Over the years, we’ve occasionally been asked for our opinion on commodities as an investment. After all, commodities, or so-called real or hard assets, are often cited for their potential diversification merit, as well as a means of preserving asset values in periods of rising inflation. Nonetheless, unlike core asset classes—namely, stocks, bonds, and cash—commodities continue to provoke widely divergent views, even among expert investors, as to their usefulness in a portfolio allocation. And at least to date, we have not been convinced that long-term investors need to own them, at least on a direct basis. (However, our clients generally own commodities indirectly through commodity producers, such as energy and mining companies, represented in broad-based index funds.)
We thought it would be worthwhile to provide some historical data to support our rationale. For the purposes of this newsletter, however, we’re going to focus on a single commodity—gold—since it’s the one we’ve been asked about most. There are, of course, numerous other types of commodities that can be harnessed through an increasing number of investment vehicles, and we hope to cover these in a future missive.
What’s Its Expected Return, If It Has No Intrinsic Value?
To cut to the chase, our biggest philosophical challenge with gold, and with commodities in general, is that we prefer to invest in assets that generate cash flow and therefore, by definition, are anchored by some underlying basis of fundamental intrinsic value.1 Stocks are valued on corporate cash flow/earnings, bonds have a definable yield based on interest payments, and real estate generates rental income. Commodities, on the other hand, do not provide any cash flow, in the form of a right to future earnings or a promise of repayment at a later date. Their only source of return is price appreciation or depreciation, caused by shifting supply and demand, which is ultimately speculative. Or as Warren Buffett, who has repeatedly professed his own preference for cash-generating assets, more eloquently stated:
The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you . . . it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.2
Is Gold a Reliable Inflation Hedge?
Some investors perceive gold as a good hedge against inflation and, at least through 2011, had pointed to its record high price as evidence (gold prices have since retreated from their 2011 peak by nearly 40%). But what does the long-term evidence actually suggest?
The chart below shows historical gold performance in nominal (gold line) and real (i.e., inflation-adjusted) terms (black line). It bears mentioning that until the 1970s, when the United States left the gold standard, the market price for gold generally matched the “official” price set by the U.S. government. Furthermore, it wasn’t until 1975 that U.S. citizens were free to directly own monetary gold, after it was outlawed during the Great Depression.
As far as inflation is concerned, while gold’s price recently climbed to record highs in nominal terms, its 2011 peak was still essentially on par with the prior peak reached 30 years earlier, when adjusted for inflation. Moreover, even though gold’s price in real terms dropped materially from its 1980 peak until its trough in 2001, inflation (represented by the bars in the bottom section of the chart) continued to increase. Indeed, even over a much longer period, from 1970 through 2005, consumer prices more than doubled, while gold lost 20% of its value!
The bottom line is that despite many investors’ perception that gold is a good hedge against inflation, there’s little if any evidence to support it being a reliable hedge over most investors’ time horizon.3
Does Gold Make Your Portfolio “Safer”?
Proponents also claim that because gold has a low historical correlation with stocks,4 it can provide some stability during times of duress. But correlation is only one factor to consider in building portfolios; volatility is equally important (as is expected return, discussed earlier).
This chart plots the range of annual nominal returns of stocks, U.S. Treasury bonds, U.S. Treasury bills, and gold from 1926 through 2013. As you can see, clearly gold has experienced a much higher variability of returns than Treasury bonds and bills. In fact, since 1968, gold’s standard deviation—a measure of volatility—has exceeded that of stocks at 20% vs. 16%,5 but more importantly, this volatility came without the benefit of the same returns stocks have provided over time. Perhaps most telling, since the United States abandoned the gold standard in the 1970s, gold has barely even outperformed T-bills.6
Moreover, during the most recent crisis, rather than provide a ballast to portfolios, gold prices fell nearly 30% from peak to trough in 2008.7 U.S. Treasuries (along with other high-quality fixed-income instruments, such as FDIC-insured CDs) were among the few asset classes that provided some cover. Further calling into doubt gold’s perception as a steadfast safe haven, an oft-cited extensive research study found that, over the last three decades, when financial markets suffered their worst returns, gold’s performance was more or less evenly divided between gains and losses.8
Still Want Gold?
For those of you who still feel a need for direct gold exposure in your portfolios, we are the first to recognize that “past performance is no guarantee of future results.” To accommodate a modest exposure for those who absolutely insist, we use exchange-traded products—an efficient and increasingly common means of attaining such exposure. (As our clients know, we have long supported the use of exchange-traded funds, or ETFs, for core, broad-based equities exposure.) Just as an example, the oldest and largest exchange-traded product that invests in gold is State Street Advisors’ SPDR® Gold Trust (ticker: GLD). Each share of GLD represents a proportional interest in physical gold bullion held in a vault at HSBC Bank in London. GLD is structured as a grantor trust, which is typically used by exchange-traded products that invest solely in physical commodities or currencies. Most equity (stock) ETFs, on the other hand, are open-end funds. There are operational and regulatory differences between the two structures, but we’ll spare you these fine details.
That said, before investing in GLD, or a similar exchange-traded grantor trust tracking precious metals, there are a few important nuances to consider. First, since the trust generates no income (again, gold has no “yield”), the operating expenses, borne proportionally by all shareholders, need to be paid by regularly liquidating gold held in the trust. In the case of GLD, given its 0.40% annual expense ratio, this means selling 0.40% of its assets each year. As stated in GLD’s prospectus, “assuming a constant gold price, the trading price of the shares is expected to gradually decline relative to the price of gold as the amount of gold represented by the shares gradually declines.”
Second, unlike the 20% maximum capital gains tax rate on equity ETFs held for more than a year (or 15% for those below the 39.6% federal income tax bracket), investors must be mindful that gold—and silver—investments, including the exchange-traded products that hold them directly, are taxed at the higher collectibles capital gains rate of 28%.9 Thus, these vehicles are best suited to tax-sheltered portfolios.
In sum, please note that we are not gold “bears” (if that’s the appropriate antonym for “bugs”). After all, we are located in the Bay Area—just a nugget’s throw away from Gold Country!
In all seriousness, though, we are ultimately mindful that one’s portfolio has only so much allocation shelf space. When all is said and done, our job is to increase the probability of a successful financial outcome for our clients. As such, we are of the firm belief that each component of a portfolio—aside from providing a potential diversification benefit—should have an expected return. While the prices of commodities, such as gold, fluctuate over time, there’s no economic reason to expect them to be worth more tomorrow than they are today. Given our evidence-based investment philosophy and discipline, we prefer to stick with assets that have a more reliable, long-term record of stacking the financial odds in our clients’ favor.
1.Intrinsic value is defined as the present value of all expected future net cash flows and is calculated using a discounted cash flow valuation.
2. CNBC interview, July, 8, 2011.
3.For additional perspective on various asset classes and inflation, we refer you to our April 2010 newsletter entitled “Inflation Deliberations.”
4. Correlation measures how closely two securities or asset groups perform relative to each other over a given time period.
5. Vanguard calculations, using data from Thomson Reuters for gold prices and the performance of the Standard & Poor’s 500 Index.
6.From 1976 to 2013, annualized compound returns were as follows: gold 5.9%, stocks 11.5%, 10-year bonds 7.6%, 3-month T-bills 5.0%.
7. World Gold Council.
8. Claude B. Erb and Harvey R. Campbell, “The Golden Dilemma,” Financial Analysts Journal, Volume 69, Number 4, 2013.
9.Note that these capital gains tax rates do not take into account the additional 3.8% Net Investment Income (so-called “Medicare”) tax for those at higher income tax brackets.