Isn't That Precious?

February 28, 2006

Are precious metal equities worth the bother? Swedroe examines the data.

Precious metals equities (PME) are the stocks of companies that mine gold, silver, and platinum. The spectacular returns of 2001-03, when PME stocks returned 40.2, 64.4, and 65.4 percent, respectively, led investors to ask: Should I consider including PME in my equity allocation? In order to answer that question we need to consider the same three important questions that should be considered when deciding on any investment:

  • How risky is the asset class?
  • What is the expected return of the asset class?
  • What is the correlation of that asset class to the rest of the assets in the portfolio -- how does its inclusion impact the overall risk of the portfolio?

Risk: PME are equities and as such are exposed to the risks of equity investing. We should thus expect that PME should provide similar returns to equities. Unfortunately, they have provided returns below those of the overall equity market.

Returns: While the data is not as robust as it is for other asset classes, we do have some information that is useful. Based on a return series provided by Global Financial Data, William Bernstein estimated that for the fifty-five-year period 1942-1996, the return to PME was about 9.5 percent.1 During the same time period the S&P 500 Index returned 14.0 percent. We also have data on PME from the Fama-French returns series. For the period July 1963-2004, PME returned 8.0 percent. For the same period the S&P 500 returned 10.7 percent.

 We can also examine data for Vanguard's Precious Metals and Mining Fund. From its inception on May 23, 1984 through December 2005, the fund returned 7.5 percent. For the period June 1, 1984 through December 2005 the S&P 500 returned 13.1 percent. 

We need to also consider the correlation of PME to the other assets in a portfolio.

Correlations: On this front there is some good news. A study by Ibbotson Associates, covering the period 1970-2004, found that "hard assets," such as precious metals and natural resource equities, had low correlations to both U.S. equities (0.34 for small caps and 0.29 for large caps) and international equities (0.36).2 In addition, hard assets were negatively correlated to intermediate term bonds (-0.25) and positively correlated with inflation (0.22). These are positive attributes.

Hedging Value of PME

It is important to note that, on occasion, PME has provided ballast to a portfolio-acting like a good anchor in a storm, keeping the ship safe in the harbor. While providing, on average, some protection against the risks of equities (though on a very inconsistent basis), PME has provided an especially good hedge against poor bond performance. This can be seen in the following tables.

Years of Negative Returns of Long-Term Government Bonds (1970-2005)

Year

Return of Long-Term Government Bonds (%)

Return of Precious Metals Equities (%)

1973

-1.1

+51.5

1977

-0.7

-2.5

1978

-1.2

+5.2

1979

-1.2

+122.4

1980

-4.0

+52.3

1987

-2.7

+76.5

1994

-7.8

-20.6

1996

-0.9

+3.3

1999

-9.0

+6.2

Average Return

-3.2

+32.7

Note that in only one year (1994) of the nine in which bonds provided negative returns did PME suffered more than a very minor loss.

Years of Negative Returns of the S&P 500 Index (1970-2005)

Year

Return of S&P 500 Index (%)

Return of Precious Metals Equities (%)

1973

-14.7

+51.5

1974

-26.5

-22.3

1977

  -7.2

-2.5

1981

  -4.9

-29.5

1990

  -3.2

-19.6

2000

  -9.1

-33.7

2001

-11.9

+40.2

2002

-22.1

+64.4

Average Return

-12.5

+6.1

The hedge against equity risks is not nearly as strong. While PME did, on average, rise 6 percent during the eight negative years for stocks, they actually rose in just three of those years. In addition, they suffered severe losses in four of those years (one-half the time). Even worse is that in three of those four years PME holdings would have exacerbated the damage done to portfolios from equity holdings.

Positive Attributes of PME

There are two other possible reasons why investors might want to consider including a small allocation to PME in their portfolio. First, PME does provide a good hedge against inflation (and thus the risk of owning longer-term bonds). During inflationary periods "hard assets," such as precious metals and real estate, tend to perform well. For investors for whom inflation is a great risk (e.g., retirees), an allocation to PME, or other hard assets (i.e., commodities) is worth considering.

Second, the low correlation of PME to other portfolio assets, along with its high volatility, means that if one has the discipline to rebalance their portfolio on a regular basis, the return contribution of PME to the total return of the portfolio will be larger (perhaps far larger) than its weighted average return-there could be a large rebalancing (diversification) bonus. Bill Bernstein, in an article in his on-line Efficient Frontier, estimates that the rebalancing bonus might be as large as 5 percent.3

Other Considerations

There are three other major issues that we need to consider regarding PME. The first two are psychological ones. And, unfortunately, the role that emotions play in determining the ultimate returns of a portfolio is great. First, PME is a highly volatile asset class, often experiencing severe drops. For example, in the forty-three calendar years from 1963 through 2005, the PME index fell more than 20 percent seven times, more than 25 percent four times, and more than 30 percent three times. If we were to look at twelve-month periods, instead of calendar years, the losses were much more severe.

Second, because of its nature as a "safe harbor" investment, PME tends to experience very long periods of very low returns (during periods of economic and political stability) and very short periods (in crises) of very high returns. (Of course, it is in periods of crises that investors most need those high returns.) For example, for the twelve-year period 1981-92, the return of PME was just -1.3 percent annualized versus 14.7 percent for the S&P 500. An even more dramatic example is that between October 1980 and August 1998, the PME index  lost almost 54 percent of its value, a -4.2 percent per annum return, and an inflation-adjusted loss of 7.7 per annum. And, for the more than 24 years between October 1980 and December 2004, the real return of PME was -0.3 percent.Investors that had the patience to stay the course for over twenty years, buying more PME along the way in order to keep the portfolio's asset allocation in balance, were ultimately rewarded with the large gains of 2001-03. Therefore, an investor must have both great discipline and a strong stomach, staying the course for a decade, or even perhaps decades, in order to reap the benefits of patience. Know thyself is a very important tenet of successful investing.

