All That’s Gold Does Not Glitter

Abstract

Spurred by economic uncertainty, interest in precious metals has increased dramatically. Investors target precious-metal funds for two primary reasons: (1) to capture an expected appreciation in precious-metal prices and (2) as a form of portfolio insurance. The authors compare the advantages and disadvantages of traditional funds with those of newer types of funds, including bullion, synthetics, and equity. They find tremendous variation in both fund returns and efficacy in serving the two primary investor motivations. Their findings imply that the success of a commodity investment hinges on the type of fund selected.

Disclosure: The authors report no conflicts of interest.

Editor’s Note

This article was externally reviewed using our double-blind peer-review process. When the article was accepted for publication, the authors thanked the reviewers in their acknowledgments. Dirk Baur and Claude Erb, CFA, were the reviewers for this article.

Submitted 31 January 2017

Accepted 14 August 2017 by Stephen J. Brown

Acknowledgment

We thank Dirk Baur, Stephen J. Brown, Claude Erb, CFA, Daniel Giamouridis, Tyler Jensen, and participants at a Creighton University research seminar for their helpful comments and suggestions.

Notes

¹ See Haverkamp (2017). Another example is offered in the “Precious Metals Investment Guide” (www.preciousmetalsinvestmentguide.com):

Precious metals investment is not the holy grail of financial investment, but it does have tremendous potential and adds great value to your financial portfolio and retirement plan if done correctly. That is why I have set up this guide, to help you gather all the information you need to help you make the right decisions when it comes to your precious metals investment. If you look at the performance history of gold and stocks competing against each other, you will see that in the 20th century stocks did perform better than gold.

² See www.regalassets.com/.

³ See www.investopedia.com/terms/p/preciousmetal.asp.

⁴ There are, however, noted skeptics regarding the benefits of holding gold. For example, Erb and Harvey (2013) reported evidence refuting the major rationales for holding gold; Ratner and Klein (2008, p. 86) contended that “the long-term portfolio benefits of holding gold are marginal at best.” And Warren Buffett is an outspoken critic of holding gold.

⁵ Each of the 10 funds has “gold,” “silver,” or “precious metals” in its name.

⁶ The synthetic funds we considered assume a long position in precious-metal futures contracts and require only a small fraction of the contract value to be retained as margin. The other portion of the invested funds is allocated to Treasury securities, which generate interest income. Synthetic funds are popular in Europe, where swaps are used as the underlying derivatives contract.

⁷ We obtained the GC1 data from Bloomberg (which sourced the data from CME Group).

⁸ The United States went off the gold standard in August 1971.

⁹ We reproduce all results using the London Bullion Market (LBMA) and XAU gold indexes as alternatives for the price of gold. To reduce the influence of nonsynchronous trading, we use weekly returns rather than daily returns. The conclusions drawn from using the alternative indexes and periodicities are not materially different from those using GC1 weekly returns. Our results from using the LBMA and XAU indexes and daily data are available upon request.

¹⁰ A synthetic position in precious metals can benefit from three alternative sources: a movement in precious-metal prices, roll yield, and interest on fixed-income securities. According to Dickson, Mance, and Rowley (2013, p. 8), “Investors in synthetic ETFs may be compensated in two main ways: through lower costs (and thus higher relative excess returns) and through lower tracking error.”

¹¹ Gorton and Rouwenhorst (2006) identified several reasons why the returns of gold-mining stocks might not mimic movements in the underlying price of gold: (1) Mining companies mine a variety of metals, (2) mining companies’ costs vary over time, and (3) the financial and operating decisions of management affect company performance.

¹² The index of major currencies includes the currencies of eurozone members, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden. The index of other trading partners includes the currencies of Mexico, China, South Korea, Singapore, Hong Kong, Malaysia, Brazil, Thailand, the Philippines, Taiwan, Indonesia, India, Israel, Saudi Arabia, Russia, Argentina, Venezuela, Chile, and Colombia.

¹³ GMF3 is less focused on precious metals than the other precious-metal funds because it also invests significantly in companies focused on industrial metals. However, “precious metals” appears first in the fund’s name. GMF3’s operations in other metals may account for its hypersensitivity to the stock market because industrial metal prices can increase significantly during economic upturns and likewise fall hard during downturns.

¹⁴ Synthetic funds are structured as partnerships, and their tax treatment depends on the unique circumstances of the partners. The specific tax implications for each fund type are beyond the scope of our analysis.

¹⁵ Bloomberg’s classification category is named “Global Senior Gold Valuation Peers,” which further promotes the supremacy of gold in the precious-metal asset class.

¹⁶ Over the 10-year sample period, the two largest integrated oil companies earned average annual ROEs of 22.11% and 16.02%, respectively. Thus, the relatively strong performance of the oil equity funds is supported by the strong profitability of oil companies, which contrasts sharply with the poor operating performance of gold miners.