, and take with them in a true worst-case scenario. While some synthetic products offer deliverability, i.e. the possibility to ask the issuer to send you the physical gold that backs the financial instruments you own, that would of course (at least to those clients) be less attractive as delivery might take time that they simply don’t have in a true crisis. In addition, at least here in Germany, buying physical gold can bring substantial tax advantages, as any gains (but beware, also losses) are tax-free if held at a private level for more than one year.

In terms of downsides, there are two main factors that we would consider: One, that holding physical gold, for example in a bank vault, typically comes at an ongoing cost that might be higher than the costs of a comparable ETF. Two, transaction costs for physical gold, at least in our experience, are much higher than for investment products, especially for actual physical golds held outside a bank.

Secondly, investing through funds.

In terms of benefits, we see especially the fungibility of an exchange-traded product. Whether an ETC or ETF (although ETC make up the majority of products in Europe), it can be freely sold at reasonable transaction costs and mark-ups. It can also be held at almost any broker, no matter if they have a secret Swiss vault or not. (The actual physical gold that underpins these funds is usually stored in secret vaults in Switzerland or London.)

When it comes to downside, there are once again a few factors. First, of course, the non-tangibility - many of the gold ETCs do not offer deliverability, meaning that gold held indirectly through a financial product can often not be directly accessed. Secondly, gold funds likely won’t provide any true ‘crisis hedge’ if it can’t be accessed physically. Third and last, here in Germany, only few of the available Gold ETCs offer the tax benefits of physical gold held for the long term.

To us, there is no clear right or wrong between physical and synthetic gold. As always, it’s a question of an investor’s individual circumstances - such as their preference on whether they want (or don’t want) to own physical gold as a ‘crisis hedge’, but also how their investments are structured (i.e. private and/or entity level). In practice, we typically use a combination of both, using synthetic gold at the entity level and/or for short-term private allocations, paired with a long-term oriented, physical gold allocation at the private level.

With all of this addressed, let us try to tackle a question that we get very often from clients these days: Should I still buy gold after last year’s rally? Obviously, we don’t have a crystal ball - but let us share our current view.

Generally, gold as well as other commodities show long cycles, meaning the prices of commodities might move sideways, or even decline, for a cycle of 10-15 years, then abruptly starting to climb again. Often after such a cycle, they end up settling on a new price level. While there might not necessarily be any notable industrial sources of demand driving the gold price over the short- to medium-term, there is another group that is very actively buying into gold: Central banks. They are generally seen as a big driver of gold demand in the coming years, in return driven by the desire to diversify their currency reserves away from the dollar and/or to reduce their political independence from the US. Once they bought their gold, they also typically don’t sell.

This price momentum, as with other asset classes, tends to attract new buyers. Look at an investor like me, for example: After not considering gold for many years, the events of 2022, and its subsequent strong performance, has clearly put it on my screen as an asset class to now consider. As I, and many other investors, realize those diversification benefits, and/or seek hedge against equity valuations and government debt, flows into gold increase. And that brings us to another dynamic: That small changes in average gold portfolio allocations can dramatically move gold prices. With the stock market being 20-30x larger than the gold market, even a shift of 1% of average stock holdings into gold means a huge demand increase for gold.

So can the rally continue? In our view, yes - even if we see stock markets climb further. But given that many investors tend to preempt the next financial crisis, there is a possibility that once the real crisis hits, Gold prices might quickly fall soon after as investors rebalance gold holdings back into a then cheaper stock market. 

As the gold rally continues, we expect more of those rapid price corrections as we saw in late January. And to some investors, that additional volatility might defeat the purpose of why they wanted to maybe invest in gold in the first place. Which brings us to our final conclusion and summary: As with other asset classes, don’t think about tactical trading, or even stand-alone trades. See it as a long-term portfolio building block that can add inflation protection and a degree of ‘hedge’.

If you wondering whether gold belongs in your portfolio, let’s review your objectives and risk profile together. We’ve worked with numerous affluent individuals in reviewing their portfolios to improve their risk-return profile by adding asset classes including gold and other commodities.

Interested in learning more? Don’t hesitate to reach out for a first call.

Cape May Wealth Advisors is a Berlin-based wealth management firm focused on helping affluent entrepreneurs find financial independence. If you are interested in learning more about how we can help you, reach out to us via email, and make sure to subscribe to our newsletter.