Got exposure to gold? One of the attractive diversification features of gold within a portfolio includes its low correlation to stocks, especially during time
From jewelry to gold mining stocks and even futures, the yellow metal commands a special allure in the world of investment.
Today, jewelry, investment, and central bank purchases comprise the three major demand drivers for the precious metal. Beyond that, it turns out, holding between 2% to 10% of your portfolio in gold over the long run may improve its performance, according to research from the World Gold Council. "One of the most important attributes that gold has is that it helps investors manage risk more effectively," says Juan Carlos Artigas, director for investment research at the World Gold Council.
Why? Gold helps manage risk and volatility through diversification. It has a low correlation to key asset classes, and it can help protect portfolio losses in times of market stress, as it acts as a high-quality and tail risk hedge, the World Gold Council says.
"Whether investors are based in the U.S., the U.K., continental Europe, or Japan, adding 2% to 10% in gold provides benefits that may not be easily replicated by a combination of traditional assets and commodities. In particular, our research shows that a 5% to 6% allocation to gold is ‘optimal’ for investors with a well-balanced medium-risk portfolio (a 60/40 portfolio allocation in equities, cash and bonds). When a portfolio also includes real estate, private equity and hedge funds, the optimal allocation for gold is closer to 4% in a medium-risk portfolio," according to a World Gold Council report. See figure 1.
FIGURE 1: DIVERSIFYING WITH GOLD.
Sample allocation of gold to a portfolio of alternatives, equities, cash, and bonds. Source: World Gold Council. For illustrative purposes only. Past performance does not guarantee future results.
An attractive diversification feature of gold within a portfolio is its (normally) low correlation to stocks, especially during times of heightened stock market stress. Gold may be considered a different animal and "behave differently" from other asset classes in part because of the dual nature of the yellow metal: it’s a luxury and consumption good as well as an investment vehicle and store of value.
The long-term correlation from 1975 to 2015 between gold and the S&P 500 is 0.006 or 0.6%, Artigas says. The result is that "historically, gold has reduced portfolio volatility."
This is where it gets really interesting. "If a pullback is really strong in the stock market, you are more likely to see a significant reaction upward in the price of gold. When the S&P 500 falls by more than 4.4% in a week, this is equivalent to falling by more than two standard deviations; the correlation between stocks and gold drops to -0.15 or -15%," Artigas noted.
Wind the clock back just a few months to the beginning of 2016 for an example of the gold/stock market relationship. While the S&P 500 tumbled 5.5% lower through February 29, gold stocks (a subsector of materials in the S&P 500) surged 43.6% in the same time period, according to data from S&P Global Market Intelligence.
Traders looking to add exposure to gold have several options. We’ll address three ways of gaining exposure including stocks of gold mining companies, funds, and futures.
Investing in stocks of companies that mine gold and other metals is one way of gaining exposure to gold. But this isn’t a direct way of gaining exposure to gold because there are a number of variables that factor into the pricing of gold mining stocks. These factors might include input costs like crude oil, management effectiveness, debt, interest rates, and other risks associated with the gold mining business. One way to spread these risks across a number of stocks is by investing in a fund that holds many gold mining stocks. And although a fund may spread the risk across many stocks, it doesn’t eliminate the risks.
Another way to gain exposure to gold is by investing in a fund that holds physical gold. These funds are a direct way to gain exposure to gold. Funds that hold physical gold offer a few benefits beyond holding physical gold like bars or coins. Funds typically offer more liquidity and lower transaction costs via tighter bid/ask spreads when compared to buying and selling physical gold. However, gold funds can pose unique risks and this is why it’s very important to read a fund’s prospectus and understand the risks before investing.
A third way to gain exposure to gold is in the futures market. Gold futures trade around the clock, following the ebbs and flows of the market from China and India to London and New York. However, gold futures involve a large degree of leverage. This can make gold futures risky and it’s imperative to study the characteristics of gold futures before investing.
"When investors are looking to protect wealth, gold is one of the vehicles they use to achieve this. When it comes to managing risk, gold offers investors true diversification. Gold has a low correlation to stocks, and not only in periods of expansion, but even more so in periods of recession," Artigas concludes.
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