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Gold vs. Commodities: Portfolio Allocation

Gold or commodities – which allocation best helps your investment portfolio...?

GOLD or COMMODITIES...? There was a time, not so very long ago, when portfolio allocation was a much simpler affair, writes Brad Zigler for Hard Assets Investor.

Financial advisers used to recommend a basic "60/40" portfolio: Allocate 60% of your money to stocks, and put the other 40% in fixed-income securities – meaning corporate or Treasury bonds.

You might tweak your investment portfolio allocation around the edges a little, allowing for a cash hoard or a dollop of Gold, but that was about as fancy as investment management advice ever got.

Recently, as exchange-traded products (such as the Gold ETFs and commodity-tracking funds) have proliferated – either carving markets into thinner and thinner subslices or opening up previously inaccessible asset classes – portfolio allocation has gotten more complex.

Further spurring investors to rethink their portfolio asset allocations are growing inflation concerns, as well as the sterling investment results obtained by the Yale and Harvard endowment funds. The two universities, operating with a very "long-term" horizon, use alternative investments to slice, dice and rejigger portfolio risk. Portfolio allocation has been critical to their success.

However, private investors hoping to mimic these endowment portfolios are often left scratching their heads when they consider the so-called "real assets" allocations. Specifically, some investors have begun pondering the utility of replacing their Gold allocation with the broader-based commodity exposure favored by institutional portfolios.

From an efficiency standpoint, the question basically boils down to this: Can exposure to a single commodity – say, gold – provide the desired diversification benefit? Or must a full basket of commodity futures be employed in your allocations?

Take the roster that makes up the S&P/GSCI Commodity Index (formerly the Goldman Sachs Commodity Index). GSCI is a production-weighted index comprising two dozen commodity futures traded in New York, Chicago and London. US crude oil contracts get the greatest weighting (39.5%). The European benchmark – Brent crude – accounts for a further 13.6%.

The first non-energy input is corn, in at No.7, with a 3.4% weighting. Gold is a middle-size component of the index, accounting for nearly 3% of the benchmark's weight. Feeder cattle, lead, silver, cocoa bring up the rear of the 24-item list, each getting a weighting of 0.5% or below.

Using the GSCI as a good (and commonly used) proxy for the broad commodity markets, which is the better diversifier – Gold or commodities?

The correlation between GSCI and gold is not particularly strong, which reflects the broad-based index's diversity. But over the past three years, gold's correlation to other asset classes has also been low – on average, half that of GSCI's. That makes gold a better portfolio diversifier, at least recently.

Gold vs. Commodities: 3-Year Correlations
CMX   -                  
GSCI 0.38  -                
NAREIT 0.10 0.31  -              
SPX 0.06 0.50 0.83  -            
MDX 0.09 0.50 0.86 0.96  -           
SML 0.01 0.39 0.91 0.94 0.96  -        
EAFE 0.20 0.58 0.76 0.93 0.91 0.85  -      
EMI 0.29 0.66 0.63 0.85 0.84 0.76 0.94  -    
TRS 0.27 -0.28 -0.22 -0.29 -0.35 -0.30 -0.27 -0.32  -  
TIPS 0.54 0.45 0.33 0.36 0.38 0.29 0.40 0.42 0.38  -

CMX = COMEX Spot Gold Settlement; GSCI = S&P/GSCI; NAREIT = FTSE NAREIT Real Estate 50; SPX = S&P500; MDX = S&P MidCap 400; SML = S&P Small Cap 600; EAFE = MSCI Europe, Australasia & Far East; EMI = MSCI Emerging Markets; TRS = Lehman Bros. 3-7 Year Treasury Bonds; TIPS = Barclays Capital Treasury Inflation-Protected Securities

Gold's lower correlation to other asset classes – the fact that it typically bears little relation to their changing prices than does the commodity fund – means risk is lowered. (Statisticians measure portfolio risk as the variance, or "Standard Deviation" from the average price over a period of time). That also helped make for a better performance, too.

