Last year was a terrible year for gold, with bullion plunging 28%, the worst yearly showing since 1981. Gold stocks did even worse with the Market Vectors Gold Miners ETF (NYSEARCA:GDX) plummeting more than 52%. This was definitely not the type of performance you wanted in your retirement account. However, I must confess that I like to maintain a small investment in precious metal products to provide diversification and add "zing" to my mostly conservative risk-adverse portfolio. If you decide to invest in this asset class, the question is: what are the "best" stocks or funds to purchase?
There are many ways to define "best." Some investors may use total return as a metric but as a retiree, risk is as important to me as return. Therefore, I define "best" as the asset that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define "best"; I am just saying that this is the definition that works for me.
Therefore, to assess how gold and other precious metals investments fared over the recent past, I analyzed several precious metal ETFs, Closed End Funds, and stocks to determine their risk-versus-reward profile. The securities that I analyzed are listed below. This is not a complete list of potential precious metal investments but I believe it provides a reasonable overview of this asset class.
- SPDR Gold Shares (NYSEARCA:GLD). This is the largest and most liquid bullion ETF. Each share is worth about one-tenth of an ounce of gold. The gold backing this ETF is held in the London vaults of HSBC Bank USA. In terms of taxes, owning shares of GLD is treated the same as physically owning the metal. If you sell within a year, the gains are taxed as ordinary income. If held more than a year, the gains are taxed at a special collectible rate (currently 28%). Please see your accountant for details. The fund has an expense ratio of 0.4% and provides no yield.
Over the recent past, the price performance of GLD is shown in Figure 1. As is evident from the figure, GLD bottomed in October of 2008, and then had a tremendous bull run until September 2011. From September 2011 to the present, gold has been in a vicious bear market.
Figure 1: Chart of GLD over bull-bear cycle
- Market Vectors Gold Miners. This ETF tracks the NYSE Arca Gold Miners Index that includes U.S. gold mining companies, weighted by market cap. The index also includes a few silver miners. The top three holdings are Barrick Gold (NYSE:ABX) at 14%, Goldcorp (NYSE:GG) at 13% and Newmont Mining (NYSE:NEM) at 8%. Over 80% of the stocks are domiciled in North America. The fund has an expense ratio of 0.5% and yields 0.9%.
- iShares Silver Trust (NYSEARCA:SLV). This ETF does not track an index but instead holds physical silver in vaults in London and New York. The Net Asset Value (NAV) represents one ounce of silver, less the fund's expenses of 0.5%.
- Agnico-Eagle Mines (NYSE:AEM). Agnico-Eagle is a Canadian gold firm that owns 7 mines in Canada, northern Finland, and northern Mexico. The company produced over a million ounces of gold and 4.6 million ounces of silver in 2013 and expects to increase production in 2014 by about 5.7%. The all-in sustaining cost for gold is $1,025 per ounce. The company pays a relatively high dividend of 3.4%.
- AngloGold Ashanti (NYSE:AU). This company is the largest gold producer in Africa and the third largest in the world. It is headquartered in Johannesburg, South Africa and has 23 operations in 11 countries (7 of the countries are in Africa, 1 in North America, 2 in South America, and 1 in Australia). It produced almost 4 million ounces last year and has an all-in sustaining cost for gold of $1155 per ounce. It has a dividend yield of 1.7%.
- Barrick Gold. Barrick is the world's largest gold producer. This company produces around 7 million ounces of gold per year and over 500 million pounds of copper from mines on 4 continents. It has proven and probable reserves of 140 million ounces of gold, 1.05 billion ounces of silver, and 13.9 billion pounds of copper. Barrick has been aggressively cutting costs and has an all-in sustaining cost for gold of only $919 per ounce. Barrick has suspended development of the Pascua-Lama project, in the high mountains on the border between Chile and Argentina, due to Chile's environmental concerns. If completed, Pascua-Lama has the potential of being one of the world's largest gold and silver mines, with nearly 18 million ounces of gold and 676 million ounces of silver. The resolution of the environmental issues could have a large impact on Barrick's performance. Barrick yields 2.6%.
- Goldcorp. Goldcorp is one of the world's largest gold producers with mines primarily in North and South America. It produced 2.67 million ounces of gold in 2013 but is on track to produce 4 million ounces by 2016. The company has proven and probable reserves of 67.1 million ounces. Goldcorp is a low cost producer with all-in sustaining costs for gold between $950 and $1000 per ounce. Silver production is forecast to be between 22 and 25 million ounces in 2014. Goldcorp has a yield of 2.4%.
- Kinross Gold (NYSE:KGC). Kinross produces 2.6 million equivalent ounces of gold per year from mines in the United States, Canada, Russia, and various countries in South American and West Africa. Estimated proven and probable reserves are 59.6 million ounces of gold, 68.2 million ounces of silver, and 1.4 billion pounds of copper. The all-in sustaining cost for gold is about $1,045 per ounce. The yield is 1.8%.
- Newmont Mining. Newmont produced 5.1 ounces of gold and 144 million pounds of copper last year. The company operates mines in 7 countries in North America, South America, Asia/Pacific, and Africa. Proven and probable reserves are estimated at 99.2 million ounces of gold and 9.5 billion pounds of copper. The all-in sustaining cost for gold is between $1100 and $1200 per ounce. Newmont pays an exceptionally high 5.7% yield.
- Pan American Silver (NASDAQ:PAAS). Pan American is the second largest primary silver miner in the world. The company has 7 operating mines in Mexico, Peru, Argentina and Brazil and has four additional mines in development. In 2013, the company produced 19.2 million ounces of silver and has proven and probable reserves of 316 million ounces. The all-in sustaining cost for silver has been significantly reduced to about $16 per ounce (down from $24 per ounce in 2012). The company yields 4%.
