Hedge Fund DE Shaw Recommends 6.5%-9% Gold Allocation Amid Market Turbulence

As gold prices reach new historical highs and bond yields in the United States, the United Kingdom, and France rise due to various political issues, financial turbulence in September seems inevitable. Gold, as a traditional "safe haven," has undoubtedly become a prized asset for investors.

So, what proportion of gold should be included in an investment portfolio to maximize its effectiveness? A prominent hedge fund, DE Shaw, has recently released a report that delves into this question, concluding that the optimal range is between 6.5% and 9%.

The report introduces an uncommon acronym, "NPSOV," which stands for "non-productive store of value." This concept can be applied to various assets such as Bitcoin, diamonds, fine wines, or renowned artwork. DE Shaw, which manages 550 billion dollars in assets, points out that as an NPSOV, gold presents unique modeling challenges. It does not generate income, has limited industrial applications, and its return drivers are variable. Its long-term growth potential is also uncertain. Additionally, like all NPSOVs, gold could become worthless if society collectively decides to stop assigning it value.

To begin valuing gold, the report starts with an interesting perspective: gold's value growth should align with the growth of global wealth. DE Shaw notes that since 1975, when data became more reliable, gold has typically constituted between 1.8% and 7.3% of the liquid total wealth in developed markets, although it has occasionally exceeded this range, as it is currently doing.

This leads to the question of the growth rate of wealth. GDP is a good starting point, but sometimes wealth grows faster than the economy. Over the past 50 years, wealth has grown 2.4 percentage points faster than the economy. If this trend continues, it implies that wealth grows by approximately 5% annually, assuming the global economy grows by 3% per year.

The report also cautions that the growth in gold supply must be considered. During the research period, the gold supply increased by about 1.6% annually, although some of this increase may already be reflected in prices. Conversely, if central banks continue to increase their reserves during geopolitical tensions, the supply increase could be partially offset.

DE Shaw's report considers various assumptions about gold's value growth. The final return assumption is that gold should outperform the inflation-adjusted risk-free rate by 0.5% annually, with a volatility of approximately 15%, consistent with historical averages. This may not seem like much, but the report also introduces another perspective: gold's value depends on its correlation with stocks and bonds.

Sometimes, gold correlates closely with stocks, particularly inflation-linked bonds. However, over the long term, gold's correlation with stocks, bonds, and inflation is relatively loose. This low correlation is crucial because it means gold lacks a significant relationship with stock risk, providing potential benefits for a portfolio primarily composed of stocks and bonds. Even if gold's risk-adjusted expected return is not superior to traditional assets, this point remains valid.

The report also emphasizes another important correlation point: gold's role in an investment portfolio depends on the correlation between stocks and bonds. Therefore, in an environment where stocks and bonds are positively correlated, gold's potential portfolio utility increases, even if the predictions about gold remain unchanged.

Finally, DE Shaw assumes that investors allocate gold partly to hedge against market crashes. If not for this purpose, gold's usefulness would be significantly reduced. The fund concludes that if stocks and bonds are negatively correlated, the optimal allocation is 6.5%; if they are positively correlated, the optimal allocation is 9%. However, the report notes that the correlation between stocks and bonds over the past 12 months has been nearly zero, which is concerning.