ISOA’s Strategy on Investing in Gold: A Strategic Hedge or Dead Weight?

Gold is back in the spotlight, emerging as one of the top-performing assets over the past year. At ISOA, we take a closer look at how gold fits into our portfolio strategy and what makes it a valuable asset in today’s market.

Should Gold be part of your portfolio?

Let’s get this question out of the way first. Gold comes with no credit risk, holds its global purchasing power, and has a low correlation with other asset classes like stocks or real estate. This makes it a reliable hedge against inflation and currency devaluation. There is one camp that simply does not trust the global financial system and focuses heavily on these assets, while others completely exclude them from their portfolios. The reason is gold on its own largely does…you guessed it, nothing! I’ve always enjoyed Warren Buffett’s sharp take on commodities, especially gold. His quotes on the subject are pure gold themselves. My personal favourite is from his 2011 shareholder letter, “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

Storing precious metals incurs transaction costs. Not only does typical a precious metal not produce cash flows and instead rely entirely on the metal appreciating, but investors also stare at a loss due to the associated expenses along the way. All of this makes gold as a portfolio investment somewhat of a controversial topic.

For many emerging market investors, the value of holding gold is clear—it is a haven when local economies crash. When currencies plummet and markets collapse, those holding gold or foreign-denominated assets appear on top. It has also been similar for developed markets, but I feel the long deflationary environment that has persisted for decades has meant gold has not been looked at enough.

So, choose your camp, but as history suggests, there is room to consider gold at least from a portfolio diversification perspective. While gold can be quite volatile, it has historically been a decent store of wealth against market volatility, political instability, currency weakness, and economic collapse.

The ISOA view

I believe having exposure around 5-10% to gold is not a far-fetched thought in a portfolio, with the allocation depending on how the market is moving. Overloading on gold could mean missing out on the growth potential of equities. However, excluding it entirely leaves you exposed to risks that stocks and bonds can’t fully shield you from. So I believe, around 5-10% on average looks ideal. I did a paper back in college testing out historical performance at varying levels of gold allocations in an Indian equity portfolio. A 5-10% allocation with annual rebalancing provided the best risk-adjusted performance.

How do we at ISOA value Gold?

Valuing a commodity like Gold has been a long-standing debate for reasons that we have discussed before – no cashflows! There is no foolproof answer. There are too many factors in play – Interest rates, inflation expectations, cost of mining, etc. One can try to estimate and model these, but it is a heavy assumption game.

Instead, we are focused on something more predictable, money supply. Around 85-90% of gold is used for jewellery and bullion, with only 10-15% going to industrial use. This makes gold behave more like a currency than a commodity—it holds steady during recessions and often rises in value as fear and uncertainty grow.

Source: Tradingview, ISOA

What you have here is a log scale chart of the US M2 Money Supply (RED LINE – left scale) and the Gold price (right scale). What you’ll notice is over the long term, the gold price has closely followed the money supply. 

One way to think of it is that the number of dollars keeps increasing per person (as Central banks keep printing money) while the amount of gold per person stays relatively static, the dollar devalues against the price of gold at the rate of new money creation per capita, or about 5-6% per year on average.

In the chart above, that is indeed what has happened over the past several decades; gold prices have grown at the same rate as per capita money supply but with volatility caused by investor behaviour, fear of recessions, liquidity and more. This volatility helps us to position to have better odds of making decent returns while benefitting from diversification. As a thumb rule, happy to add gold as long as it is not above the money supply line. If it goes way above, we generally look to trim down our exposure.

Another way that we capture this is through the M2 Money Supply/ Gold ratio as below. The chart shows the US M2 money supply in USD billions divided by the gold price (USD) per ounce. A high ratio indicates that a bigger quantity of gold is needed to cover the US M2 money supply and vice versa. Again, similar rules there, happy to take positions if the ratio is around 10 and above and trim down exposure when the ratio is near or below 6.

Source: Federal Reserve St. Louis, ISOA

All these tools help us estimate a ballpark medium-term estimate for gold price which then feeds into our portfolio allocation model. 5-6% p.a. of Money supply growth + 2-4% p.a. of local currency depreciation benefits in INR vs USD, and the additional returns can come from timing it better (using the volatility moves).

There are many other ways that investors use to value gold be it measuring the profit cycles of gold mining companies or looking at the correlations with real interest rates. However, we’ve kept it fairly simple in our investing approach.

Methods used to take exposure and Current Positioning

I generally take exposure in INR through Gold ETFs. The average currency depreciation of 2-3% adds to the local returns in the portfolio. Another way I usually take exposure is through gold financing companies like Muthoot Finance which is currently a part of our Dynamic Advantage Fund since its inception in July 2023. Muthoot is an NBFC offering strong gold price leverage with gold being > 80% of AUM vs other peers. In terms of operating efficiency, franchise strength and focus on gold, Muthoot was a clear pick to play out this theme. The below chart shows the strong correlation between gold NBFCs with gold prices.

Source: Jefferies, Bloomberg, Company data

The below table comparing Muthoot Finance vs other key peers summarises our views on the company well.

Source: Jefferies

Another way that a lot of investors take indirect exposure is through gold mining and the royalty and streaming industry internationally. I haven’t studied these in detail so don’t have any opinion on these, but could be potential options as well. Overall, our call to take around 10% allocation to gold through direct and indirect exposure has worked out well over the last year. With where the prices and ratios are (see charts above), we are not adding any new exposure here but continue to hold for the time being.

Final thoughts

Gold adds value as a separate asset class, offering diversification benefits with its unique risks and opportunities, partially uncorrelated with stocks and bonds. This makes gold particularly suitable for use as part of a portfolio diversification strategy in the portfolios. The boom-and-bust cycles can be long in commodities, so patience is key. Do not invest in gold based on short-term interest rate cuts or inflation readings.

I encourage you to reflect on how gold can enhance your portfolio diversification strategy. Here’s signing off on that note, happy investing!

Warm Regards,

Shivam Jain, CFA

Disclaimers:

• The information provided in this content is for educational purposes only and should not be considered as financial or investment advice. I am not a registered investment advisor and do not provide personalized investment recommendations or guidance.

• Please consult with a qualified financial professional before making any investment decisions.

• The views and opinions expressed in this content are my own and do not necessarily reflect the views of my employer. The content is intended to share educational insights and general information related to investments and macroeconomic trends. It should not be interpreted as official statements or representations from my employer.

• Any references to specific investment products, services, companies, or strategies in this content are for illustrative purposes only and should not be considered endorsements or recommendations. You should conduct your own research and due diligence before considering any investment opportunities.