Nothing's simple anymore. Remember the time when an entire portfolio allocation could be summed up as simply “60/40?”
With the ascendency of endowment-style investing and the proliferation of exchange-traded products that slice, dice, cut and carve the investment universe into ever-thinner segments, portfolio mixes can get pretty complex nowadays.
Part of the blame, of course, can be laid upon the doorstep of the Harvard and Yale endowments whose market-trouncing returns so fascinated retail investors. (See Registered Rep. “Illiquidity Is Beautiful For Some,” July 2007, and “Is The Bloom Off The Ivies?” December 2009). The endowments' use of alternative investments that produced equity-sized returns without equity-sensitive risk inspired investors and their advisors to mimic the Ivy League portfolios with newer-generation exchange-traded products.
A lot of head-scratching ensued, however, when investors considered the “real assets” allocation of the endowment portfolios. A chunk of that is typically committed to commodity futures. The beauty of commodity futures is their relatively low correlation to stocks and fixed-income assets. A dollop of futures can bestow a “zag” to traditional assets' “zig” and thus reduce overall volatility.
A commodity index, however, is populated with a diverse mix of futures — each with its unique fundamentals and seasonal variations. Take the roster that makes up the S&P/GSCI (formerly the Goldman Sachs Commodity Index) for example. GSCI is a production-weighted index comprised of two dozen commodity futures traded in New York, Chicago and London. Among them is gold — a middling component of the index — accounting for three percent of the benchmark's weight. (See Table 1.)
Someone concerned with portfolio efficiency might well ask if the roster could be cut down to a smaller number of futures. Ideally, a single commodity — say, gold — might provide the desired diversification benefit for the portfolio. After all, if commodities' essential utility as an inflation hedge is what's sought, isn't gold the “hedgiest?”
The Barbarous Diversifier
Let's compare the diversification benefits of gold — expressed through the daily settlement price of COMEX futures — to those of GSCI to find out.
As it turns out, the correlation between GSCI and gold isn't particularly strong. To boot, gold's correlation to other asset classes has also been lower — by about a third — than that of GSCI over the past three years. That's made gold a better portfolio diversifier, (See Table 2).
A diversified endowment-style portfolio allocating 20 percent to real assets such as precious metals, commodities and real estate, 50 percent to equities and 30 percent to fixed income, would have fared better over the past three years if gold was used in the real asset slot rather than broad-based commodity exposure. (See Table 3.)
Gold has been a more versatile and reliable portfolio diversifier over the past five- and ten-year periods as well. In each time span, gold's return has been higher and its risk — measured as the standard deviation of returns — has been lower than GSCI's. As a result, gold's reward-to-risk ratio has been consistently higher than GSCI's. (See Table 4.)
It's even easier to see the impact of the gold/GSCI selection (Table 5) if we use a simplified three-asset portfolio, one that devotes 50 percent to domestic equities (as represented by the S&P 500 Composite); 40 percent to U.S. fixed income (the Barclays Capital Aggregate Bond Index as a proxy) and 10 percent to hard assets, either COMEX gold or GSCI.
With all this in mind, you might be tempted to foreswear commodities in favor of the yellow metal. Before you do, though, consider this: Our study uses COMEX spot settlements as a proxy for gold's cash price return. The GSCI tracks a futures portfolio that's constantly rolling soon-to-expire contracts forward to maintain the allocations mandated by the index methodology. At times, the futures curve may be in contango, meaning near-term contracts are priced below later-dated deliveries. Rolling a long position forward in a contango incurs a cost as the low-priced contract is sold and the more expensive deferred contract is bought. At other times, the market may invert, making the nearby contract higher priced. In such circumstances, a forward roll provides an enhancement to the index portfolio's return. Over the past decade, there's been more contango than backwardation in GSCI's largest component, crude oil. GSCI's return has thus been whittled away by carrying charges.
There's virtually no carrying charge embedded in the spot COMEX gold settlement price. Holding all else static, whenever the weighty issues in a broad-based commodity index are in contango, spot gold is going to look more attractive.
Generally speaking, other commodities haven't seen the price arc scribed by gold. Partly, that's due to the topography of our financial landscape. With banks largely disintermediated now, there's been a decline in monetary velocity and in supply despite central bank efforts to kick-start lending. Excess industrial capacity, debt-shy consumers, and sluggish credit markets, have forced money flows into alternative assets such as commodities. It's been these flows — a form of monetary inflation — that have buoyed commodity prices in recent cycles. Likewise, whenever monetary inflation wanes, commodity prices weaken. (You can follow the daily ebb and flow of monetary inflation at www.hardassetsinvestor.com/brads-desktop.html.) If a hedge against monetary inflation is sought, a long position in monetary, or precious metals, makes more sense than an exposure comprised of base metals and agricultural commodities.
But if you're going to have gold in a portfolio, you're going to have to be prepared for the times when the metal's shunned. Gold's been in an uptrend for most of the past decade. Beforehand, though, the metal spent a long time in the wilderness. After a decline from its Volker-era peak, gold took 28 years to break even with its 1980 dollar price.
In the end, gold has been a more efficient real asset deployment than a broader-based commodity index like GSCI recently, but it's best to keep in mind the disclaimer long favored by financial advisors: “Past performance doesn't guarantee future results.”