Brad Zigler: How Good Is YOUR Hard Asset Investment? Part 2

April 07, 2011


Gold Overlay

Gold Overlay


Adding a 10 percent dollop of gold—or, more properly, carving a 10 percent allocation from our portfolio's fixed-income allocation—didn't change the one-year performance of the portfolio much. That is, the portfolio ended up pretty much in the same place with or without gold—somewhere around a 12 percent compound return.

But it's how the portfolio got there that's telling. Take a look at the volatility endured over the past 12 months.


Gold Overlay With Monthly Rebalancing

Return Volatility Reward-to-Risk Ratio
SPY/AGG 12.7% 16.4% 0.77
SPY/AGG/GLD 13.1% 16.4% 0.80
SPY/AGG/GDX 11.8% 9.8% 1.21
SPY/AGG/GDXJ 13.6% 10.9% 1.25


Bullion exposure provided a barely perceptible yield pickup with no reduction in portfolio risk. Instead, it was the miners that gave our portfolio a goose; in particular, junior miners. Surprisingly, the more volatile stocks provided the greatest risk reduction. That's because the mining stocks provided a more leveraged "zag" to the base portfolio's "zig." The juniors bestowed better diversification over the past year—producing a significant improvement to the portfolio's reward-to-risk ratio.

Now let's see about using oil exposure instead.


Oil Two Ways

It's obviously impractical to hold physical oil as a portfolio asset. But you can gain exposure to crude oil's price through shares of an exchange-traded fund that holds oil futures. The oldest of these is the United States Oil Fund (NYSE Arca: USO), which maintains constant exposure to the front-month NYMEX West Texas Intermediate contract.

Holding a constant long futures position comes with a complication—contango. Contango describes a price structure in which longer-dated futures are more expensive than near-term deliveries. When, for example, May futures trade for $108 a barrel and June sells for $109, we say there's a $1 contango. That extra buck represents the storage, insurance and financing costs to carry the oil cargo for a month until delivery.

For the USO portfolio to maintain constant exposure to the nearby crude oil futures, it must roll its position forward ahead of each contract's expiration. In other words, the soon-to-expire contract must be sold and replaced by purchasing the next-available delivery month. When the market's in contango—as it's been since June 2008—that means selling the low-priced expiring contract and buying the higher-priced near-term one, a cost that effectively reduces the oil return.

To combat contango's effect, the United States 12-Month Oil Fund (NYSE Arca: USL) was launched. Instead of holding just the front-month contract, USL holds a year's worth of deliveries—the spot month and the 11 subsequent months.

You can see the dramatic effect contango would have had on your portfolio if you'd used USO as your hard asset allocation last year.

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