Can Gold Supplant Commodities in Your Portfolio?

By Brad Zigler

There was a time not so long ago when allocating investment capital was a pretty simple affair. Financial advisers used to recommend a basic "60/40" portfolio: 60 percent in equities and 40 percent in fixed-income securities. Investors might tweak their portfolios around the edges to allow for a cash hoard or a dollop of gold, but that was about as fancy as investing got.

Recently, as exchange-traded products have proliferated—with some carving markets into thinner and thinner subslices, and others opening up previously inaccessible asset classes—portfolios have gotten more complex.

Further spurring investors to rethink their asset allocations are growing inflation concerns and the sterling investment results obtained by the Yale and Harvard endowments, which use alternative investments to slice, dice and rejigger portfolio risk.

However, investors hoping to mimic the endowment portfolios are often left scratching their heads when they consider the so-called real assets allocations.

Specifically, investors have begun pondering the utility of replacing their gold allocation with the broader-based commodity exposure favored by institutional portfolios. From an efficiency standpoint, the question basically boils down to this: Can exposure to a single commodity—say, gold—provide the desired diversification benefit? Or must a full basket of futures be employed?

Take the roster that makes up the S&P/GSCI Commodity Index (formerly the Goldman Sachs Commodity Index). GSCI is a production-weighted index comprising two dozen commodity futures traded in New York, Chicago and London. Gold is a middling component of the index, accounting for nearly 3 percent of the benchmark's weight.

GSCI Components

Commodity	Dollar Weight (%)
WTI Crude Oil	39.5
Brent Crude Oil	13.6
GasOil	4.7
RBOB Gasoline	4.6
Heating Oil	4.5
Natural Gas	4.4
Corn	3.4
Copper	3.3
Chicago Wheat	3.1
Gold	2.9
Live Cattle	2.4
Sugar	2.3
Aluminum	2.3
Soybeans	2.2
Lean Hogs	1.2
Cotton	1.1
Zinc	0.7
Coffee	0.7
Nickel	0.7
Kansas Wheat	0.6
Feeder Cattle	0.5
Lead	0.5
Silver	0.4
Cocoa	0.4

Source: Goldman Sachs. All figures as of Nov. 10, 2009

Note: Commodity weights may total more than 100% due to rounding

Which Is The Better Diversifier?

The correlation between GSCI and gold is not particularly strong, which reflects the broad-based index's diversity. But over the past three years, gold's correlation to other asset classes has also been low—on average, half that of GSCI's. That makes gold a better portfolio diversifier, at least recently:

Three-Year Correlations

	CMX	GSCI	NAREIT	SPX	MDX	SML	EAFE	EMI	TRS	TIPS
CMX	1.00
GSCI	0.38	1.00
NAREIT	0.10	0.31	1.00
SPX	0.06	0.50	0.83	1.00
MDX	0.09	0.50	0.86	0.96	1.00
SML	0.01	0.39	0.91	0.94	0.96	1.00
EAFE	0.20	0.58	0.76	0.93	0.91	0.85	1.00
EMI	0.29	0.66	0.63	0.85	0.84	0.76	0.94	1.00
TRS	0.27	-0.28	-0.22	-0.29	-0.35	-0.30	-0.27	-0.32	1.00
TIPS	0.54	0.45	0.33	0.36	0.38	0.29	0.40	0.42	0.38	1.00

CMX = COMEX Spot Gold Settlement GSCI = S&P/GSCI NAREIT = FTSE NAREIT Real Estate 50 SPX = S&P 500 MDX = S&P MidCap 400 SML = S&P Small Cap 600 EAFE = MSCI Europe, Australasia & Far East EMI = MSCI Emerging Markets TRS = Lehman Bros. 3-7 Year Treasury TIPS = Barclays Capital Treasury Inflation-Protected Securities

An endowment-style portfolio that allocated 50 percent to equities, 30 percent to fixed income, and 20 percent to real assets such as precious metals, commodities and real estate would have fared better over the past three years if gold were used in the real asset slot rather than GSCI exposure:

Three-Year (October 2006-October 2009) Performance Differential

Asset	Allocation	Asset
CMX	10%	GSCI
NAREIT	10%	NAREIT
SPX	15%	SPX
MDX	5%	MDX
SML	10%	SML
EAFE	15%	EAFE
EMI	5%	EMI
TRS	15%	TRS
TIPS	15%	TIPS
1.0%	Ann. Return	-2.2%
13.4%	Std. Deviation	15.3%

Gold has been a more versatile and reliable portfolio diversifier over the past five- and 10-year periods as well. In each time span, gold's return has been higher and its risk—measured as the standard deviation of returns—has been lower than GSCI's. As a result, gold's reward-to-risk ratio has been consistently higher than GSCI's.

