Assessing the Use of Gold as a Zero-Beta Asset in Empirical Asset Pricing: Application to the US Equity Market

This paper examines the use of the return on gold instead of treasury bills in empirical asset pricing models for the US equity market. It builds upon previous research on the safe-haven, hedging, and zero-beta characteristics of gold in developed markets and the close relationship between interest rates, stock, and gold returns. In particular, we extend this research by showing that using gold as a zero-beta asset helps to improve the time-series performance of asset pricing models when pricing US equities and industries between 1981 and 2015. The performance of gold zero-beta models is also compared with traditional empirical factor models using the 1-month Treasury bill rate as the risk-free rate. Our results indicate that using gold as a zero-beta asset leads to higher R-squared values, lower Sharpe ratios of alphas, and fewer significant pricing errors in the time-series analysis. Similarly, the pricing of small stock and industry portfolios is improved. In cross-section, we also find improved results, with fewer cross-sectional pricing errors and more economically meaningful pricing of risk factors. We also find that a zero-beta gold factor constructed to be orthogonal to the Carhart four factors is significant in cross-section and helps to improve factor model performance on momentum portfolios. Furthermore, the Fama–French three- and five-factor asset pricing models and the Carhart model are all improved by these means, particularly on test assets which have been poorly priced by the traditional versions. Our results have salient implications for policymakers, governments, central bank rate-setting decisions, and investors.