Gold and other precious metals are a volatile asset class. Whether or not they deserve a place in a retirement portfolio is a matter of debate. Some pundits, like Alexander Green, who formulated the "Gone Fishing Portfolio" recommends about 5%. Others, like Harry Browne, in his "Permanent Portfolio" believes as much as 25% is justified. Still others, like Bill Schultheis' "Coffee House Portfolio" does not allocate any to precious metals. There is, of course, no right answer. It depends on your investment objectives, time horizons, and risk profile. This article does not try to justify any percentage allocation to precious metals. However, if you decide to include them in your portfolio, then this article will provide an analysis of how the different types of precious metal securities have performed on a risk adjusted basis.
There are a number of ETFs and closed end funds that focus on gold and silver. For this analysis, I chose representatives that had at least a five year history and were liquid (trading at least 50,000 shares on average per day). These selections are summarized below.
- SPDR Gold Shares (GLD). One share of this ETF represents a tenth of an ounce of gold. It is not the cheapest (expense ratio of 0.4%) but is by far the most liquid, trading over 11 million shares per day on average. The gold bullion backing this ETF is held in vaults in London. Gains from this ETF are taxed like you owned the physical gold directly (taxed at collectibles rate if you hold for more than a year).
- iShares Silver Trust (SLV). One share of this ETF tracks the price of one ounce of silver bullion. The shares are backed by silver held in banks in London and New York. Silver is more volatile than gold, primarily because it is sensitive to industrial demand in addition to being a "safe haven" asset. This is not all bad since the industrial uses may serve to support prices if the desire for silver wanes among investors. This fund is very liquid (average 12 million shares per day) and has an expense ratio of 0.5%, which is similar to other funds. Like GLD, gains from SLV are taxed as collectibles.
- Central Fund of Canada (CEF). This is a closed end fund that holds roughly 50% gold bullion and 50% silver bullion. As a closed end fund, it can sell at a premium or discount to Net Asset Value (NAV). During the heyday of the precious metal frenzy, the fund sold at a 15% premium. It currently sells at a 2% discount, which is historically low. This fund does not use leverage and has a low expense ratio of 0.3%. It is relatively liquid for a closed end fund, trading about 1.4 million shares per day. For tax purposes, this fund is a passive foreign investment company so you should consult your tax advisor relative to the treatment of gains and losses.
- Market Vector Gold Miners (GDX). This ETF holds 30 cap-weighted precious metal mining companies (mostly gold miners but with a few silver miners). The three largest holdings are Goldcorp (GG), Barrick Gold (ABX), and Newmont Mining (NEM). A little over 60% of the assets are Canadian companies with the rest primarily in the US and South Africa. It is extremely liquid (over 26 million shares per day) and has a reasonable expense ratio of 0.5%.
- GAMCO Global Gold Natural Resources and Income (GGN). This is a closed end fund that writes options on gold and natural resources stocks. It uses a small amount of leverage (8%) and has a relatively high expense ratio of 1.3%. However, it currently is distributing a huge 13% monthly, but about a third of this is return of capital (ROC). It is also selling at a 2% premium (which is close to the average premium over the past 52 weeks). It has 120 holding, primarily precious metal companies but some oil and other resource stocks. It also has 16% of the total assets invested in bonds. About 75% of the holdings are from North American firms.
To analyze risks and return, I used the Smartfolio 3 program (www.smartfolio.com). Figure 1 provides the rate of return in excess of the risk free rate of return (called Excess Mu on the charts) plotted against the historical volatility over the past 5 years.
Figure 1. Risk versus Reward Precious Metals 5 years
As is evident from the figure, there was a relatively large range of returns and volatilities. For example, SLV had a high rate of return but also had a high volatility. Was the increased return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio.
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. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with GLD. If an asset is above the line, it has a higher Sharpe Ratio than GLD. Conversely, if an asset is below the line, the reward-to-risk is worse than GLD. Similarly, the blue line represents the Sharpe Ratio associated with SLV.
As is evident from the Figure, GLD had the best risk-adjusted return. SLV was significantly more volatile than gold and, although it had higher total return, it did not have as good risk-adjusted return. As you might expect, CEF had volatility between GLD and SLV but the risk-adjusted return was worse than either.
