Gold or gilts: which is best for inflation protection?

On reaching a savings milestone, your first thought might be to preserve the real value of your capital. This is most likely to happen when you scale back on work after a lifetime of investing, but might also occur when you reach your first £10,000 or £100,000 saved.

Inflation’s assault on consumers is easing. Some commentators, such as consultancy Oxford Economics, think UK inflation is returning to its 2 per cent target. The Bank of England has recently made some optimistic comments, though it said it can’t rule out another global shock that keeps inflation high. Even if it goes away in the short term, there’s always the worry that it might return — with even low levels a concern for retirees.

Investing in shares is good inflation protection when you’re accumulating funds. This is because listed businesses that are making or doing things can adjust the prices of their goods or services to align with inflation.

But once you’re drawing an income from investments, you may need a new perspective.

Wealth managers usually advise retirees to “de-risk” their investments by reducing levels of equity exposure. This ensures your investments don’t fluctuate in value as much as they did while you were accumulating them.

Sharp falls can be hard to recoup when you draw down a regular income from investment. But if the stock market crashes at the start of your investment drawdown, it can have a devastating impact on your long-term income.

Most de-risking involves some exposure to gold, simply because the price of gold doesn’t always move in the same direction as share prices. However, on Wednesday, the gold price reached a record high of $2,295 per troy ounce. I think that’s a “klaxon” signalling it’s time to examine the reasons for holding it.

“There have been a range of reasons for the all-time high gold prices, however, they nearly all come back to the fact that gold is a stable investment,” says Rick Kanda, managing director at The Gold Bullion Company. “Gold has historically been seen as a reliable store of value during economic and political uncertainty, making it unsurprising that a record number of investors backed gold in 2023.”

Gold is protection against war or economic crisis. But some investors also hold gold as protection against inflation. This seems debatable.

On the one hand, Schroders looked at data from March 1973 to December 2022 and found on average, over a 12-month period, gold returned 21 per cent above inflation during times of high and rising inflation.

However, Laith Khalaf, head of investment analysis at AJ Bell, says: “Gold has spent long spells in the doldrums, going sideways or down, and it’s pretty volatile, so I think the argument it’s an effective hedge against inflation is quite tenuous.”

The alternative for investors who want to de-risk away from equities but also build in inflation protection is index-linked gilts. These assets, backed by the UK government, will provide inflation protection if you hold them until maturity and can pick up a positive real yield — which isn’t always the case, but is today.

“In the current market you can pick up index-linked bonds yielding between 0 per cent and 1 per cent above inflation, depending on maturity,” says Khalaf.

These “linkers” may complement your gold holdings too. Sam Benstead, deputy collectives editor at investment platform Interactive Investor, thinks of the difference this way: “Overall, gold could be viewed as a defence against very high inflation (or hyperinflation); and inflation-linked bonds a defence against sustained higher than expected inflation, so long as the bonds offer a positive real yield when purchased and investors are wary of the risk that bond prices can move up and down.” 

Ideally, you would construct a ladder with individual UK linkers that mature at intervals. But investors without advisers to do it for them may not have the time or the inclination. Despite the varying efforts of the platforms to explain and identify index-linkers, many find it mind-bogglingly difficult.

Meanwhile, although you can easily add gold to your portfolio by buying an exchange-traded product, such as iShares Physical Gold ETC Acc (recommended by four investment platforms: AJ Bell, Interactive Investor, Fidelity and Charles Stanley Direct), be cautious around the exchange-traded products that give exposure to UK index linkers.

The passive index-linked gilts index has a very long average maturity, essentially because issuance was designed to meet the need of pension funds, which have long-duration liabilities. Almost 50 per cent of the iShares Index Linked Gilts ETF is gilts with maturity of more than 15 years. 

But ETFs with big proportions of long-duration gilts can be volatile when prices fluctuate. For example, from December 1 2021 to September 27 2022, the iShares Index Linked Gilts Ucits ETF dropped 50 per cent.

Benstead explains: “This was the period when markets began pricing in higher inflation and interest rates, causing index-linked bonds to drop in value even as inflation soared. While your coupons would have seen an uplift, the capital value of your index-linked bonds would have crashed.”

To find shorter average maturity than the UK passive index-based products, you can widen your search to active management and global linker funds. Fidelity includes Royal London Short Duration Global Index Linked Fund M Inc in its “Select 50” list of recommended investments, saying: “The loans are made over short periods (under five years usually) and this also helps reduce the fund’s risk. The manager has displayed skill in running the strategy and the fairly low cost reduces the drag on modest expected gains.”

However, with only 30 per cent exposure to UK linkers, this fund might not be what you need if you’re worried about UK RPI inflation.

If you deflate the gold price over the past four decades, it hasn’t held its value in real terms

Again you should be wary, as some of the actively managed UK index-linked gilt funds have high exposure to long duration, too, and do come with higher expenses than trackers.

Enter the relatively new CG UK Index-Linked Bond Fund with costs of 0.15 per cent — an actively managed fund close to the price of a passive fund. With 14 UK index-linkers in the portfolio and an average duration of 5.5 years, it looks promising.

It launched in October 2023, but its managers have experience in this area — the multi-asset fund they also manage, the Capital Gearing Portfolio Fund, aims to protect clients’ capital and has big exposure to index linkers while holding 1 per cent in gold.

“If you deflate the gold price over the past four decades, it hasn’t held its value in real terms,” says Emma Moriarty, investment manager at CG Asset Management. “Where gold adds value is in the apocalypse scenario — that’s why we hold the 1 per cent.”

You may feel apocalypse planning requires a higher level of gold. But inflation planning gives a reason to cash in a little of your gold gains in favour of linkers. 

Moira O’Neill is a freelance money and investment writer. She holds none of the funds mentioned. X: @MoiraONeill, Instagram @MoiraOnMoney, email: moira.o’neill@ft.com