Are Gold Stocks Better For Your Portfolio?

September 23, 2010

 

Top-line performance—that is, year-to-date returns—have clearly been the junior miners' strong suit this year. Prices for smaller-cap mining issues rose at nearly twice the pace of bullion in 2010. GDX's return, at nearly 22 percent, was closer to the metal's, but its risk—the standard deviation of its daily returns—was just a shade under that of the juniors.

Plainly, exploration and development companies have been riskier than bullion in 2010. The annualized volatility of the juniors was greater than 38 percent vs. GLD's, which was just shy of 18 percent. Because of the miners' close correlation to bullion, however, there isn't any diversification benefit derived from the extra risk. In short, miners don't provide any "zag" beyond gold's "zig."

This becomes readily evident when gold investments are overlaid on a portfolio made up of equal parts large-cap stocks represented by the SPDR Trust and fixed-income securities tracked by the iShares Barclays Capital Aggregate Bond Index Fund. Table 2 shows the performance of constantly rebalanced portfolios using each of the three exchange-traded gold products.

 

 

Table 2 - Year-To-Date (Through Sept. 22, 2010) Performance

Portfolio Equal-Weighted In Stock, Bond And Gold Exposures

(Constant Rebalancing)

 

Portfolio

with GLD

Portfolio

with GDX

Portfolio

with GDXJ

Return

7.57%

6.00%

5.84%

Volatility

8.57%

9.87%

9.74%

Sharpe Ratio

0.83

0.57

0.56

 

 

The outcomes shown in Table 2 may seem counterintuitive at first glance. Despite the greater stand-alone returns obtained by mining share funds this year, the bullion-backed GLD trust provided the best diversification benefit when used as a portfolio component. The benefit derives from GLD's more negative correlation to stocks and the trust's nearly flat correlation to bonds.

Of course, it's not likely that investors would hold such a large exposure to gold. Neither is it likely that portfolios would be constantly rebalanced. A more common allocation to gold would be 5-10 percent. Monthly rebalancing, too, is more than adequate for most portfolios.

When the gold exposure is reduced to 10 percent and the portfolio rebalancing frequency dialed down to monthly, composite returns become nearly identical, no matter what gold investment is selected. The essential difference between the gold products performance as portfolio constituents lies in their volatility effect. Bullion dampened volatility better than either of the miners funds, as reflected in Table 3's Sharpe ratios.

 

Table 3 - Year-To-Date (through Sept. 1, 2010) Performance

Portfolio Weighted 50% In Stocks, 40% In Bonds And 10% In A Gold Exposure

(Monthly Rebalancing)

 

Portfolio

with GLD

Portfolio

with GDX

Portfolio

with GDXJ

Return

6.23%

6.21%

6.07%

Volatility

9.41%

10.48%

11.23%

Sharpe Ratio

0.98

0.88

0.80

 

 

The takeaway from all this is that mining shares, as a class, are clearly more volatile than bullion. Sometimes, their higher risk yields compensatory rewards and sometimes not. There's really no reason to buy mining shares if you can't get a diversification kicker (a higher portfolio return that justifies their higher volatility).

In sum, despite the stellar returns of junior miners in 2010, this has been a "not" year. Gold stocks just haven't paid off as well as bullion when used as a portfolio building block.

 

If you liked this article, then check out:

 

Find your next ETF

Reset All