Potential benefits of a precious metals allocation
Posted on: 08/10/2016
Precious metals such as gold, silver, platinum, and palladium have grown in prominence in recent years as viable investment alternatives to include in asset allocations. Despite being one of the oldest financial instruments, however, precious metals largely remain an underutilized and overlooked investment option for many investors’ portfolios. This may present an opportunity for many to further diversify and benefit from the distinct investment characteristics precious metals have historically offered within an asset allocation.
Furthermore, the performance of individual precious metals varies over time with no one metal continuously leading the others. A diversified basket of precious metals tends to perform more consistently versus any single metal and creates an exposure to both the cyclical and non-cyclical drivers of gold, silver, platinum, and palladium as a whole. A basket offers further opportunities to benefit from diversification advantages of an asset class while maintaining the unique qualities inherent to the individual precious metals.
A key benefit from investing in precious metals lies within its distinct role as a risk management tool. Precious metals wear many hats on the risk management front and thereby serve as a dynamic and multi-faceted hedge against many forms of risk. They also have a track record of protecting investor portfolios against severe market drawdowns. This role as a risk management tool is especially useful for long term investors seeking to continually hedge against a broad spectrum of both known and unknown risks.
Precious metals have historically shown low correlations with most asset classes, particularly equities. Over the past 20 years, precious metals have carried lower correlations to both US and global equities than other alternative investments (see Exhibit 1). The source of this low correlation lies within the diverse sources of demand across gold, silver, platinum, and palladium. Pro-cyclical sources of demand (jewelry, consumer, and industrial applications) increase as growth and incomes increase along with the economy.
Exhibit 1: Precious metals historically have a low correlation relative to equity markets
Counter-cyclical sources of demand, primarily investment demand, pick up during economic slowdowns and market pullbacks as interest in stores of value and defensive assets increases. These pro-cyclical and counter-cyclical sources occur at different times and result in low overall correlations to the broader market and economic cycle. As a result, precious metals can act as effective diversifiers against traditional risk assets, particularly equities. By holding precious metals, investors can help diversify against their equity exposure.
This attribute is even more critical because diversification has become more challenging to achieve following the 2008 financial crisis. Correlations across alternative investments rose dramatically in 2008 compared to the preceding period from 1996 to 2007. Following 2008, however, several alternative investments’ correlations and equity exposure to global equities remain elevated compared to their pre-crisis levels, particularly commodities and REITs. Meanwhile, precious metals remain an exception – further highlighting their effectiveness as a true alternative investment.
Precious metals also remain resilient during extreme events and market turmoil. This can be seen in their relative performance against global equities during several key events of market uncertainty in recent decades (see Exhibit 2). A precious metals basket performs admirably (posting positive returns) during these periods of heightened turmoil and volatility where global equities have shown negative returns and large drawdowns.
During these events, global equities experience large sell offs in response to investors seeking to reduce exposure to risk assets and seek more stable, defensive investments in an environment of rising fear and uncertainty. This performance showcases precious metals’ ability to help protect against downside risks and its chief role as a risk management tool for investors to manage their equity exposure within portfolios.
It is evident that precious metals are distinct and effective diversifiers, but the true benefit of a precious metal allocation emerges when they are added to a diversified portfolio allocation. By adding precious metals to a diversified stock-bond portfolio, the portfolio efficiency can increase – whereby the portfolio risk is lowered while the portfolio return remains the same or increases – compared to diversified portfolio without an allocation to precious metals.
This principle can be illustrated using a precious metals basket and a fixed 60% stock and 40% bond allocation (60/40), which is typically referenced as a default proxy for a diversified portfolio of a balanced or moderate risk profile. Starting with the example of a 60/40 allocation without any precious metals in the portfolio, it is observed that the total portfolio return since is 3.9% annualized and the total portfolio volatility is 9.5%. Subtracting the return on the 3 Month US Treasury Bill (a proxy for a “risk-free asset”) from the portfolio return and dividing by volatility yields a risk-adjusted return metric (the Sharpe ratio) for the 60/40 portfolio of 0.22. This ratio can be increased by adding a precious metals basket allocation under different scenarios and weights. A 5% precious metals allocation funded by reducing the equity allocation from 60% to 55% yields a drop in portfolio volatility to 9.0%, the portfolio return increasing slightly to 4.2%, and the Sharpe ratio rising to 0.26 from 0.22 (see Table 1). Additionally, the annualized return and Sharpe ratio increased to 4.4% and 0.29 respectively, while the volatility dropped to 8.7% for a 10% precious metals allocation. These results reflect the efficiency and effectiveness of precious metals as a diversifying asset against equity risk. As the allocation to stocks was lowered in the portfolio and replaced with precious metals, the portfolio became more efficient over the long run. The realized benefits of incorporating precious metals into an allocation, however, are not limited by only reducing stocks.
This same principle can be applied by replacing both stocks and bonds in a portfolio to fund an addition of precious metals. Turning to an example whereby the 60/40 portfolio is reduced proportionately (“pro-rated”) between stocks and bonds (maintaining a 60/40 ratio between stocks and bonds) to allocate to precious metals, the portfolio still experiences an increase in efficiency. A 10% allocation to precious metals with 90% allocated to a 60/40 split of stocks and bonds, sees portfolio volatility fall to 9.3% compared to 9.5% for a portfolio holding no precious metals. Additionally, the Sharpe ratio increases to 0.26 as the portfolio return increased slightly and as the portfolio risk fell by adding precious metals to the mix.
Given that precious metals demonstrate a low correlation to equities, the diversification benefits are larger by sourcing precious metals in a portfolio from the stock allocation. The increase in efficiency, however, occurs under both funding scenarios because precious metals also carry a low correlation historically to bonds. Also as more complex asset allocations with more asset classes apply this principle, further portfolio efficiencies can be captured since the largest contributor to volatility is equity risk and many risk assets have high factor sensitivities to equity markets.
This highlights that regardless of whether precious metals are added by reducing only stocks or both stocks and bonds the result is a more efficient asset allocation. As this simple example illustrates portfolios can better manage risk and return levels by having an active allocation to precious metals. While the proper weighting will vary depending on investors’ different risk profiles and investment objects, a zero percent allocation to precious metals remains sub-optimal.
Table 1: Precious metals help increase portfolio efficiency
Precious metals are not the only asset class that can increase portfolio efficiency. Bonds and cash historically have provided similar properties and remain attractive from a diversification standpoint. Interest rates globally, however, are widely expected to trend higher over the long term to offset a 30 year cycle of falling interest rates and rising fixed income values. This will put downward pressure on bond valuations and make holding them less attractive to investors to meet their investment objectives. Moreover, low and negative interest rate policies by central banks globally have pushed yields on cash to negative on a real basis. Given this outlook, precious metals may offer an additional option to incorporate with other asset classes to effectively manage asset allocations and portfolio exposures.
Past performance is no guarantee of future results.
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