Comparative Rewards And Risks

It's even easier to see the impact of the gold/GSCI selection if we use a simplified three-asset portfolio, one that devotes 50 percent to domestic equities (as represented by the S&P 500 Composite); 40 percent to U.S. fixed income (proxied by the Barclays Capital Aggregate Bond Index) and 10 percent to hard assets, either COMEX gold or GSCI:

Comparative Performance

	3-Year w/CMX	3-Year w/GSCI	5-Year w/CMX	5-year w/GSCI	10-Year w/CMX	10-Year w/GSCI
Ann. Return	1.8%	-1.4%	4.8%	1.8%	4.4%	3.2%
Std. Deviation	9.7%	11.3%	8.5%	9.5%	7.2%	8.3%
Reward-to-Risk	.19	-.12	.57	.19	.61	.38

A Caveat On Gold

With all this in mind, you might be tempted to dump commodities in favor of the yellow metal. Before you do, though, consider this: Our study uses COMEX spot settlements as a proxy for gold's cash price return, while the GSCI tracks a futures portfolio that constantly rolls soon-to-expire contracts forward to maintain the allocations mandated by the index methodology.

That means, at times the futures curve may be in contango, such that near-term contracts are priced below later-dated deliveries. Rolling forward in a contango incurs a cost, as the low-priced contract is sold and the more expensive contract is bought. At other times, however, the market may invert into backwardation, making the nearby contract higher priced. In such circumstances, a forward roll enhances the index portfolio's return.

Over the past decade, GSCI's largest component—crude oil—has seen more contango than backwardation; thus, its return has been whittled away by carrying charges.

On the other hand, there's virtually no carrying charge embedded in the spot COMEX gold settlement price. Holding all else static, whenever the weighty issues in a broad-based commodity index are in contango, spot gold is going to look more attractive.

What's more, gold has been in an uptrend for most of the past decade. After a dramatic decline from its Volcker-era highs, the metal spent a long time in the wilderness. On an absolute price basis, gold took 28 years to break even with its 1980 peak.

Generally speaking, other commodities haven't seen a similar price arc. So if you're going to have gold in your portfolio, you must be prepared for times when the metal is favored—and when it's shunned.

Despite that fact that gold has been a more efficient real asset deployment than a broader-based commodity index like GSCI, it's best to keep in mind the disclaimer long favored by financial advisers: "Past performance doesn't guarantee future results."

Comments

[Carlos Lam:]

Good article, but there is a distinction between gold-backed products (ETFs, futures) and physical gold. The latter poses no counterparty risk and--in times of strife--is a kind of insurance policy: one can buy one's way out of harm by offering gold. Of course, one who holds physical gold must also store the metal, which causes wariness in some quarters.

Nov 15 06:56 AM

[Michael Clark:]

seekingalpha.com/insta...

Get into gold now -- and stay in until about 2019. See the instapost above to find out why.

Get out of gold around 2019. Once the selling start in about 2019, gold will fall again until 2037.

Nov 15 07:12 AM

[Solon:]

Excellent article. I do not see the relevance of the contango and backwardation effect other than to skew; which should be ok, in my opinion.

Nov 15 10:10 AM

[change is t...:]

Brad-

Good article with interesting subtleties. The first being: a) all commodities are not created equal; b) an index's weighting makes a huge difference on return (the dark side of diversification); and c) one commodities' forward looking components (contango) can fund other commodities to be acquired, if the constant belief in a higher price is met with flat or falling demand, and you are on your toes. The last point gets to how to have flat or declining price commodities fund rising ones. This is not stock portfolio diversification, but hard asset diversification and how commodity asset selection can generate an internal rate of return. Entire asset classes should be more predictable than individual companies, as indeed asset classes are usually a proxy to estimate individual company future profitability. Thanks Brad, very, very useful.

Nov 15 10:42 AM

[Thomas Smic...:]

Excellent article. My simplistic thought is that when it seems as though everybody is piling into an investment, including those eeking out an existence living in double-wides selling their gold via mail due to an avalanche of television advertisements, it might not be the most appropriate time to gold-up. Then again, I was thinking the same when gold at $900.

Nov 15 11:00 AM

[bobbybutte:]

Markets swing drastically in BOTh directions as nasdaq 1999 ,housing market 2005 and oil 2008 proved

as a person who has become financially independent solely from allocating capital i can tell you this

What wise peopel do in the beginning,fools do at the end

Gold was a great call in the earlier part of the decade when it is at multiyear lows

Equities that are now the investment which are priced fairly when you combine the reinvested dividends

Multinationals that pay good dividends are a better hedge against the falling dollar then gold

Nov 15 11:15 AM

[Brian McMorris:]

Gold is a poor substitute for other more broadly used / consumed commodities like those listed in this article. Gold has only psychic value and very little productive value. It is almost never destroyed (is hard to destroy), so is available in greater and greater quantities throughout time. Yes, as the world's economies develop, there is increasing demand. But the best that can be achieved is demand equaling supply over a long period of time. Price will only increase proportional to the increase in global wealth. It is best as a currency hedge, but not an investment.

