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Take care with precious metals

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Gold has been a byword for trust and value for millennia. For many investors today this still holds true. Unlike in bygone centuries, however, investors now have a great many ways of investing in precious metals. 

Key points

  • Most investors in precious metals do so through funds
  • Such portfolios vary considerably in terms of returns and diversification properties
  • Exchange trade funds (ETFs) in this area can invest directly into bullion, or into synthetic portfolios or into mining stocks
  • Investors into this asset class should carefully consider which vehicle to use

Gold has been a byword for trust and value for millennia. For many investors today this still holds true. Unlike in bygone centuries, however, investors now have a great many ways of investing in precious metals. 

Retail investors do still buy gold bars and bury them in their back gardens, as owners of gold have done over the centuries, but this practice is dying out as more practical investment options have proliferated.   

For the vast majority of investors, allocations to gold and other precious metals will inevitably be made through fund structures. That naturally begs the question of what type of fund to invest in. 

The decision about how to invest in precious metals is as important as whether to invest, argues an article ‘All That’s Gold Does Not Glitter’ published in the Financial Analysts Journal for the first quarter of 2018. It was written by CFA charterholders Gerald R Jensen, and Kenneth M Washer, both of Creighton University, and Robert R Johnson of the American College of Financial Services. The article shows there is a huge dispersion in likely investment outcomes, depending on the vehicle chosen. In other words, the choice of vehicle is critical to investment success. 

the price of gold

Precious metals appeal to investors for two main reasons. One is their potential to rise in value, the other is for their diversification benefits – as a hedge against inflation and currency devaluation, and against economic and market turbulence. 

Once investors have decided to invest for one or other (perhaps both) of these reasons, they seek the best way to maximise the returns or hedges. They have several fund vehicles to choose from. 

They can gain direct exposure to precious-metal prices through bullion exchange-traded funds (ETFs), which own physical bullion. Another possibility is to invest in synthetic ETFs, which take a long position in precious-metal futures contracts. Investors can also gain indirect exposure by investing in precious-metal equity funds or ETFs, which hold stocks in mining companies. 

Treating all these vehicles as interchangeable ways of gaining exposure to gold, say the authors, is a mistake investors will want to avoid.  

By investigating 10 of the most prominent US precious-metal funds, the authors showed there are considerable differences in performance between them. Of the 10, three were bullion ETFs (two gold, one silver), three were synthetic ETFs that aim to mirror the performance of the underlying commodities (one gold, one silver, one mixed), and four equity funds (three mutual funds and one ETF, all investing in gold-mining stocks).

Although the price of gold climbed by 80.6% over the 10-year period of the study, none of the funds was able to match this performance. The best performers were the gold bullion funds, which returned 76.1% and 74.3%. 

“The choice of vehicle is critical to investment success”

Synthetic funds provided positive returns – as high as 55.7% for the gold-only synthetic fund – but this represented significant underperformance against the spot gold price. 

Of most concern to investors is that the performance of the equity funds was extremely poor, with returns from the four equity funds ranging from a fall of 18.2% to a drop of 44.8%. In addition, the equity funds experienced far greater volatility than the bullion and synthetic ETFs. 

Aside from absolute performance, how well do the funds track the spot price of gold? The article found that all the funds – including the silver funds – track the price of gold up and down to some extent. But here, too, there are marked differences: the bullion and synthetic funds are far better at tracking the gold price than the equity funds. And although managers of synthetic funds frequently argue that these funds reduce tracking error relative to bullion funds, the authors did not find this to be true. 

In terms of the diversification benefits of the funds, the authors discovered that all of the funds provided an effective hedge against a declining dollar. Meanwhile, the gold bullion and synthetic ETFs had a low correlation with equities, offering some protection against market volatility and extreme equity market movements. But they were a less effective hedge against inflation. 

But here, again, there is bad news for the equity funds. Although they provide an effective hedge against inflation, they give ineffective protection against volatility, producing their worst performance during dramatically declining markets and their best in an exceptionally strong one. This is not what many investors seeking diversification through precious metals would hope for. 

Although none of the funds are 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.

As the Financial Analysts Journal article shows, it seems clear that different vehicles for investing in precious metals can have strikingly different returns and diversification properties. Investors will want to devote as much thought to how they gain their exposure to precious metals as to their decision to invest in precious metals in the first place. 

The article confirms that equity precious-metal funds can be a poor hedging instrument because they experience the most volatility and do not effectively hedge against extremely negative equity market conditions – which is one of the foremost reasons why many investors seek exposure to precious metals. Equity funds may be most attractive to investors looking to speculate on short-term movements in the price of gold. 

Meanwhile, although synthetic ETFs are often promoted as a design improvement over bullion ETFs, they seem to offer much lower returns without the advantage of reducing tracking error.

Investors may regard these findings as leading to the conclusion that they would be better off buying physical gold and hiding it. The obvious risks of this course of action make it inadvisable, particularly for institutional investors. 

But the findings should, at least, lead to greater consideration and deeper analysis of how to gain exposure to precious metals. 

Ultimately, once investors have decided to get from A to B they need to devote some thought to which vehicle to select for the journey. 

Gary Baker is managing director, EMEA, CFA Institute

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