- ASA Gold (NYSE:ASA). This is a closed end fund ((NYSEMKT:CEF)) that invests in shares of companies engaged in exploration, mining, and processing of precious metals. The fund sells at a discount of 5%. The portfolio has 36 holdings with 84% in gold equities and 14% in other natural resource companies. About 46% of the portfolio is invested in Canadian companies, 19% in U.S. companies, and 12% in South African firms. About 6% of the portfolio is invested in platinum equities. The fund does not use leverage and has an expense ratio of 0.8%. The distribution rate is 1.4%.
- Central Fund of Canada. This closed end fund invests in both gold (56%) and silver (43%) bullion. The fund currently sells at a 6% discount, which is below the 52-week average discount of 3%. During a gold bull market, this fund might sell at a premium of 10% to 15%. This fund does not use leverage and has an expense ratio of 0.3%. It does not have a significant distribution. Beware that this fund is domiciled in Canada and if held in a taxable account, the tax computations may be complex.
To determine which of the precious metal investments were "best," it seemed reasonable to analyze data over a complete market cycle. As shown in Figure 1, gold bottomed on 10/24/2008 and then had an extended bull run to make a top on 9/2/2011. From September 2011 to the present, gold has been in a protracted bear market. Therefore, for the bull-bear cycle I used data from 10/24/2008 to the present and plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility. The Smartfolio 3 program was used to generate the plot shown in Figure 2.
Figure 2. Risk vs. reward over the bull-bear cycle
As is evident from the figure, there was a relatively large range of returns and volatilities. For example, PAAS 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 2, I plotted a red line that represents the Sharpe Ratio associated with GLD (representing gold bullion). 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 the S&P 500. Similarly, I plotted a blue line that represents the Sharpe Ratio associated with GDX (representing a collection of gold miners). For reference, I also included the SPDR S&P 500 ETF (NYSEARCA:SPY) to see how the volatility of precious metal investments compared with the general stock market.
Some interesting observations are apparent from Figure 2. First off, over the period of interest, gold bullion had about the same volatility as the overall stock market. This was somewhat surprising since gold is usually considered a very volatile asset class. However, all the other precious metal investments lived up to their reputation and booked volatilities significantly greater than the general market. A second observation is that although silver bullion is much more volatile than gold, SLV is on the "red line" so the risk-adjusted return is the same as gold. Thus, silver investors have been adequately compensated for the added risk.
The blue line represents the Sharpe Ratio for gold mining stocks, as represented by GDX. All the stock related investments had much higher volatilities than bullion and investors were not adequately compensated for the increased list. However, if you wanted to invest in equities, Goldcorp had the best risk-adjusted return. Three investments, Agnico-Eagle Mines, Pan American Silver, and ASA Gold, had about the same risk-adjusted return as GDX. All the other stocks had significantly poorer risk adjusted performance. KGC was by far the worst performer, generating only a small return with high volatility.
The next part of my analysis was to assess how much diversification gold provides. 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. Therefore, I calculated the pair-wise correlations associated with bullion, stocks, and SPY. The results are shown in Figure 3.
Figure 3. Correlation matrix over bull-bear cycle
Gold bullion provided excellent diversification, being only 15% correlated with S&P 500 stocks. Silver bullion and gold stocks also provided good diversification with correlations of 30% and 40% respectively. I was a little surprised to see that gold mining stocks were only moderately correlated with the price of bullion, with a correlation of 77%. The price of silver bullion was about 80% correlated with gold bullion. In summary, this matrix verifies the common belief that precious metals do provide diversification to an equities portfolio.
If you are one of the people that believe that gold may have bottomed, you might be interested in seeing how gold investments performed relative to one another in the last bull market (10/24/2008 to 9/2/2011). The results are shown in Figure 4. As you would expect, all the investments had excellent returns. Gold and silver bullion led the way in terms of risk-adjusted returns. CEF had a return between gold and silver but was more volatile than pure bullion, likely because it is a closed end fund that can sell at either a discount or premium. Interestingly, GDX was the best stock investment, with ASA following very close behind on a risk-adjusted basis. All the gold and silver stocks were tightly bunched, with GG having the best risk-adjusted performance but other mining companies such as NEM, ABX, and AU were not far behind. KGC continued to be a laggard. PAAS had the highest volatility but did not provide a commensurate return so the risk-adjusted performance was relatively poor.
Figure 4. Risk vs. reward in a bull market
My next analysis was to see how these precious metal investments performed in a bear market, so I used data from 9/2/2011 to the present. The results are shown in Figure 5. As you would expect, all the returns are negative. Unfortunately, the Sharpe Ratio is not a good metric for negative returns so it is more challenging to rank the investments. However, some investments are clearly better than others. For example, it is clear that gold bullion performed the best since it had the best return and lowest volatility. CEF was superior to ASA since CEF had a better return with the same volatility as ASA. Similarly, ASA had better performance than GDX (maybe because ASA is actively managed and GDX is passive). Precise comparisons among the gold stock investment are difficult. However, generally you can see that GG had relatively good performance among the gold miners and KGC had the worst. Also, as you would anticipate, gold stocks were significantly more volatile than the bullion.
Figure 5. Risk vs. reward in a bear market
So which are the "best" gold investments? Based on past performance, over the long run, encompassing both bull and bear markets, the winner is GLD. If you would rather invest in a precious metal stock fund, GDX is likely the best (but ASA is not far behind and did better in the bear market). In terms of a gold mining stock, I like GG on a risk-adjusted basis.
No one knows what the future will hold but if you want to diversify your portfolio, these precious metal investments are worth your consideration. But keep in mind that these investments are not for the faint hearted and you might be in for a wild ride.