The Gold stocks did terrible, with a very high volatility and just barely eking out a positive return. In past markets, in the 1980s and 1990s, this was not the case; mining stocks usually outperformed their bullion counterparts. But not recently! Some might consider this a good contrarian situation and I have to confess, I own some miners in my "speculative" accounts. However, from a portfolio allocation point of view, the miners have a lot to prove before they would be considered a competitive asset class.
One of the reasons many pundits recommend that people allocate a portion of their portfolio to precious metal is because they are a "diversifier". To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. To check out if these funds do, in fact, provide diversification, I calculated correlation matrix. I also included the SPDR S&P 500 (SPY) ETF for reference. The results are shown in Figure 2. As you would expect, the funds are moderately correlated with one another since they are all associated with precious metals but they are all virtually uncorrelated with SPY. So if you have an equity portfolio that mimics the S&P 500, using precious metal funds does provide diversification.
Figure 2. Correlation Matrix Precious Metal with SPY (5 years)
I next looked at a 3 year time frame. During this period, some new ETFs were launched so I also included the following in my analysis
- ETFS Physical Platinum (PPLT). Platinum is used primarily in industrial applications and jewelry, rather than being held as a hedge against fiat currency. It is rarer than gold and the price is usually, but not always, higher than gold. A primary use of platinum is in automobile catalytic converters but it also has a wide demand in jewelry, especially when the price falls below gold. One share of PPLT represents about a tenth of an ounce of platinum. It is not nearly as liquid as other precious metal ETFs (trading only about 60,000 shares per day). The ETF holds bullion in banks in London and Zurich. Like the other precious metal ETFs, gains are taxed as collectibles. The fund has an expense ratio of 0.65%.
- ETFS Physical Palladium (PALL). Palladium is a lesser known precious metal that sells for about $725 per ounce. In can be used instead of platinum in catalytic converters and in jewelry. It has many of the same properties as other precious metals in that it is malleable, easy to polish and remains tarnish free. In Europe, 15% palladium is typically alloyed with gold to produce "white gold". Palladium is used primarily for industrial applications and is generally not considered a "safe haven" asset. Each share of PALL represents about a tenth of an ounce of Palladium. The ETF trades over 100,000 shares per day so it is relatively liquid. The bullion associated with the ETF is stored in vaults in London and Zurich. The fund has an expense ratio of 0.6%. Like gold and silver, it is taxed like collectibles.
- Global X Silver Miners (SIL). This ETF holds 31 cap-weighted silver mining companies, of which Silver Wheaton (SLW) is the largest holding. Almost 95% of the constituents are based in either North America or Latin America. It is relatively liquid (trading about 200,000 shares per day) and has an expense ratio of 0.65%.
The Risk-Reward plot for the past 3 years is shown in Figure 3. The results are similar to those for the 5 year period, except that the new entry PALL had excellent performance. If you exclude PALL, then gold and silver bullion still offers the best risk-adjusted performance, with the mining stocks pulling up the rear. One interesting note is platinum, which had much poorer performance than gold.
Figure 3. Risk versus Reward Precious Metals 3 years
As you may know, the prices of gold and other precious metals peaked near the end of 2011 and have been in a sever bear market ever since. I therefore made one more plot from January, 2012 to the present to see how these funds fared in a major bear market. The results are shown in Figure 4. Over this period PALL still managed to keep above water and platinum did better than gold. GGN with its option strategy held up pretty well but still lost. The other mining stocks continued their under-performance.
Figure 4. Risk versus Reward Precious Metals Bear Market
From being the darling of the investment world to one of the most hated asset classes, precious metals have come full circle. Whether or not you have precious metals in your portfolio is a personal decision. However, if you decide to allocate some of your resources to this asset class, then based on past data, bullion has been a better performer than mining stocks. Gold and silver bullion have similar risk adjusted returns. If you want both, then CEF is a possibility (if it is selling at a discount). Palladium is the new kid on the block and has done very well over the past 3 years. Only time will tell which of the funds will shine over the next few years. However, if you have precious metals in your portfolio you will not be bored and you can expect a wild ride!