The Economic Case For Gold In Your Portfolio

Dec. 06, 2011 8:36 AM ETGLD, UUP, SPY, VGK5 Comments
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By Emil Emilov

Market volatility and turbulent times always seem to cause people to turn away from the traditional asset classes in search for a better return and protection. Gold is often cited as a good means of portfolio protection as well as a hedge against inflation and currency depreciation. However, the flight to quality that drives up the price of gold should not influence investors to jump into the asset without sound reasoning.

Demand for Gold

Trade demand – mostly from the jewelry industry and as a raw material in some advanced industries like electronics and medical appliances. Jewelry demand tends to fluctuate with the price of gold, increasing during times of price stability and decreasing when prices become volatile.

Investment demand for gold as purely investment motive such as to hedge against possible inflation or currency depreciation in order to protect the purchasing power of one's currency. An investment in gold could also be made because of expectations that the demand for it will outpace its supply for the investment horizon time.

Supply of Gold

Mining production – characterized by being inelastic mostly due to the long time needed for a mine to become operational (about 10 years). Supply over the last few years has largely been to replace older mine production, so overall supply has been flat.

Recycled gold – supply of recycled gold depends strongly on price. Supply from recycled gold helps stabilize price volatility as it is more cyclical in nature and does not have the long time lags associated with mine production. For the years 2005 – 2009 recycled gold contributed to about 32% of the supply.

Central banks and other multinational institutions hold about 1/5 of the available above-earth stocks of gold. Since 1989 they have been a net seller of gold, but during recent years there is a slowdown noticed in their speed of supplying gold. Most nations have maintained their holdings fairly consistently. Germany sold 0.02% of its stock and IMF sold 1.82%. Russia increased its stock by about 10.7% while Mexico made the biggest change by increasing the country's gold stock by about 1290%.

Purchasing power protection

Gold plays relatively successfully its role as a protection of the value of money. In an inflationary environment its price usually rises due to some of the above mentioned demand factors, namely the jewelry demand. The more the investment interest in gold increases the bigger its influence in an inflation environment would be.

Gold's price in local currencies also depends on the exchange rate of that local currency, mostly to the US dollar. Historical data from 2000 till now show that gold's price has a significant negative correlation to the exchange rate of the US dollar measured towards major currencies, i.e. when the dollar appreciates, the gold price falls. This means that gold practically gives a nice option to protect the dollar's purchasing power against depreciation toward other currencies. Some of those correlation coefficients are presented in the following table:

We see that for investors from different countries gold offers different levels of probable protection against depreciation. It is bigger when gold is priced in US dollars and Japanese yen, while when it is priced in euro or pound it is smaller. For US investors who would like to protect their dollars, gold generally could offer a better protection against depreciation toward the yen or the Swiss franc than toward the euro or the pound.

Risk-Adjusted Portfolio Returns

Another, and even maybe a more important reason for having gold in an investment portfolio, is its ability to lower the overall variance of the portfolio and thus to reduce the portfolio risk and increase risk-adjusted returns. This function of gold is based on its current negative correlations with some major stock markets as well as to the price of US dollar. Modern portfolio theory (MPT) tells us that adding an asset to a portfolio which has a negative or close to zero correlation with the other assets in the portfolio leads to an overall decrease of the portfolio risk. In the current globalized world with equity markets, which are strongly positively correlated with each other, adding such an asset is of utmost importance.

As an example let's examine two hypothetical portfolios. The first one has three assets – SPDR S&P 500 (SPY), European ETF (VGK), DB USD Index Bullish (UUP) and the second one consists of the same three plus SPDR Gold Trust Profile (GLD).

SPY tracks the S&P 500 index. The index measures the performance of the large capitalization companies in the US and is often regarded as representative of the country's equity market. The fund has a very low expense ratio of .09%.

VGK tracks the MSCI Europe index which consists of companies from 16 European countries. The fund's exposure to Europe is 97.4% so effectively it tracks the developed European market. It has about 2% invested in other parts of the world and about 0.4% in cash. The countries with the largest weight in the index are the United Kingdom, France, Switzerland, and Germany. The fund has an expense ratio of .14%.

