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1 October 212 For professional investors only Pensio on Scheme Strategies Gold for UK Pension Schemes 211 marked the 11thh consecutive year off positive returns for gold, which shone in a period characterised by poor performance for many asset classes. However, despite its recent track record, the non-yielding nature of gold has led some to argue that it should not be considered an investment in the traditional sense. This paper addresses this debate, and asks: what role, if any, should gold play in a pensionn scheme ss portfolio? In answering the above question, we will examine gold from the perspective of an institutional investor, considering the following areas: What are the characteristics of goldd as an investment and which factors affect the price of gold? What are the benefits of holding gold as part of a diversified portfolio? How can a pension scheme invest in gold? Gold performance under different scenarios What are the investment characteristicss of gold? Store of value As one of the earliest known currencies, gold has long been viewed as a store of valuee and a hedge against inflation risk. To a certain extent (and over extendedd periods) this does appear to be true. Comparedd with many other commodities, the purchasing power off gold has remained surprisingly steady over the years. In fact, the purchasing power of gold in the UK was almost thee same in 21 as it wass in Historically, the existence of gold standard 2 regimes ensured that the price of gold remained in step with the money supply, resulting in a positive correlation between the price of gold and a inflation.. In 1971, the convertibility of US dollars into gold was abolished, and with thee explicit link between thee price of gold and the money supply severed, theree is no longer any guarantee that an investment in gold will retain its real value over time. 1 Jastram, R. (29). The Golden Constant: The English and American Experience, , with updated material by J. Leyland (212). 2 A gold standard is a monetary system in which a unit of currency represents a fixed weight of gold. For example, between WWII and 1971, the price of gold was fixed at USD35/oz.. Historically gold standardss have inhibited inflation by preventing governments from printing excessive amounts of paper currency.

2 Figure 1: Price of gold versus inflation since 1971 USD per troy oz 1,8 1,6 1, 1,2 1, Gold (lhs) CPI (rhs) Source: Schroders, Datastream, 15 September 212. Inflation is represented by US CPI 3 rebased to 1 in Figure 1 shows that while gold has retained its real value since the collapse of the gold standard, it has not done so consistently. While the bull market of the 2s enabled gold to catch up with inflation, there was a long period during the 199s where the price of gold fell in real terms. Therefore, although one could argue that gold functions as a store of value in the long term, over the shorter time frames by which investment performance tends to be measured gold may be a fairly unreliable hedge against inflation. Figure 2: Real percentage increase in gold price in high inflation environments (CPI 5%) Real % increase in gold price 1% 8% 6% 4% 2% % -2% -4% -6% High inflation years (CPI 5%) Source: Schroders, Datastream, Inflation is represented by US CPI. Nominal increase in gold price deflated by US CPI to calculate increase in real terms. The relationship between gold prices and inflation is a nuanced one, and the price of gold is influenced by a number of factors (see below) which may override the impact of inflation. Figure 2 demonstrates this variability in gold s performance as a hedge against inflation: while gold did function as an effective insurance asset in some high inflation years (such as 1973, 1974, and 198), in others it did not. For example 1982 saw the gold bubble of the late 197s and early 198s burst in spite of high inflation. 3 CPI (the Consumer Price Index) is a widely used measure of inflation based upon the price of a basket of consumer goods and services.

