Gold bullion has had an illustrious and volatile past. In 1934, a year after the U.S. went off the gold standard, the price of gold was pegged by the Government at $35 per ounce. It stayed at this value until 1971 when President Nixon allowed the value to float. And float it did, hitting a high of $850 an ounce in 1980. It subsequently collapsed to $250 an ounce in late 1980s and stayed in a relatively narrow trading range for the next decade. During the early years of the new millennium, gold blasted off, reaching a price of over $1800 in September of 2011. Many called this a "bubble" but it is interesting to note that the gold's peak price of $850 in 1980 is equivalent to an inflation adjusted price of over $2,300 today. After reaching the 2011 peak, the infatuation with gold died and gold has now entered bear market territory, currently down over 25% to about $1,300 an ounce.
To get a feel for how gold and other precious metals investments fared over the recent past, I analyzed several precious metal ETFs and Closed End Funds (CEFs). My objective was to see if the rewards have been commensurate with the risks for this volatile asset class.
First, I analyzed performance over a complete market cycle, from 12 October, 2007 (start of the bear market) to the present. The most popular and liquid funds over this timeframe are summarized below.
- SPDR Gold Shares (GLD) has become synonymous with gold investing, usually trading over 10 million shares a day. Each share represents one tenth ounce of gold bullion. Figure 1 is a plot of GLD, which shows that gold dropped only about 30% in 2008, stabilized in 2009, and then had a meteoric rise to over $180 in 2011.
- Central Gold Trust (GTU) is a CEF that invests in gold bullion. It has frequently sold at a premium to Net Asset Value (NAV). Over the past 5 years, the premium has averaged over 5% and spiked to over 30% in 2009. Currently, it is selling at a discount of 5%, which is very unusual. GTU is not very liquid (volume less than 100K shares per day) so limit orders are advised when purchasing this CEF.
- Central Fund of Canada (CEF) is a Closed End Fund that invests in both gold (56%) and silver (43%) bullion. This fund was launched in 1983 and is one of the oldest precious metal funds. Since 2002, it has commonly sold at a premium, with a premium of almost 30% recorded in 2003. Like GTU, it has recently fallen on hard times and now sells at a discount of over 5%. It is very liquid, with a trading volume of over 1.5 million shares per day.
- Market Vectors Gold Miners (GDX) is an ETF that tracks the NYSE Arca Gold Miners Index. This index is primarily large cap gold mines (72%) but does include a few silver mines. Over all, this ETF has 30 holdings with over 70% of its assets concentrated in the top ten miners. Only about 15% of the holdings are US based stocks. In addition to the fluctuations in the price of bullion, miners also have operational risks as well as political risks.
Figure 1: Plot of GLD weekly prices since inception
In Figure 2, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of these ETFs and CEFs. The Smartfolio 3 program (smartfolio.com) was used to generate this chart. I also included SPY, the SDPR S&P 500 ETF, to facilitate comparison with the overall equity market.
Figure 2: Risk Reward Plot for Gold ETFs & CEFs over market cycle
Over the market cycle, all the precious metal bullion funds (except for the miners) had exceptional performance when compared with SPY. The bullion funds handily beat the SPY but most experienced greater volatility. The outperformance of the precious metal funds was not surprising since bullion weathered the bear market better than equities and until recently, the gold bull had been extremely strong.
To assess if the reward was worth the increased risk, I calculated the Sharpe Ratio for each gold fund. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility (the reward-to-risk ratio if you measure "risk" by the volatility). It is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. Reviewing Figure 2, it is easy to see that all the precious metal funds, except GDX, had a higher Sharpe Ratio than the SPY, indicating that the rewards of investing in these funds were worth the risks.
The underperformance of the mining stocks GDX was a little surprising. Precious metal stocks were hit relatively hard in 2008 and never fully recovered. Even though the price of gold bullion increased substantially, the miners have not followed suit and their performance has been dismal. Many of the major mining companies, like Newmont Mining and Barrick Gold (ABX) are selling for the same price they did in the 1990s! Investing in mining stocks has certainly not been worth the risk.
In addition to potential returns, another positive quality of gold funds is the diversification they can potentially provide a portfolio. As seen in Figure 3, the gold bullion funds are only slightly correlated with the SPY. Even among themselves, the gold funds are only moderately correlated with most correlations in the 70% to 80% range.
Figure 3: Correlation of Gold Funds (over 5.5 years)
The risk-to-reward story changed dramatically when I shortened the look back period to the past 3 years. With the shorter period, I was also able to include two additional funds that were launched after 2008:
- Sprott Physical Gold Trust (PHYS) is a CEF with an inception date of February, 2010. This fund holds only gold bullion. It has a unique marketing feature that allows you to receive gold bullion in lieu of cash if you decide to redeem the fund. Before you rush out and buy this fund, make sure you read the fine print. The redemption in bullion is only available in multiples of gold bars. Since a gold bar weighs between 350 to 450 ounces, this is a minimum of $450,000 even at today's low gold prices; plus, you would have to pay for an armored car for the delivery. So I don't think many people will take advantage of the gold redemption option. However, the idea was brilliant and likely was one of the factors in generating over a 20% premium in 2010. But like all the other gold CEFs, the shares now sell at about a 2% discount. The fund continues to have great liquidity, with a volume exceeding a million shares daily.
- Market Vector Junior Gold (GDXJ) is an ETF that invests in mid to small cap miners. This is one of the most volatile ETFs. In addition to fluctuations in the price of bullion, small gold mines have many other risks including operations, geopolitical, and cash flow. Even though interest rates are low, the tough credit criteria have made it difficult for small mines to raise money.
The risk to reward plot for the past 3 years is shown in Figure 4. Both the SPY and the gold funds had a strong bull markets at the beginning of the look back period but the gold funds ran out of steam in 2011. The risk reward plot illustrates the current sad state of affairs for precious metal funds. The volatility is still present but the rate of return is atrocious. None of the funds come close to beating the S&P 500 and the gold miners are mired in negative returns. GTU and PHYS had poorer price performance than GLD due to the collapse of their premiums.
Figure 4: Risk Reward Plot for Gold ETFs & CEFs over past 3 years
I have always been somewhat of a gold bug and I hope that precious metals make a comeback. But until there is a dramatic turnaround, gold funds have definitely lost their glitter!