The Midas Touch: How to Make Gold Part of Your Portfolio

Gold seems to be everywhere these days. While we are used to seeing gold piling up in central bank vaults, being fashioned into jewellery or handed out at athletic events, more recently, you can even pick up bars alongside milk and eggs at Costco. The precious metal has also been a longtime staple in many investors’ portfolios, but is it something to add to yours?

There’s a reason interest in gold has been growing. Prices have climbed by nearly 40 per cent over the past two years according to S&P Capital IQ – you can buy one ounce for about $2,300 USD at the time of writing. One factor that has contributed to the increase is unease over the global economy. High inflation and geopolitical turmoil tend to be key drivers for the price of gold and these challenges have been hard to ignore in recent years. What may be surprising about the gains in gold is that they’re happening at a time when the U.S. dollar remains strong; normally, gold is inversely correlated with the greenback.

Gold has typically been viewed as a hedge against economic challenges, especially inflation, because of concern that interest earned on savings won’t keep up with the rising cost of living, explains Jeffrey Schok, a Senior Portfolio Manager with RBC Global Asset Management who oversees the RBC Global Precious Metals Fund. Historically, gold has increased in value in inflationary periods because, unlike government-backed currencies which are not supported by a physical commodity, there is a limited supply of gold, which means it can’t get diluted the way paper money can. “People who’ve invested in gold over long periods of time have generally been able to maintain their purchasing power,” he says.

Another reason for the rising price of gold is that global central banks have been adding to their stockpiles in recent years. Many countries hold their foreign reserves in U.S. dollars but worries over how sanctions or economic disputes could affect the value of their local currencies have caused some countries to diversify their reserves beyond the U.S. dollar. “Central banks around the world have realized how potentially insecure and fragile their reserves are,” says Schok.

For example, according to the World Gold Council, China has ramped up its gold purchases, which now make up about 4.6 per cent of that country’s total reserves as of the first quarter of 2024, up from 3.9 per cent for the same period a year earlier. That’s a significant increase in demand for gold considering the size of the Chinese economy, explains Schok. Asian consumers have also been buying into the rally, fuelling demand even more.

Ways to invest

Although half of the demand for gold comes from jewellery, the price is largely driven by sentiment and its use as a currency. With a commodity like silver, which is used in electronics, solar technology and medicines, there is supply and demand that can increase or decrease prices. With gold, if investors think there may be an economic downturn, they’ll buy, but as soon as the clouds part, they’ll sell, which can drive down the price.

Saying that, because of its hedging properties, it can be useful to hold at least a little bit of gold in a portfolio. There are a few different ways you can invest in gold. You can buy physical bars and store them at home or pay to keep them in a safety deposit box, or you can buy shares in the mining companies that produce the metal. Even within the public markets, there are a range of investment options that behave differently and serve different objectives. For instance, some exploration companies are, as Schok puts it, “always potentially one drill hole away from making a massive discovery,” but these are often much riskier businesses to hold. If they don’t hit the jackpot, their stock could plummet. If you want something with a slightly lower risk profile, there are other developers who are advancing already proven projects, potentially with an eye to selling to a larger, more developed producer that has the capital and experience to operate a mine.

You can also buy shares in royalty companies or streamers. These businesses have contracts with the producers that allow them to buy a portion of their production, typically at a fixed price, says Schok. Because each type of company will react differently to the market, Schok favours a diversified approach to balance risk and return. “We recommend gaining exposure to a mix of companies at various stages of the mining lifecycle,” he says.

While investing in companies could be riskier in some ways, holding physical bars could also limit your upside, says Schok. “The advantage of investing in a company’s stock instead of bullion [physical gold of high purity] is that, theoretically, these companies have enhanced leverage to the price of gold, which translates into profitability and free cash flow rising at a faster pace than the underlying commodity.”

Do your research

If you decide to invest in individual gold companies, there are four main points Schok likes to consider before buying. He looks at the quality and location of the assets, the track record of the management team, the company’s valuation, and the company’s environmental, social and governance (ESG) characteristics.

The last point is key, he explains. A mine can’t succeed without strong environmental and social policies. Mines that fail to gain ‘social license’ often encounter community issues such as protests or blockades, and an accident that damages the environment could result in the suspension of the mine’s operating permit. “Social and environmental governance in mining is critical,” says Schok. “We’ve been looking at the elements of ESG well before it became a buzzword.”

“In the end, they just fail,” he says of companies that don’t have strong ESG policies. “It hurts their operations, which in turn negatively impacts their share price and makes it more difficult for them to raise money.”

If researching individual investments is intimidating, there are a range of exchange-traded funds (ETFs) that give you access to this part of the market. Some ETFs and mutual funds invest in a mix of different gold companies, while others may target one part of the sector. There are even ETFs that hold physical gold.

Physical gold vs. gold stocks

The price of gold may have gone up over the last couple of years, but shareholders in publicly traded gold companies haven’t been rewarded to the same extent. Over the last 12 months, the S&P/TSX Global Gold Index, which tracks a collection of publicly listed gold miners, has climbed, but it’s down about one per cent since 2021. You can blame inflation for weaker performance. That may sound counterintuitive, given gold is meant to hedge against inflation, but mining and exploration companies also felt the sting of rising costs.

Before the pandemic, the sustainable price of gold for producers – the point at which it covers the company’s operating costs and capital required to sustain production – was around US$1,000 an ounce, explains Schok. After two years of inflation, he says those costs are closer to US$1,400 to US$1,500 today.

Although the spot price of gold has consistently been above that price, with a floor of US$1,600 in the past three years, the issue for some producers was that their margins got squeezed as costs increased at a faster pace than gold prices. Inflation also impacted the capital required for projects under development, which reduced the attractiveness of a project’s returns. Others also locked in the fee at which they sold their gold before prices spiked, making them less attractive to investors than owning the metal directly. “It just didn’t translate to better profitability,” says Schok. “That’s why the gold stocks, even though gold was high, didn’t benefit.”

There’s reason to believe that could soon change. Operating costs for gold producers, particularly for key inputs in the mining process, have begun to stabilize as inflation has cooled. Without inflation impacting costs and gold pushing near all-time highs, margins for these companies are starting to expand again, says Schok.

Adding gold to your portfolio

RBC Global Asset Management Research¹ has shown that holding a portion of your portfolio in either gold or a fund can improve risk-adjusted returns on a balanced portfolio, notes Schok. Although some retail stores are capitalizing on the frenzy of gold prices by marketing gold bars to consumers, he says a more diversified approach within the gold sector has historically outperformed physical gold.

Still, he cautions investors against concentrating their portfolio with the yellow metal but says adding a small amount can act as an insurance policy for your investments. “If you add a negatively correlated asset to a portfolio, what it typically does is it increases your risk-adjusted return.”

¹_{Source: RBC Global Asset Management, "Gold and gold equities ‘Barbarous relics’ or contemporary strategic assets?", Fall 2020}