3 Lack of counterparty risk and hedge for economic instability The lack of counterparties involved in a direct investment in gold mean that it is often perceived to be a hedge against financial risk. In periods of economic instability, when investors are fearful of default or of counterparties otherwise failing to meet their obligations, this characteristic is particularly appealing and could lead to increased demand for gold (although it is important to note that there may still be counterparty risk associated with indirect investments in gold and gold derivatives). Also, while governments and central banks may devalue currency by printing money (e.g. to finance debts), gold is not exposed to this risk, as it is a finite resource and cannot be manufactured. Many investors therefore see gold as an insurance asset against political risk, with demand increasing when investors lose faith in fiat currencies. However, in the short term, the price of gold could actually fall during periods of economic crisis. When forced to sell assets to meet margin requirements, investors may prefer to sell their gold particularly if gold has performed well in recent years than to realise large losses on risk assets. Additionally, investors may be forced to divest themselves of their gold due to its high liquidity (if they are unable to sell other assets to meet margin calls). This is a temporary effect which tends to reverse when general risk aversion takes over. The graph below, which plots the TED Spread 4 against the price of gold, demonstrates this effect, with short-term dips in the price of gold corresponding with periods of illiquidity in 28 and 211. Figure 3: TED Spread versus gold price USD per troy oz Jan 8 Jul 8 Jan 9 Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Gold (LHS) (lhs) TED Spread (rhs) Source: Schroders, Bloomberg, Datastream, 28 September 212. Non-yielding Gold is a non-yielding asset, which means that investor returns are linked solely to price increases. This means that there is an opportunity cost associated with holding gold, which varies according to the risk-free rate of return (that is, the return investors could earn by investing instead in safe assets such as government bonds or the US dollar). When risk-free interest rates are high, the price return on gold must be greater in order to compensate for the higher opportunity cost. On the other hand, negative real interest rates eliminate the opportunity cost of holding a non-yielding asset. One would therefore expect there to be a negative correlation between the price of gold and interest rates, with gold prices falling as interest rates and thus opportunity costs rise and vice versa. 4 The TED Spread is based on the difference in 3-month LIBOR and 3-month T-bill interest rates and is a commonly used measure of liquidity and perceived credit risk in the market. A larger TED Spread is reflective of higher perceived risk and lower liquidity.

4 Figure 4 demonstrates this effect: during periods in which real interest rates fell below zero (eliminating the opportunity cost associated with holding a non-yielding asset) the price of gold is shown to have risen substantially. Figure 4: Real yield versus gold price USD per troy oz % 8% 6% 4% 2% % -2% -4% Gold (LHS) Real Fed Funds Rate (RHS) Source: Schroders, Datastream. Data to 31 December 211. Real yield is represented by the real Fed Funds rate (Fed Funds rate deflated by CPI). Supply and demand characteristics For a commodity, gold is relatively unaffected by supply factors, with movements in gold price instead driven primarily by demand. Supply is surprisingly stable in the face of price movements, and mine production has held steady at around 2,5 tonnes per year for several years now* 5. The fact that new mines tend to be replacements for defunct mines serving to maintain rather than increase global production levels contributes to this invariability. Figure 5: Global gold mine output (tonnes) 7 3, ,5 2, 1,5 1, Source: MEG, September 211. SA US CN AU CH World 5 GFMS (211) Gold Survey 211. *However, it is worth noting that an increasing proportion of this supply is being provided by China (green bars on Figure 5) who have thus far shown little inclination to export their gold.

5 Around half of global gold demand is driven by jewellery, with only a relatively small amount being used in industry relative to other precious metals (1% compared to 5% for silver) 6. The non-cyclical nature of gold means that it could be held as a defensive asset, as its price may fall less than that of many other commodities during business cycle troughs. Central banks hold a substantial portion of the world s above-ground gold stocks (17% at the end of 211) 7, and can exert a significant influence on global supply and demand through the management of their gold reserves. In the 199s, following a prolonged period of relative economic stability, demand for safe haven assets fell. Increasing pressure was placed on reserve managers to generate returns, and combined with falling gold prices this led many central banks (most of whom still held large quantities of gold as a relic of the gold exchange standard) to divest themselves of a portion of their gold reserves. Net outflows from central reserves flooded the markets with gold, placing further downward pressure on prices. This trend has since reversed, and in the current environment, with the safe haven qualities of gold more highly valued (and confidence in traditional reserve currencies such as the US dollar and the euro falling in the face of high government debt burdens), we are seeing net purchases by central banks. Again, this serves to accentuate the upward trend in gold prices. Figure 6: Official sector net transactions (tonnes) from 1985 to Source: World Gold Council 8, GFMS. Denominated in US dollars Because gold is denominated in US dollars its price is likely to be influenced by the value of the US dollar relative to other currencies the stronger the dollar, the more expensive (and less attractive) gold will be to foreign investors, which could push gold prices (denominated in US dollars) down. This results in a negative correlation between the price of gold and the strength of the US dollar. The fact that both gold and the US dollar are viewed as safe haven investments reinforces this inverse relationship: a weak US dollar may force investors to seek other safe haven investments, and demand for gold (as an alternative store of value) may increase. 9 6 World Gold Council (211). Gold: A commodity like no other. 7 World Gold Council website: 8 Recreated from World Gold Council (211). Liquidity in the global gold market. 9 Oxford Economics (211). The Impact of deflation and inflation on the case for gold.

