Are Gold Stocks Better For Your Portfolio?

September 23, 2010

In a year where the gold price has hit new highs, which has been the better investment: stocks or bullion?

 

Some lucky investors have had a golden touch this year. Literally. It's because they actually touched gold that they became such standout investors. Gold attained new nominal highs this week, making bullion one of the best-performing assets of the year for U.S. dollar investors.

As of Wednesday, gold has notched a better-than-17-percent return compared with the breakeven performance for large-cap stocks reflected by the S&P 500 Composite Index and the 5 percent capital appreciation in the Barclays Capital Aggregate Bond Index.

Bullion isn't without its detractors, however. As gold's price rises, so too does the volume of the ongoing debate between mining stock aficionados and bullion fans. Gold equity advocates point to the leveraged returns obtainable through shares, reveling in the outsized gains earned by gold stock indexes this year. One such benchmark, tracked by the Market Vectors Gold Miners Index ETF (NYSE Arca: GDX), has risen 22 percent year-to-date.

 

Mining Stocks

Mining stocks magnify gold's moves because of the enormous influence the metal's market price has on a company's earnings. Once bullion advances beyond production costs, price changes flow directly to a producer's bottom line.

The names populating GDX's underlying index are some of the world's biggest and best-known producers, such as Barrick Gold Corp. (NYSE: ABX) and Newmont Mining Corp. (NYSE: NEM). Nearly 90 percent of GDX constituents carry a market capitalization of $5 billion or more.

Another index-tracker, the Market Vectors Junior Gold Miners Index ETF (NYSE Arca: GDXJ), mirrors the performance of companies engaged in the exploration and development of mining properties. The appeal of these so-called juniors—or miners with an average market capitalization of $850 million—is their potential for high growth or as acquisition targets. That appeal has translated into a 33 percent gain for the GDXJ portfolio this year.

Taking a stake in the GDX portfolio is akin to buying blue-chip stocks, while the GDXJ portfolio exhibits the risk and reward characteristics of a venture capital investment.

Bullion investors highlight the two-edged nature of leverage as a potential liability. They have a point. Over the past five years, the downside semivariance—volatility's "bad half"—of the Philadelphia Gold-Silver Index has been twice that of London gold fixings.

 

Bullion

Bullion fans also point to the purity of a metals investment. Through direct investment in metal, one can avoid both equity market influence and management risk.

So is the true measure of a gold investment just its return? Its volatility? As a gold investment isn't usually the sole asset in a portfolio, how does it fit in with other components? In short, what's been the better portfolio addition this year, miners or bullion?

To effectively compare the highly tradable stock-based products against bullion, we need to find an equally transparent and liquid proxy for gold. That would have to be the SPDR Gold Shares Trust (NYSE Arca: GLD), the world's largest bullion-backed portfolio. The correlation of GLD's price to that of bullion is better than 99 percent.

 

Side-By-Side Comparisons

Table 1 exhibits the reward-to-risk characteristics of the bullion and stock products. The Sharpe ratio measures the risk-adjusted payback for each product. Because the risk (the volatility) of holding the GLD shares was less than the return realized, the trust's Sharpe ratio is higher than those of the miners' ETFs.

The year-to-date correlations of the gold products to one another and to other representative exchange-traded products are also exhibited in Table 1. The SPDR Trust (NYSE Arca: SPY) is a proxy for the S&P 500 Composite Index, while the iShares Barclays Aggregate Bond Index Fund (NYSE Arca: AGG) stands in for broad-based fixed-income exposure.

 

Table 1 - Year-To-Date (Through Sept. 22, 2010) Performance

 

GLD

GDX

GDXJ

Return

17.60%

21.99%

33.10%

Annualized Volatility

16.51%

31.52%

38.52%

Sharpe Ratio

1.01

0.66

0.81

Correlation: GLD

--

75.18%

72.86%

Correlation: SPY

-2.78%

-0.01%

0.87%

Correlation: AGG

0.03%

-10.12%

-19.91%

 

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