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Even if bitcoin ($BTC) is, as some allege, a ponzi or pyramid scheme magnified by behavioral weaknesses and regulatory indifference, the cryptocurrency has performed at least one valuable service: It has challenged the investment world to re-examine what actually qualifies a currency as a store of value.
So for the bitcoin skeptics, what is the best way to hold more traditional stores of value, such as gold?
Precious metals appeal to investors for two main reasons: They have the potential to rise in value and earn favorable returns; and they enhance diversification by hedging against inflation and currency devaluation as well as economic and market turbulence.
In evaluating the options available to investors seeking exposure to gold and precious metals, this In Practice summary gives a practitioner’s perspective on the research article “All That’s Gold Does Not Glitter,” by Gerald R. Jensen, CFA, Robert R. Johnson, CFA, and Kenneth M. Washer, CFA, published recently in the CFA Institute Financial Analysts Journal®.
What’s the investment issue?
Investors seeking exposure to the gold asset class through a fund can choose from a number of vehicles.
- They can gain direct exposure to precious-metal prices through bullion exchange-traded funds (ETFs), which own — and thus track the price of — physical bullion.
- They can invest in synthetic ETFs that assume a long position in precious-metal futures contracts while holding Treasury securities that provide interest income.
- They can gain indirect exposure to movements in prices by investing in precious-metal equity funds that hold stocks in mining companies. These funds can take the form of either traditional mutual funds or increasingly popular ETFs,
Although these vehicles can differ from each other, the authors suggest that investors erroneously treat precious metals as a largely homogeneous asset class.
How do the authors tackle the issue?
The authors choose gold bullion as the benchmark investment for gaining exposure to precious metals because of both the dominance of gold in the asset class and its high correlation with other precious metals.
They set out to investigate 10 of the most prominent US precious-metal funds: three bullion ETFs (two gold, one silver); three synthetic ETFs that aim to mirror the performance of the underlying commodities while earning interest income (one gold, one silver, one mixed); and four equity funds (three mutual funds and one ETF, all investing in gold-mining stocks). There are marked differences in the size of these funds based on their popularity: The two gold bullion funds account for 65% of the market, whereas the three ETFs combined make up just 1%.
The authors examine these funds over the decade between January 2007 and December 2016. First, they look at each fund’s overall performance, including their geometric mean weekly return compared with that of gold bullion. They consider each fund from a portfolio-hedging perspective, including their effectiveness as a hedge against inflation, currency devaluation, and economic turbulence.
What are the findings?
Although the price of gold climbed by 80.6% over the 10-year period, the authors find tremendous variation in the performance of the 10 funds they examined. The best performers were gold bullion funds, returning 76.1% and 74.3%, respectively.
Nonetheless, the authors confirm that all these funds — including the silver funds — effectively track variations in the price of gold. But here, too, there are marked differences: The bullion and synthetic funds do a much better job of tracking gold than the equity funds.
In terms of diversification, the authors discover that all precious-metal funds appear to be an effective hedge against a declining dollar. Moreover, the gold bullion and synthetic ETFs generally have a low correlation with equities, offering some protection against market volatility and extreme equity market movements — though they are a less effective hedge against inflation. Although none of the funds is an ideal safe haven during a severe market decline, the gold bullion and synthetic gold funds are far more effective than the silver and equity funds.
What are the implications for investors and investment professionals?
Different vehicles for investing in precious metals can have strikingly different returns and diversification properties, as well as different tax implications. Investors should give as much thought to the underlying structure of the type of fund they choose as to their decision to invest in the precious-metal class itself.
For example, equity precious-metal funds can be poor hedging instruments because they experience the most volatility and do not effectively hedge against extremely negative equity market conditions — one of the foremost reasons why many investors seek exposure to precious metals. Such funds can still attract investors looking to speculate on a short-term increase in the price of gold.
Meanwhile, although synthetic ETFs are often promoted as a design improvement over bullion ETFs, they offer considerably lower returns without reducing tracking error.
This article is an In Practice summary of “All That’s Gold Does Not Glitter,” by Gerald R. Jensen, CFA, Robert R. Johnson, CFA, and Kenneth M. Washer, CFA, from the CFA Institute Financial Analysts Journal®.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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