6 Figure 7: US dollar nominal effective exchange rate versus gold price (log scale) Weak dollar Strong dollar Gold (lhs) USD Nominal Effective Exchange Rate (Inverted) (rhs) Source: Schroders, Datastream, 28 September 212. The graph above demonstrates this negative correlation, with a weakening dollar corresponding with rising gold prices in the late 197s and 2s, and a strengthening dollar with falling gold prices in the late 199s and (to a certain extent) early 198s. One point at which the relationship between gold prices and US dollar strength appears to have decoupled is in the mid-198s. This potentially reflected investors fears that the high interest rates at that time 1 (which are likely to have contributed to the strong US dollar) would spark a recession, thereby increasing demand for gold as protection against economic instability. Liquidity The relatively high liquidity of gold contributes to its status as an alternative currency (or store of value) and along with the impressive depth and breadth of the market means that gold is easily accessible for investors. However, as discussed previously, the high liquidity of gold also means that it may be one of the first assets to be sold off in a liquidity crisis, with dips in the gold price historically associated with spikes in illiquidity measures such as the TED spread (see figure 3). What are the benefits of holding gold as part of a diversified portfolio? In the wake of an 11 year bull market 11, speculative allocations to gold (with the sole intent of capitalising on price increases) may seem less appealing. However holding gold as part of a diverisifed portfolio still offers a number of possible advantages for UK pension schemes. Gold has historically displayed low or negative correlations with many risk assets, which means the addition of gold to a portfolio could provide relative diversification benefits. Figure 8: Correlation between gold and other asset classes* year correlation 1 year correlation UK Equities US Equities Global Equities Emerging Market Equities US Treasuries US Corporates Global High Yield Commodities Hedge Funds Real Estate USD Spot Source: Schroders, Bloomberg. *Correlations based on monthly data over 3 and 1 years to 29 February See Figure Which peaked in September 211.

7 Pension schemes wishing to protect against downside tail risks may also be interested in gold s function as a possible offset against inflation, financial risk, and US dollar depreciation. As an example, the graph below plots the price of gold against the S&P5 between January 28 and March 29 (i.e. the credit crunch). Figure 9: Price of gold during periods of market crisis gold versus S&P5 January 28 to March USD per troy oz Credit crunch: gold and equities fall simultaneously (see Figure 3) Jan 8 Mar 8 May 8 Jul 8 Sep 8 Nov 8 Jan 9 Mar 9 7 S&P (lhs) Gold (rhs) Source: World Gold Council 12, Schroders, Datastream. Over this period, gold served as an effective offset against equity losses (although there is of course no guarantee that this relationship would hold in any future crisis). However investors should be wary of relying too heavily on the potential merit of gold as an insurance asset. There is a considerable behavioural element to the demand for gold, with market sentiment playing a significant role in driving price movements. The function of gold as a hedge against inflation or financial risk is somewhat reliant on the fact that investors perceive it as such: a self-fulfilling cycle exists, with gold performing well during crises partly because investors expect it to do so. This introduces the potential for sharp falls in value if investors were to become disillusioned. For example, the gold bubble of the 197s and early 198s burst even before the reversal of the equity bear market Recreated from World Gold Council (21). An investor s guide to the gold market: UK edition. 13 Ritter, J. & Warr, R. (22). The decline of inflation and the bull market of Journal of Financial and Quantitative Analysis.

