Asset Allocation: The Merits Of Gold

Includes: AGG, GLD, LQD, SPY, TLH, TLT
by: Daniel Moser

Recently, a reader made a comment on an article of mine that was posted in September in which they basically stated that while they liked the article, there are more assets in the investment universe than equities and fixed income (i.e. gold). In essence my article examined the characteristics of the classic 60/40 portfolio in which an investor holds 60% of their assets in equities and 40% in fixed income. Many people consider this classic approach to asset allocation to be a relatively balanced way to invest. However, from a risk exposure perspective, the typical 60/40 portfolio is nowhere near balanced. The volatility inherent in stocks is so much greater than that of fixed income that the classic 60/40 portfolio is really something closer to 95% equities, 5% fixed income if you peer through the lens of risk exposure.

Nonetheless, this reader made a solid point. What about gold? Does gold have a place in an investor's portfolio? The gold bugs out there will immediately shout out "Duh!" But, I suspect there are a lot of people out there who are unable to articulate the impacts of incorporating gold in a portfolio. So, let's take a look at the potential impacts now.

The principal guiding force for this analysis is one of the key components of the holy trinity of finance: correlation. As you accumulate non-correlated assets overtime, you enhance the diversification of your portfolio. By constructing a better diversified portfolio you explicitly reduce the risk that you experience dramatic losses. Remember Warren Buffett's number one rule for investing? Never lose money. Taking actions to sufficiently diversify a portfolio will go a long way in successfully adhering to Warren Buffett's number one rule. Having said that, just how correlated is gold to other assets?

Based on daily returns from January 2008 through December 2012, as you can see, the gold ETF (NYSEARCA:GLD) has not been particularly correlated to anything. From an asset allocation perspective, this is a great trait for a security. Because GLD is not super positively, or super negatively, correlated with other assets, GLD can serve as an independent anchor of value to a portfolio constructed using the securities included in the table above. When there is a dramatic bull market in fixed income instruments such as TLH, LQD, or TLT, GLD is not likely to get hammered. Conversely, when equities go gangbusters, GLD is not likely to get hammered.

What possible reason could GLD remain so unscathed by moves in other asset classes? I think it is most likely due to the fundamental economic characteristics of gold. Most of the arguments I have ever heard about the fundamental merits for gold revolve around the relatively fixed supply/production of gold which grows at 1-2% per year at best vs. the supply/production of "money" around the world which can grow at substantially more than 1-2% per year. Gold is perceived as a store of value which is born out in the data with a virtually non-existent correlation to equities, government debt, or corporate debt.

Let's consider the stereotypical investor holding 60% of their assets in equities which can be represented by the S&P 500 ETF (NYSEARCA:SPY) and 40% of their assets in an aggregate bond ETF such as AGG. Does this investor have anything to gain by reducing their exposure to equities while adding some exposure to gold?

Based on daily returns gathered from January 2008 through December 2012, an investor who held 50% of their assets in SPY, 40% in AGG and 10% in GLD would have earned an incremental 1.13% annualized return while reducing their portfolio's volatility from 15.66% to 13.41% in comparison to simply holding 60% in SPY and 40% in AGG. The combination of increased returns and lower volatility translates into a 59% increase in risk adjusted returns as measured by the Sharpe ratio. From an asset allocation perspective, GLD improves the portfolio characteristics of a 60/40 portfolio.

Alright, let me go ahead and say it, this analysis does rely on historical data. Having said, I think anyone who wants to make a case that gold is going to somehow become an asset that is inextricably linked to other asset classes such as equities or fixed income over a long time horizon will have a pretty challenging time making a convincing case unless a serious shift in the underlying fundamental economic characteristics of gold takes place. Nonetheless, using any sort of statistical analysis to help guide asset allocation requires periodically reviewing and analyzing the performance characteristics and rebalancing as the data changes. End disclaimer.

In terms of risk exposure, equities still grossly dominate the overall portfolio which can be seen in the table below:

Let's take this one step further. Unfortunately, AGG is a relatively boring security to work with in the context of asset allocation. But, the good news is that by expanding the security universe to include a corporate bond ETF represented by LQD and longer term government debt ETFs represented by TLH and TLT, you can construct a portfolio that offers a much more diversified profile of risk exposures between these three asset classes while enhancing, at least historically, the performance characteristics of the overall portfolio.

Okay, calling this third portfolio "risk balanced" is a bit of an overstatement. The portfolio is still inherently over weight equities, but there is a discernible amount of risk allocated to the other two asset classes in this analysis.

The graph, shown above, essentially provides a visual display of the proportion of total portfolio volatility (a.k.a. risk) that is attributable to each asset class which I refer to as risk exposure. I know that many people disagree with the interpretation that portfolio risk equates to volatility, but just accept it for the purposes of this analysis as most people are pretty well entrenched in their existing viewpoint making arguments over such matters less than productive.

The next two exhibits provide a view of the annual performance of each asset allocation strategy as well as a view of the cumulative performance over the entire time period. This data must certainly be taken with a grain of salt as historical data is by no means guaranteed to be indicative of the future. However it does illustrate a lofty point… big losses matter!

If you had relatively perfect foresight at the end of 2008 and decided to invest 100% of your assets in the S&P 500 at the start of 2009, you would have earned just under a 50% total return. With that same foresight, if you had invested in the risk balanced approach, you would have earned a total return of roughly 41%. Unfortunately, we have to accept the fact that most people are not blessed with terrific forecasting/market timing abilities; thus a more balanced approach is, in my opinion, a better approach over the long run. By having some balance in the asset allocation mix, you can dramatically reduce the impact of significant bear markets and, over the long run, achieve excellent cumulative returns. The 60/40 approach cut the 2008 losses nearly in half, which helped drive a total cumulative return of 15.5%, double the S&P 500 total return of 7.4% over the entire time period. By simply adding a modest exposure to GLD (using the weights disclosed earlier), the total performance is even better at 21.1%. And finally, by further balancing the risk exposures among the three asset classes incorporated in this analysis (i.e. the Risk Balanced Portfolio) an investor would have earned a total return at 33.8%.

Based on the data, I would argue that gold has a meaningful place in most people's portfolio. GLD does not exhibit a strong correlation to any other asset included in this analysis and, as such, GLD provides an anchor of value that helps reduce the impact of dramatic market down turns while providing an opportunity to enhance returns during the market booms. Gold is simply in a class on its own.

Disclosure: I am long SPY, LQD, TLT, GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.