Jeff Benjamin

Investment Insights: The Blogblog

Jeff Benjamin breaks down the game for advisers and clients.

A 20% allocation to gold? Seriously.

Given the shiny metal's price volatility, a lower exposure makes more sense, detractors say

Aug 21, 2014 @ 11:25 am

By Jeff Benjamin

If history is your guide, the case for owning lots of gold all the time is an easy one to make.

With a 40-year compound annual growth rate of more than 7.5%, gold's long-term performance is second only to equities, at 8.2%.

Jerry Wagner, founder and president of Flexible Plan Investments Ltd., is such a believer in gold that last year he launched the first and only registered mutual fund offering exposure to gold bullion.

Mr. Wagner, who is responsible for nearly $2 billion under management, is now making the bold claim that a 20% allocation to gold is the appropriate exposure for a traditional portfolio of 60% stocks and 40% bonds.

“Over the past 40 years, during periods including seven different types of crisis that investors fear most, gold has been the number one or number two performer, with just a 12% correlation to the S&P 500 Index,” he said. “The optimal allocation to gold over that period would have been 20%.”

(More: Six tried-and-true ways to add gold to your portfolio)

Even hardcore gold bugs are balking at Mr. Wagner's call for such a whopping allocation to the timeless commodity.

(Related: Investors warm to commodities in search for return)

As a hard asset, gold is often used as a hedge against inflation, as a portfolio diversifier, and as a safe haven in times of extreme market risk. But the reason most financial advisers cap allocations to around 5% usually comes down to the simple reality of volatility.

While the price of gold has been on a relatively steady climb since 2000, it has a long and unpredictable history of falling off a cliff and that's the kind of reality that can keep financial advisers and their clients up at night.

Consider, for example, gold's 120% rally in 1979, followed by a 29% gain in 1980. That was followed by a 32% drop in 1981, and after that it took until 2006 for the price of gold to finish a year above the $594 mark it reached at the end of 1980.

“The problem with too much gold is too much volatility, which is something that clients really have a hard time with,” said Janet Briaud, founder and president of Briaud Financial Advisors.

“I started buying gold for my clients around 2003 when the price was around $250 an ounce, and a lot of my colleagues looked at me like I was crazy,” she said.

Ms. Briaud, who typically recommends maintaining a 5% allocation to gold, and has gone as high as 10%, said she thinks 20% is over the top.

“You have gold in a portfolio for times of stress,” she said. “But it is volatile and there's not a decent way to apply a valuation to gold like you would a stock, so you don't really have a clue what it's going to do next.”

And despite that sterling 40-year compound annual growth rate — even at nearly $1,300 an ounce, down from a high of more than $1,800 in 2011 — gold has failed to keep pace with inflation since 1982.

“My overall outlook for gold is bearish, and we have a price target on it of $999 for the year,” said Karyn Cavanaugh, senior market strategist at Voya Financial Inc.

“Gold has obviously had a huge run-up since 2009, but that has been predicated on fear and it's not sustainable,” she added. “We think gold will lose its luster as more people start to realize the U.S. economy is in better shape.”

Don't tell that to Mr. Wagner, because he is banking on gold morphing into the next big portfolio allocation slice, suggesting that the 20% weighting should replace 12 percentage points of equity exposure and eight percentage points of fixed income exposure.

His mutual fund, Gold Bullion Strategy Fund (QGLDX), which maintains a 25% weighting in leveraged gold bullion futures contracts and a 75% allocation to short-term bonds, is designed to track the price of gold, without introducing the tax consequences of a pure commodity fund, or the trading costs of an exchange-traded fund.

In addition to measuring gold's performance during various times of market unrest — including negative Treasury returns, equity bear markets, U.S. dollar bear markets, commodity bull markets, rising rate environments, inflationary cycles, and extreme market volatility — Mr. Wagner also measured gold against multiple economic environments.

In a so-called normal economic period of both increased economic growth and inflation, which is where the economy is three-quarters of the time, gold has generated a 40-year compound annual growth rate of 8.5%, second to stocks at 11.5%.

In periods of stagflation — nearly five of the past 40 years that included periods of declining economic growth coupled with rising inflation — gold was the top annualized performer at 21.7%, followed by Treasuries at 14.3%.

The so-called ideal environment, which happened just 10% of the time when economic growth is rising and inflation is falling, gold's annualized return was 2.5%, lagging way behind stocks at 31.4%, Treasuries at 10.5% and commodities at 3.3%.

And during the rarest scenario of deflation, which happened just 2% of the time and meant the economy growing and inflation falling at the same time, gold declined by 28.6% while Treasuries gained 23.7% and the U.S. dollar rose 20.8%.

“I was as shocked as anyone by the findings, because I always lived under the assumption that you have a 5% allocation to gold, if any at all,” Mr. Wagner said. “But it is all about trying to create portfolios with a chance of surviving the unknowns.”

For now, the biggest unknown is whether advisers are ready to start approaching clients with the idea of building a 20% allocation to gold.

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