The third important consideration has to do with implementation. Unfortunately there are no passively managed or index funds available for investors to choose for a PME allocation. This presents four significant problems. First, since we know that the average actively managed equity funds underperforms its benchmark by almost 2 percent per annum on a pretax basis, investors are not likely to be fully rewarded for the risks of investing in PME. The Vanguard Precious Metals and Mining Fund should perform better than the average actively managed fund because its expense ratio is well below average-an almost index-like 0.48 percent. The problem is that the operating expense ratio is not the only expense of active funds-trading costs must also be considered. The second problem is that actively managed funds are highly likely to prove to be less tax efficient than passively managed ones. The third problem is that there are very few stocks in this asset class. In most years, the Fama-French series on PME contains as few as ten to fifteen stocks. Thus it is hard to diversify the unsystematic, and thus uncompensated, risk of owning the individual stocks. Other asset classes typically contain hundreds, if not thousands, of individual stocks. The fourth problem is perhaps the greatest. In order to address the issue of the large cash inflows it received (likely due to investors chasing the very high returns of 2001-03), the Vanguard Precious Metals Fund closed in February 2003. In order to accommodate demand and reopen the fund, Vanguard allowed the fund to expand its mandate to include non-precious metals. There were just not enough stocks to buy, without creating large market impact costs while keeping the percentage holdings in any one company to an acceptable level. Thus, the fund's name was changed to Precious Metals and Mining. The fund now not only invests in companies that are engaged in activities related to gold, silver, and platinum, but also in companies that are engaged in activities related to diamonds, nickel, copper, zinc, and other base or common metals or minerals. The fund has changed its nature, and the historical data we rely on to make decisions is no longer of much, if any, value.  (As of February 2, 2006, Vanguard once again closed the fund to new investors.)    

To summarize, while the historic risk and reward profile of PME is not attractive on a stand-alone basis, its low correlation to both domestic and international equities, and to intermediate bonds as well, makes it at least worthy of consideration. This is especially true for investors for whom the risk of inflation is an important consideration. The problem is that there is not a truly effective way to invest in the asset class. Thus, all things considered, there is not a compelling reason to include PME in a well-diversified portfolio. On the other hand, if you are attracted by the diversification benefits PME can provide, and have a great deal of patience and discipline, you might consider a small allocation, perhaps 5 percent, to Vanguard's fund-should it reopen to new investors (see Appendix for alternatives). 

Conclusion

For investors seeking the diversification attributes of PME, PIMCO's Commodity Real Return Strategy Fund is a better alternative than a precious metals or precious metals and mining fund. Commodities, because they have negative correlation to both stocks and bonds, have provided just as an effective a hedge against the risks of bonds, but a superior hedge against the risks of stocks. This can be seen in the following data:·       

  • In the nine years from 1970-2005, when bonds had negative returns, PME rose in seven of the nine and provided an average return of 32.7 percent. For those same nine years commodities rose every year, with an average return of +29.5 percent.·       
  • In the eight years from 1970-2005, when the S&P 500 had negative returns, on average PME rose 6.1 percent, but managed to provide positive returns in just three of the eight years. Commodities, on the other hand, rose in six of the eight years, providing an average return of +22.6 percent.  

The one issue that might lead one to prefer PME is that commodities, because the returns are received in a tax inefficient manner, should be held in a tax-advantaged account. Investors that do not have room in a tax-advantaged account to accommodate a position in commodities might consider holding the Vanguard PME fund in a taxable account (assuming it reopens to new investors).        

Appendix

While strategies themselves have no costs, implementing them does. In order to access the PME asset class, the best alternative is the Vanguard Precious Metals and Mining Fund, with its reasonable expense ratio of 0.48 percent. For the twenty-year period 1986-2005, the fund returned 10.6 percent. During the same period, the S&P 500 returned 11.9 percent. However, the fund did provide a diversification benefit as can be seen in the fund's very low correlation (0.2) to the S&P 500. Since the Vanguard fund is closed as of this writing, investors need to seek other alternatives. The only other diversified PME fund with at least ten-year track record and an expense ratio of less than 1 percent is the Franklin Gold and Precious Metals Fund. For the same period, the class A shares of the fund, which has an expense ratio of 0.96 and carries a load of 5.75 percent, returned just 9.3 percent (versus 10.6 for the Vanguard fund) and had the same low 0.2 correlation to the S&P 500 as did the Vanguard fund. 

In addition to these diversified funds, there are two PME funds that limit their exposure to PME to only gold producers. There are two such funds that meet the dual criteria of having at least a ten-year track record and an expense ratio of less than 1 percent. The American Century Global Gold Fund has an expense ratio of 0.68 percent. For the period September 1988 (inception)-December 2005, the fund returned just 3.8 percent. During the same period, the S&P 500 rose 11.9 percent. The fund did have a very low correlation (0.1) to the S&P 500, thus offering some diversification benefit. The other fund is Fidelity's Select Gold, with an expense ratio of 0.89 percent. For the twenty-year period ending December 2005, it returned 7.9 percent versus a return of 11.9 percent for the S&P 500. The low correlation of just 0.2 percent also demonstrates a diversification benefit.

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1.      William Bernstein, "What is the Expected Return of Precious Metals Equity? Part II," The Efficient Frontier, October 1997.

2.      Gary Baierl, Robert Cummisford, Mark W. Riepe, and updated by James St. Aubin, "Investing in Global Hard Assets." 

3.      William Bernstein, "The Longest Discipline," The Efficient Frontier, December 2005.

William Bernstein, "The Expected Return of Precious Metals Equity," The Efficient Frontier, January 1997.

 

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