This In Practice piece gives a practitioner’s perspective on the article “All That’s Gold Does Not Glitter,” by Gerald R. Jensen, CFA, Robert R. Johnson, CFA, and Kenneth M. Washer, CFA, published in the First Quarter 2018 issue of the Financial Analysts Journal.
What’s the Investment Issue?
Precious metals appeal to investors for two main reasons. One reason is their potential to rise in value and earn favorable returns. The other is their diversification benefits—as a hedge against inflation and currency devaluation and against economic and market turbulence.
Investors seeking exposure to this asset class through a fund can choose from a number of vehicles. They can gain direct exposure to precious-metal prices through bullion exchange-traded funds (ETFs), which own—and thus track the price of—physical bullion. Another option is to invest in synthetic ETFs, which assume a long position in precious-metal futures contracts while holding Treasury securities that provide interest income. Investors can also get indirect exposure to movements in prices by investing in precious-metal equity funds, which hold stocks in mining companies. These funds can take the form of either traditional mutual funds or ETFs, which have grown in popularity recently.
Although these vehicles can be markedly different from each other, the authors contend that investors erroneously treat precious metals as a largely homogeneous asset class. Many previous studies, they note, have examined the considerable benefits of investing in precious metals. Their study explores the effectiveness of the available vehicles in implementing a decision to invest in gold.How Do the Authors Tackle the Issue?
The authors choose gold bullion as the benchmark investment for gaining exposure to precious metals, because of both the dominance of gold in the asset class and its high correlation with other precious metals. They set out to investigate 10 of the most prominent US precious-metal funds: three bullion ETFs (two gold, one silver), three synthetic ETFs that aim to mirror the performance of the underlying commodities while earning interest income (one gold, one silver, one mixed), and four equity funds (three mutual funds and one ETF, all investing in gold -mining stocks). There are marked differences in the size of these funds, reflecting their popularity: The two gold bullion funds account for 65% of the market, whereas the three ETFs combined make up just 1%.
They examine these funds over the decade January 2007–December 2016. First, they look at the funds’ overall performance, including the geometric mean weekly return for each fund compared with the returns on gold bullion. The authors consider each fund from a portfolio-hedging perspective, including its effectiveness as a hedge against inflation, currency devaluation, and economic turbulence.What Are the Findings?
Although the price of gold climbs by 80.6% over the 10-year period, the authors find tremendous variation in the performance of the 10 funds they examine. The best performers are gold bullion funds, returning 76.1% and 74.3%, respectively. Synthetic funds underperform their gold counterparts but still offer positive returns—as high as 55.7% for the gold-only synthetic fund. Conversely, all four equity funds are well into negative territory, with returns ranging from –18.2% to –44.8%. In addition, the equity funds experience far greater volatility than the bullion and synthetic ETFs, suggesting that they also subject investors to more risk.
Nonetheless, the authors confirm that all these funds—including the silver funds—effectively track variations in the price of gold. But here too there are marked differences: The bullion and synthetic funds do a much better job of tracking gold than the equity funds. One of the purported advantages of synthetic funds is that they reduce tracking error even further than bullion funds—but the authors determine this does not apply in their sample.
In terms of diversification, the authors discover that all precious-metal funds appear to be an effective hedge against a declining dollar. Moreover, the gold bullion and synthetic ETFs generally have a low correlation with equities, offering some protection against market volatility and extreme equity market movements—though they are a less effective hedge against inflation. But there is more bad news for the equity funds on this front. Although the equity funds hedge well against inflation, they are ineffective protection against volatility, turning in their worst performance in a dramatically declining market and their best in an exceptionally strong one. Although none of the funds are an ideal safe haven during a severe market decline, the gold bullion and synthetic gold funds are far more effective than the silver and equity funds.What Are the Implications for Investors and Investment Professionals?
Different vehicles for investing in precious metals can have strikingly different returns and diversification properties (as well as different tax implications). Investors should give as much thought to the underlying structure of the type of fund they choose as to their decision to invest in the precious-metal class itself.
For example, equity precious-metal funds can be a poor hedging instrument because they experience the most volatility and do not effectively hedge against extremely negative equity market conditions—which is one of the foremost reasons many investors seek exposure to precious metals. Such funds can still attract investors looking to speculate on a short-term increase in the price of gold. Meanwhile, although synthetic ETFs are often promoted as a design improvement over bullion ETFs, they offer considerably lower returns without reducing tracking error.