Retirement pick: Gold and the long-term investor

Market Realist

The place for gold in a long-term investor’s portfolio

There is often a debate among academics, financial gurus, asset managers, and advisors as to the place for non-traditional assets in a portfolio. By “non-traditional,” we mean anything other than stocks and bonds. Commodities, real estate, currencies, and other asset classes were historically held by high–net worth investors, but typically shunned by those that influence retirement investors. This trend began to change after the dot com bust and the increased prevalence of Exchange Traded Funds (ETFs). As Federal Reserve monetary policy became looser and looser, gold, via the $38 billion SPDR Gold Trust ETF (GLD), became the tool of choice for managers looking to hedge portfolios against inflationary and global macro-economic headwinds. When gold came crashing down from its high trading price near $1,900 in the summer of 2011, to $1,200 earlier this year (a more than 35% peak-to-trough drop), many managers began to question the value of holding GLD for retirement clients long-term.

 

We feel the best way to analyze this issue is to examine the dynamics of a portfolio that holds GLD versus a portfolio that doesn’t. In our example, we start with the simplest of portfolios, a five security 60/40 ETF portfolio made up of the SPDR S&P 500 ETF (SPY), the iShares Russell 1000 Value ETF (IWD), the iShares Russell 2000 Index ETF (IWM), the iShares MSCI EAFE Index ETF (EFA), and the Vanguard Total Bond Market ETF (BND), as shown in the chart below.

Security Name

Symbol

Weight

SPDR S&P 500 ETF

SPY

25%

iShares Russell 1000 Value ETF

IWD

10%

iShares Russell 2000 Index ETF

IWM

10%

iShares MSCI EAFE Index ETF

EFA

15%

Vanguard Total Bond Market ETF

BND

40%

 

At Hedgeable, we measure the dynamics of portfolio composition through a proprietary measurement called the Hedgeable Diversification Score. We use this score when structuring portfolios, as it measures how much portfolio downside risk has been reduced by holding various asset classes and securities in a portfolio. If you think about it, what’s the point of holding a diversified portfolio if you can’t do this? This is the thinking behind those that believe the best way to invest is to simply hold a single market ETF, such as the Vanguard Total Stock Market ETF (VTI). To best examine the effects GLD has, let’s run our analysis on a portfolio that has swapped 10% of our bond exposure for a 10% exposure to GLD, as shown in the chart below.

 

Security Name

Symbol

Weight

SPDR S&P 500 ETF

SPY

25%

iShares Russell 1000 Value ETF

IWD

10%

iShares Russell 2000 Index ETF

IWM

10%

iShares MSCI EAFE Index ETF

EFA

15%

Vanguard Total Bond Market ETF

BND

30%

SPDR Gold Trust ETF

GLD

10%

Now let’s run our analysis to see the diversification score of the new portfolio.

 

A score greater than 100 means the portfolio is better diversified. A score less than 100 means it is less diversified. Given our score of 114, what does this imply? Adjusted for overall risk, this new portfolio allocation that includes GLD has reduced the negative effects of security correlation 14% more than the 60/40 portfolio. In the long term, this reduced correlation will benefit the new portfolio during high-risk periods. Let’s go through the key takeaways that we can derive from this score.

1.  Gold can reduce portfolio risk

The overall downside risk of a portfolio is lowered when GLD is included. A portfolio containing multiple securities will never have total risk that is greater than the sum of the individual risks of the component securities. This is because the correlation of securities in a portfolio can never be more than 100%. Simply swapping out 10% of our bond exposure for 10% exposure to GLD, we have reduced portfolio risk by 14%.

2.   Nobody can forecast gold’s price movements

Yet that might be a good thing if held in a portfolio. Securities tend to move and drift together—what is mathematically known as “correlation.” Typically, when risky assets such as equities go down, you don’t even have to check Yahoo Finance. It stands to reason that other risky assets are lower as well. But that is not the case with gold. There is no statistical relationship between gold movements and equity prices. It is just as likely that gold will go up as down when equities sell off.

3.  Maximum portfolio losses can be lowered with GLD

Even though gold is by its nature a more volatile asset than bonds, by swapping out a small amount of bonds for gold, there is a tangible reduction in potential long-term portfolio losses. This is because gold has slightly better diversification benefits when paired with equities, as compared to bonds. Simply put, on days when equities and bonds are lower, there is a chance that gold may actually be higher. Therefore the potential losses are decreased even though gold is a more volatile security on its own.

The bottom line is this: if a portfolio manager is serious about increasing portfolio diversification, GLD can be a powerful tool in a long-term investor’s portfolio. This is one of the reasons why we hold GLD in many retirement client portfolios and why we believe many portfolio managers should view the recent market correction as potentially a good entry point into the asset class for the long term.

The Market Realist Take

Gold has historically been a safe-haven asset during periods of economic and political uncertainty. It has been considered a hedge against inflation, fluctuations in currency, and low interest rates. The Federal Reserve’s (Fed’s) Quantitative Easing (or QE) program led to a boost in gold prices, which reached record levels in 2011. The metal has, however, seen its fortunes wane since the start of 2013 in light of news of the Fed tapering its bond buying program. Plus, with the rise in global stocks this year, investors have rotated out of gold and into equities. Although gold prices have been volatile in the recent past, it seems to be somehow closely tied to the US monetary policy and the dollar. In the beginning of October, gold prices were supported on concerns that the 16-day shutdown would affect the US economic recovery, and therefore the Fed would delay its tapering program until at least the beginning of 2014. On October 22, the metal gained after a weaker US jobs report. The Bureau of Labor Statistics said only 148,000 jobs were added in September—lower than the 180,000 expected. The unemployment rate was down, from 7.3% to 7.2%.

Meanwhile, gold ETF outflows seemed to have accelerated in October after remaining unchanged in August and September, according to recent Barclays Research data. Global holdings in exchange-traded products have declined to around 2,027 metric tonnes, around the low from May 2010, compared to the record of 2,768.16 tonnes at the start of the year. Despite these reports, industry experts and analysts are upbeat about the metal’s prospects for the long term, as they don’t expect the Fed tapering to happen soon. This optimism is also supported by inflation, concerns about rising US debt, and continuing currency depreciation. So it’s necessary to include gold funds in a portfolio, namely the SPDR Gold Shares (GLD), iShares Gold Trust (IAU), and PowerShares DB Gold Fund (DGL).

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