Pile of gold bars Source: Adobe Stock

Gold is regaining attention as a portfolio diversifier and hedge against traditional investments, especially after the March stock market sell-off. 

Although gold has been a financial instrument for millennia, the metal remains misunderstood by financial advisors and others, some market observers say. Chuck Self, chief investment officer at iSectors, a financial advisory firm, says in some academic programs, such as the chartered financial analyst or certified financial planner program, gold is often dismissed as an asset that doesn’t have economic use. 

“But the reality is, it’s hard to find another asset class that has zero correlation to both equities and fixed income and that’s very liquid,” he says.

It’s easier than ever to hold gold in a portfolio, whether it’s gold equities, gold-backed exchange-traded funds or holding physical metal in a self-directed individual retirement account. And, like any investment vehicle, holding gold has pros and cons.

Pros

Tom Essaye, founder and president of Sevens Report Research, says gold’s lack of correlation with traditional investments is what makes the yellow metal a good hedge. “That’s been proven out over years and years of research,” Essaye says. “And it’s proven its worth in this environment.”

Gold is generally uncorrelated from stocks and bonds because it’s not used in industry, unlike other metals. Gold is mostly used for jewelry, with investment demand the second-largest use category.

Essaye says there’s also a psychological aspect to gold. “Some people like having that perceived safety net, and I think that’s a really good marketing point for clients, especially with advisors. Gold can be a very strong crisis hedge,” he says.

Self says gold sits in the alternatives sleeve of a portfolio, and he prefers it to other portfolio alternatives such as private equity. Not only can the yellow metal can be used strategically or tactically, but the market is liquid and it’s inexpensive to hold, unlike other expensive alternatives that have lengthy lockup periods. 

“You can get a gold ETF with an expense ratio as low as 17 basis points,” he says.

The World Gold Council, an industry group, says in 2019, gold’s traded volume averaged $145 billion daily, similar to the average daily trading volume for the S&P 500 and one-to-three-year U.S. Treasury notes. 

Gold equities and gold ETFs are the easiest ways to own gold. Self says he uses gold equities tactically. Gold-miner shares benefit when the metal’s value rises, which pushes up stock prices, making the shares a leverage bet on the gold price. Gold-backed ETFs track spot gold prices using physical gold held in vaults. Self says these are more useful as strategic positions.

A common rule-of-thumb is to have 5% to 10% allocated to gold, Essaye says, depending on a person’s risk tolerance, although Self says he’s used between 10% and 15%.

Gold makes a good safe haven because it’s a finite resource, points out Peter Thomas, senior vice president at Zaner Precious Metals. “You can’t print more of it. Period,” he says.

In addition to gold stocks and ETFs, investors can hold physical gold in a self-directed individual retirement account. However, these have strict IRS rules, so advisors should work with precious metals specialists to stay in compliance. Thomas recommends investors stick to bullion coins issued by sovereign mints, such as the U.S. Mint or Royal Canadian Mint for IRAs.

Cons

As a high-quality asset, gold isn’t immune to panic selling. That happened both in 2008 and in the recent stock market break. In March, gold fell 12.5 percent, although less than the S&P 500’s drop of more than 30 percent. However, gold rebounded swiftly and turned positive by April.

Gold pays no dividend, a common strike against adding it to portfolios. However, with interest rates at rock bottom, few safe havens offer much of a yield. Bart Melek, global head of commodity strategy at TD Securities, also notes inflation-adjusted interest rates are negative. Also called “real” rates, inflation-adjusted rates are calculated by using the U.S. 10-year Treasury yield minus the consumer price index. 

“Gold has zero yield, yes, but zero yield quite often is better than negative yields,” he says, noting that inflation-adjusted rates are a key determinant for gold prices.

The IRS taxes gold as a collectible, Self says, so the investment gains from physical gold or physically backed gold ETFs held in taxable accounts are treated differently from traditional assets. If gold investments are held for more than one year, the gains at time of selling are taxed at the same rate as ordinary income, with a maximum tax rate of 28 percent.

There is some debate about gold’s role as a pure inflation hedge. Gold won its reputation as an inflation hedge during the 1970s. When global central banks embarked on quantitative easing in 2008, gold rallied from $680 an ounce to more than $1,900 by 2011. But Essaye says other assets like stocks and real estate saw greater gains over time. 

That said, Essaye suggests a more diversified inflation hedge is a mix of assets including gold, real estate, very high-quality large-cap stocks and U.S. Treasury Inflation-Protected Securities (TIPS).

Thomas says long-term gold is a store of value, but in the short-term, it can be volatile. “It will build a base, and when it decides to run, it rocks, and it rocks hard. Then the problem arises that you can’t buy it when it runs. That’s why you buy gold when prices are quiet,” he says.  

Essaye says investors who hold gold will need to accept the short-term volatility inherent in the metal and keep a small part of it in portfolios at all times. 

“I view it personally, and I think many advisors see it this way, is that it’s a piece of your portfolio that you allocate to it because you know you should. The statistics tell us we should do this because it improves overall portfolio optimization. During times like this, we can look and say, ‘hey, you know, it’s really doing its job’,” he says.