How gold could replace bonds as a portfolio diversifier

Looking past the precious metal's volatile performance to its lack of correlation with other investments

Sep 11, 2019 @ 2:02 pm

By Jeff Benjamin

Instead of trying to navigate the freewheeling price of gold over various market cycles, financial advisers might be better served by focusing on the precious metal's lack of correlation with other investments.

That's the basic premise of a research report showing that a 5% allocation to gold improves the risk-adjusted performance of a standard portfolio of 60% stocks and 40% bonds.

But for optimal risk-adjusted performance, as measured by the Sharpe ratio, the standard 60-40 portfolio should be set at 60% stocks, 5% bonds and 35% gold, according to GraniteShares' research.

"Adding gold to a portfolio improves the Sharpe ratio, and a 35% allocation is optimal," said Will Rhind, founder and chief executive of GraniteShares, an ETF provider whose funds include the GraniteShares Gold Trust ETF (BAR).

"We're not telling everyone to have 35% gold in their portfolio, we're challenging the groupthink about traditional 60-40 portfolios," he said. "Gold has more value in a portfolio than most people think."

Asked whether the research report favors issuers of gold funds, Mr. Rhind replied, "The outcome is just math."

And it is.

Over the 15-year period through December 2018, a portfolio with a 60% allocation to the S&P 500 Index and a 40% allocation to the Bloomberg Aggregate Bond Index produced a 10% annualized gain with annualized risk of approximately 10.5%.

By reweighting the portfolio to 60% stocks, 25% bonds and 15% gold, the annualized return improves to nearly 11.2% with annualized risk of 11%.

increasing that gold allocation to 35% and trimming bonds to 5% over the same 15-year period generates an annualized return of 12.8% with annualized risk of 12.5%.

When the same analysis was pushed back to the beginning of 2000, it showed that adding an allocation of just 5% gold provided superior or equal risk-adjusted returns to a 60-40 portfolio 79% of the time.

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"People often only think about how something correlates to equities, but you really need to think about how it correlates to everything else in the portfolio," said Ryan Giannotto, director of research at GraniteShares.

"Gold is essentially noncorrelated to all market factors," Mr. Giannotto said, pointing out that over the past 20 years gold has had a 0.007 correlation to equities and a 0.16 correlation to bonds.

For perspective, consider that the historical correlation of utilities to equities is 0.6, and the correlation of real estate to equities is 0.7.

But even as the study makes a compelling case for upping portfolios' allocation to gold, there are some caveats that also deserve attention.

For instance, the price of gold can be volatile; from a low of $250 an ounce in 1999, it spiked up near $1,800 in 2011, dipped to around $1,000 in 2016, and is currently around $1,500.

"Market cycles can be interesting, and I think their research picked a bull-market cycle for gold," said Janet Briaud, founder of Briaud Financial Advisors, which currently has clients 15% allocated to gold.

Even as a fan of gold, Ms. Briaud doesn't believe it is something that should be permanently overweighted in a portfolio.

"There is a season for everything, and correlations change," she said. "It's a safe-haven asset right now because stocks are incredibly overvalued, and bonds have some value if you have some deflation. When people are scared, they tend to go to gold."

Thomas Rindahl, a financial adviser at TruWest Wealth Management, also sees gold as a "price-play asset."

"I don't advise my clients to buy gold," he said. "Unlike bonds bought at a discount, rental real estate or dividend-paying stocks, gold doesn't pay you while you wait for it to appreciate in value."

Excellent points about the risks of betting on the next direction in the price of gold, but the GraniteShares research is about the benefits of gold as a portfolio diversifier.

For example, over the 15-year study period, the four-year period from 2010 to 2013 was the only time when gold negatively impacted the portfolio's Sharpe ratio even though that was a time when gold prices were spiking.

The reason those spiking gold prices hurt the overall risk-adjusted return is because it became more correlated with other assets.

"Gold has an ability to diversify away market risk," said Mr. Giannotto. "It is this zero-correlation feature that may earn gold its place in a portfolio, any price return being very much an ancillary benefit."


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