UUP tries to replicate the performance of being long in the US dollar against six major currencies – euro, Japanese yen, British pound, Canadian dollar, Swedish Krona and Swiss franc. Its expense ratio is .50%. UUP is included in the portfolio to represent the movement of the US dollar against other currencies and to show how its performance, be it appreciation or depreciation could affect the portfolio's characteristics.

GLD tracks the spot price of the gold bullion. The fund's inception date is November 18, 2004 and has an expense ratio of .40%. The fund is 100% invested in physical gold bullion. The correlation coefficient between the GLD and the gold price in US dollars is 1.

The correlation matrix of these for the last 4 years follows. The period is chosen of such length so as to include full years of performance of the funds. The main reason is the little time the DB USD Index Bullish fund has had since its inception.

We can see from the matrix that GLD has a significant negative correlation with UUP which is in line with the possibility of a hedge against a depreciation of the US dollar. GLD has lower but still negative correlations with SPY and VGK. We also see that both equity markets show a strong positive correlation.

Concerning the returns, the annualized return for the last four years is SPY (-4.2%), UUP (-1.9%), VGK (-13.4%), GLD (21.8%). It is interesting to note that there are no significant differences in the annualized standard deviation between the ETFs for the period - SPY (20.39%), UUP (11.14%), VGK (27.75%), GLD (21.58%).

The following table shows how the addition of GLD to the portfolio changes its annualized volatility.

A bias problem might seem to be present in the particular period examined above because of the macro- and microeconomic events that took place during those years. So in order to remove this possible bias we could extend the period to ten years back. We should change the included assets as not all of the funds were available back then, including GLD. The changes include replacing UUP, VGK and GLD with USDEUR exchange rate, the German DAX index and the spot gold price in US dollars.

The 10 years correlation coefficients follow:

The most notable change from the more recent period is that during the last ten years the gold price shows a positive correlation with both the American and the German equity markets. It still has a relatively smaller correlation to the US market than to the German one.

The annualized return for the last ten years is SPY (1.7%), USDEUR (-4.2%), DAX (3.0%), gold $/oz (20.0%). The annualized standard deviation for the period has changed also a bit and generally become smaller - SPY (16.4%), USDEUR (10.98%), DAX (23.34%), gold $/oz (17.68%).

The following table shows how adding gold to a portfolio might change its characteristics if we extend the data to ten years back.

Comparing both the longer and the shorter periods we see that annualized returns change but such a change seems normal having in mind the strong decline of equity markets during the last 4 years. There is a significant change in the correlations between gold and equity assets seen which could mean the gold could not have such positive effect on a portfolio risk during times of growth. Having the negative correlation between gold price and equity markets during the current turbulent times, however, presents an opportunity to lower the overall variance of a portfolio together with taking part of a possible higher return.

Those are three of the premises currently making gold an attractive addition to an investment portfolio. In a more confident rising mood of the equity markets maybe some of the appealing characteristics of gold would change (like lowering the negative correlation between gold price and equity markets), but for the moment they are present and could be used.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Efficient Alpha provides written content & investment research solutions for small and medium-sized advisor firms. Our core products include: financial newsletters, blogging, presentation preparation, investment research and ghost writing. Our normal clientele are small to medium-sized firms with research, analysis, or marketing needs but whom may have insufficient staff or topic expertise. Joseph Hogue, founder and analyst, has more than ten years in the investment industry and holds the Chartered Financial Analyst designation. His experience covers a wide range of investment related areas but he specializes in web & social media content for financial advisors and other professionals. His work has been published by the International Economic Development Council, Alternative Latin Investor, Emerging Money, Morningstar, and the financial website Seeking Alpha. Mr. Hogue is also the administrator for the FinQuiz Blog, an online source for CFA exam preparation advice and preparation. Working from Medellin, Colombia, he has worked for clients ranging from individual investors to large multinational firms. Prior to his work as a financial writer, Mr. Hogue worked as an economist for the State of Iowa, as a consultant on trade issues and analyzed real estate development deals in Colombia. A veteran of the United States Marine Corps, Mr. Hogue is a graduate of Iowa State University with a B.S. in Finance, a B.A. in Communications, and a Master’s in Business Administration. He is the former Communications Chair on the board of directors for the CFA Society of Iowa. Areas of Interest: · Financial Blogging and Social Media Content · Equity Research and Analysis · Strategic Asset Allocation & Portfolio Planning
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