8 How can a pension scheme invest in gold? Institutional investors can invest in gold directly (through physical or synthetic investments in gold) or indirectly (for example by investing in the shares of gold mining companies). The key features, advantages, and disadvantages of each means of gaining exposure to gold are detailed below: Direct investment While a physical investment in gold may be the most direct approach to obtaining exposure to this asset class, there are a number of disadvantages. Investors in physical gold incur costs associated with storage and insurance, as well as transportation to and from the storage location. Gold Exchange Traded Funds (ETFs) are an alternative to a physical investment in gold. A gold ETF holds a large quantity of physical gold, and investors can purchase shares in the ETF through a stock exchange. The advantage of obtaining exposure to gold through an ETF is that shares are highly liquid and closely track the price of gold, while enabling investors to avoid many of the issues associated with physical ownership. Indirect investment Investors can also achieve exposure to gold indirectly, through investment in gold mutual funds, or by purchasing shares in firms whose performance is positively correlated to the price of gold (such as gold mining companies). Gold mutual funds tend to invest in companies involved in various stages in the gold production process (and may also invest directly in gold itself, using the methods discussed above). Because the mutual fund invests in a number of different companies, a fair portion of the specific risk of individual companies is diversified away. However, the question remains as to how closely investments in gold mining companies actually follow gold prices. Due to the fixed costs of the underlying companies, shares in gold-focused firms represent a leveraged play on gold, and returns may be substantially more volatile than the price of gold itself. Purchasing the shares of gold mining companies exposes investors to substantially more stock specific risk than investing in gold mutual funds. Investors will therefore need to carefully consider the fundamentals of the individual company as well as the outlook for gold in planning their investment. It is also possible to obtain exposure to gold through investments in multi-asset mutual funds, many of which make both strategic and tactical allocations to gold in response to long and short-term capital market expectations. Gold performance under different scenarios Scenario 1 Period of deleveraging, low growth, relatively low inflation A period of deleveraging (in response to the unsustainably high levels of government debt in developed markets) would be likely to be accompanied by slow growth and weak and volatile stock market returns. If other asset classes were underperfoming, or if investors believed that they were likely to underperfom in the future, this could increase the appetite for gold. In light of poor growth expectations, central banks would be expected to take a dovish stance. In the absence of deflation, very low interest rates would result in a negative real interest rate environment; and with no opportunity cost associated with holding a non-yielding asset, increased demand for gold could ensue. With central banks focused on encouraging growth rather than meeting their inflation target for example by combining Quantitative Easing policies with very low interest rates there is also a possibility that we could enter a period of higher inflation. In this eventuality, one could expect demand for gold to increase.

9 Scenario 2 Deflation A global financial crisis would be accompanied by high levels of risk aversion, large losses on risk assets, and possibly deflation (in response to non-existent or negative economic growth and high unemployment). If we were to enter a period of deflation, we could see gold prices fall. As well as decreasing demand for gold as an inflation hedge, deflation would counteract the effect of low interest rates, increasing real rates and thus the opportunity costs of holding gold. However demand for gold as a hedge against financial instability could overshadow this effect. Scenario 3 Sustained recovery, moderate inflation In the event of economic recovery, we would expect to see stronger growth, with an increased appetite for risk and commensurate good performance of risk assets (and potentially reduced demand for gold). With a strong recovery, central banks could raise interest rates without fear of inhibiting economic growth, and in this scenario increased opportunity costs would be expected to reduce investor s appetite for gold. On the other hand, if the economy were to overheat, inflation fears could cause demand for gold to rise. Conclusion It is almost impossible to accurately predict the direction of gold price movements because demand for gold is affected by a number of (often conflicting) factors, including: Inflation Macro-economic environment Interest rates US dollar strength Despite the difficulties associated with forecasting price movements, an allocation to gold can provide the following benefits: Low correlation with other assets (diversification benefits) Non-cyclical demand Potential value as an insurance asset against inflation and financial instability A long-term strategic allocation to gold, combined with short-term tactical adjustments to this exposure, could therefore prove advantageous to a UK pension scheme. This exposure could be achieved through direct investments in gold itself, or through indirect investments via shares in gold-mining companies, gold mutual funds, or multi-asset mutual funds with allocations to gold. If you would like to discuss any of the topics in this paper, please contact a member of the UK Strategic Solutions team

10 Important information The views and opinions contained herein are those of the UK Strategic Solutions team at Schroders, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. General Forecast Risk Warning The forecasts stated in the document are the result of statistical modelling, based on a number of assumptions. Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. The forecasts are provided to you for information purposes as at today's date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things, as economic and market conditions change. We assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions, models or other matters change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No England. Authorised and regulated by the Financial Services Authority. For your security, communications may be recorded or monitored.