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Gold 'more than a defensive asset', has unique properties as a portfolio diversifier - WisdomTree's Nitesh Shah

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(Kitco News) - Investors need to understand all the ways that gold can help maximize returns and minimize risk, especially during periods of extreme market volatility, according to Nitesh Shah, Head of Commodities and Macroeconomic Research at WisdomTree Europe.

Shah points out that the idea behind diversification is to mix different investments within a portfolio to reduce the overall risk to the investor. “The lower the correlation between the assets in the portfolio, the greater the benefits of diversification,” he said.

Shah argues that gold is among the least correlated assets to traditional investments like stocks and bonds, which gives it a number of unique advantages.

“While gold is technically a commodity, it behaves very differently to most cyclical commodities,” he said. “The drivers of gold price (such as inflation, bond yields, exchange rates and market sentiment) make the metal appear more like a currency than a regular commodity. So, even though gold futures are part of a broad commodity allocation, they have a relatively low correlation with the rest of the commodity complex (0.37) and so they can also be considered as a separate line item for further diversification.”

Shah also points out gold enjoys strong defensive traits, making it a good candidate to protect investment portfolios against sudden market downturns. “Gold prices tend to rise in financial crises, economic downturns, and geopolitical shocks,” he said, adding that gold has also performed well during equity market crises.

“Gold has returned positive performance in 15 out of the 20 worst quarters of performance for the S&P 500,” he said. “Of the remaining five quarters, gold has outperformed the S&P in four quarters. The only quarter when gold fell harder than equities - Q3 1975 - came a year after abnormally large gains in gold prices (in 1974 gold prices rose 72% and then corrected downward 24% in 1975).”

Gold’s performance has also been strong at the extremes: during deep recessions and periods of rapid market growth. “Gold has, historically, performed well in times of inflation,” he said, which means it’s more than just a defensive asset. “In fact, no other asset behaves like gold: the metal performs strongly in both economic downturns and upturns.”

Shah reviews the performance of gold and other assets based on Composite Leading Indicators (CLIs), which signal turning points in the economic cycle.

He then compares the relative performance of various assets during different periods of the economic cycle. “Gold performs better than any other asset in deep recessions,” he says. “It also strongly outperforms defensive assets in times of economic expansion. It even outperforms bonds (government and corporate) in times of mild recession.”

Drawing on historical data, Shah attempts to determine the amount of gold that would optimize an investment portfolio, beginning with the Sharpe ratio. “By adding gold to a traditional portfolio of stocks and bonds, it’s easy to see that the Sharpe ratio (the return of portfolio relative to its risk) can be improved,” he said, beginning with a classic 60/40 portfolio with no gold allocation.

“That has a Sharpe ratio of 0.37 (grey line, left axis),” he said. “As we increase the allocation to gold (moving along the x-axis) and keep the rest of the example portfolio weights in a 60/40 bond-equity allocation, the Sharpe ratio starts to rise” before peaking at 0.41 with an allocation of 12%.

He then calculates the allocation based on mitigating the worst expected performance for a traditional portfolio over a full year.

“The orange line on the right axis shows that allocations of gold up to 30% reduce the worst expected performance in a 12-month period,” he said. “This is a lot more than what most investors currently allocate to gold.”

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