Commodities that are consumed, however, and must be replaced every year, like oil or grain, are truly an investment. Read my post here for more: wealth-ed.com/2009/11/.../

Nov 15 11:45 AM

[MexCom:]

I bought gold coins 3-4 years ago as a curiosity to have a US type set. But to speculate on price advance? Or to stock up because of a future need? Sorry, other than my collector's item I don't even have a gold watch nor desire to ever have one. As for other commodities, I have 2 boxes of Cheerios on the shelf bought on sale but have no desire to speculate on wheat or oats for that matter.

Commodities are a poor investment. For anyone not producing the stuff or buying it as an intermediary in production - it is pure gambling.

Those advising on this speculation are the ones that gain from the enterprise - commissions and management fees. The buyers and sellers are speculating in a zero sum game with the house raking off their percentage.

These contracts and funds are highly leveraged. Small changes in price can result in margin calls on futures with mark to market requirements at the end of each day where extra cash has to be paid at the brokerage cashier window.

Enticing small investors to get involved with this stuff is unethical - it should be regulated that any advertisement saying that this is an investment should be questioned along with the firm quoting same.

Nov 15 12:19 PM

[mark swann:]

Isn't the basis for the rise in gold the prevailing mood/atmosphere of uncertainty? We simply don't know how and when this economic downturn will shake out, we don't know at what cost, we don't how serious the risks of inflation are, etc. Part of this is smoke and mirrors, i.e., we have so much more information than we can assess and the big boys--the financial wizards--so much more power than we low-life can even imagine. But part of it is also massive uncertainty. I hesitate to mention my global warming fears...

Nov 15 01:09 PM

[Carlos Lam:]

On Nov 15 11:00 AM Thomas Smicklas wrote:

> Excellent article. My simplistic thought is that when it seems as
> though everybody is piling into an investment, including those eeking
> out an existence living in double-wides selling their gold via mail
> due to an avalanche of television advertisements, it might not be
> the most appropriate time to gold-up. Then again, I was thinking
> the same when gold at $900.

Think about what you wrote: those who are sending in their gold are essentially going long the USD and shorting gold. The "insiders" of the industry--jewelers--are all going long gold by buying. Which do you think has better information?

Nov 15 07:06 PM

[CLH:]

Stocks down for over 10 years while gold is up. Always buy what is down.

Nov 15 07:15 PM

[The Geoffster:]

I was with you until you revealed your global warming fears, but you get a thumbs up on points. My big fear is that the price of gold collapses before I take my profits.


On Nov 15 01:09 PM mark swann wrote:

> Isn't the basis for the rise in gold the prevailing mood/atmosphere
> of uncertainty? We simply don't know how and when this economic downturn
> will shake out, we don't know at what cost, we don't how serious
> the risks of inflation are, etc. Part of this is smoke and mirrors,
> i.e., we have so much more information than we can assess and the
> big boys--the financial wizards--so much more power than we low-life
> can even imagine. But part of it is also massive uncertainty. I hesitate
> to mention my global warming fears...

Nov 15 08:08 PM

[goodasgold:]

Even if gold may serve this purpose, why rely exclusively on it? Why not choose several other commodities you expect to do well, for example, agriculture and water, and invest there too? Think black swans, grey swans. Isn't diversification a basic principle of risk control. Why imitate investment "professionals" when 99 percent of them lost a lot of money last year?

Nov 15 08:47 PM

[GadflyOnThe...:]

Yes, Thomas, I thought the same thing until I asked myself that if these double-wides thought that gold prices would go higher, why would they sell now? A better indicator is to ask the ordinary man-on-the-street how much gold or gold-related investments they have in their portfolio. Today I am finding very few people have gold (or gold-related) investments in their portfolios. Would this change by the time Michael Clark's forecasted top in 2017? We shall see.


On Nov 15 11:00 AM Thomas Smicklas wrote:

> Excellent article. My simplistic thought is that when it seems as
> though everybody is piling into an investment, including those eeking
> out an existence living in double-wides selling their gold via mail
> due to an avalanche of television advertisements, it might not be
> the most appropriate time to gold-up. Then again, I was thinking
> the same when gold at $900.

Nov 15 09:46 PM

[Blair:]

I look upon holding gold and its derivatives, as a hedge against fiscal and monetary uncertainty.

I don't try to decipher whether we are going to had inflation or deflation. What I do know is that I have no trust in what ever the western governments will do to get our economy going again.

Consequently, my opinion is to buy and hold gold over the long term. I think that the time to get out of gold will be fairly obvious when everyone is going out and buying gold. Just like the 2002, 2007 and 1929 tops.

Nov 16 02:18 AM

[The Recusant:]

To steal from real estate, "allocation, allocation, allocation!" But to better it one more step, "allocation within allocation, within allocation!" Investing in gold will provide safety from the pending inflation peeking around the corner. But how you invest in gold is even more important. Paper bullion, physical bullion, and miners would be a better choice than investing in just one of the three. And to hedge that bet, pick up a good deal of other commodities and foreign currencies as well. You don't want to break all your eggs in a golden basket if it falls.

Nov 16 06:20 PM