An endowment-style portfolio that allocated, say, 50% to equities, 30% to fixed income, and 20% to real assets such as precious metals, commodities and real estate would have fared better over the past three years if gold were used in the real asset slot rather than GSCI exposure.

Portfolio with gold Allocation Portfolio with GSCI
CMX Gold 10% GSCI
1.0% Annual Return -2.2%
13.4% Std.Deviation 15.3%

Gold has been more versatile and reliable, in short, as a portfolio diversifier. That's also true over the past five and 10-year periods, as well as over the last three.

In each time span, Gold's return has been higher, and its risk – measured as the standard deviation of returns – has been lower than the GSCI funds. As a result, gold's reward-to-risk ratio has been consistently higher than GSCI's.

It's even easier to see the impact of the gold vs. commodities allocation if we use a simplified three-asset portfolio, one that devotes 50% to domestic US equities (as represented by the S&P500 index); 40% to US fixed income (proxied by the Barclays Capital Aggregate Bond Index); and 10% to hard assets.

Here we'll use put the hard assets allocation into either Comex Spot Gold Future contract, rolling it forwards, or the GSCI commodities index.

Comparative Performance
  with Gold
with GSCI
with Gold
with GSCI
with Gold with GSCI
Annual Return 1.8% -1.4% 4.8% 1.8% 4.4% 3.2%
Std.Deviation 9.7% 11.3% 8.5% 9.5% 7.2% 8.3%
Reward-to-Risk 0.19 -0.12 0.57 0.19 0.61 0.38

As you can see, annual returns with an allocation to Gold – not commodities – were markedly stronger.

Risk as measured by the standard deviation was low, too. Making the risk-reward ratio (also known as the Sharpe Ratio) stronger for a diversified portfolio allocating a chunk of its money to gold, rather than commodities.

With all this in mind, you might be tempted to dump commodities in favor of a gold allocation. Before you do though, consider this:

Our study uses Comex Gold Futures spot settlement prices as a proxy for gold's cash price return. Whereas the GSCI commodity index tracks a futures portfolio that constantly rolls soon-to-expire contracts forward, working to maintain the allocations mandated by the index's methodology.

That means that at times the futures curve may be in contango, so that near-term contracts are priced below later-dated deliveries. Rolling a position forward in a contango incurs a cost, as the low-priced contract is sold and the more expensive contract is bought. At other times, however, the market may invert into what's called backwardation, making the nearby contract higher priced. In such circumstances, a forward roll enhances the index portfolio's return.

Over the past decade, GSCI's largest component – crude oil – has seen more contango than backwardation; thus, its return has been whittled away by carrying charges. On the other hand, there's virtually no carrying charge embedded in the spot Comex gold settlement price.

So holding all else static, whenever the weighty issues in a broad-based commodity index are in contango, spot gold is going to look more attractive. [Ed.Note: You can slash gold's transaction costs, and secure storage fees too, enjoying strong& deep liquidity when you want to sell for as little as 0.12% per year. See Hard Assets' report on Bullion Vault vs. GLD here...]

What's more, Gold has been in an uptrend for most of the past decade. After a dramatic decline from its Volker-era highs, the metal spent a long time in the wilderness. On an absolute price basis, gold took 28 years to break even with its 1980 peak. Generally speaking, other commodities haven't seen a similar price arc. So if you're going to have gold in your investment portfolio, you must be prepared for times when the metal is favored – and when it's shunned.

Despite that fact that gold has been a more efficient allocation to real assets than a broader-based commodity index like GSCI over the last 3, 5 and 10 years, it is best to keep in mind the disclaimer long favored by financial advisers:

"Past performance doesn't guarantee future results."

How best to Buy Gold today? Learn more now... is a research-oriented website devoted to sharing ideas about investing in the natural resources sector. Published by Van Eck Associates Corporation, the site offers an educational resource for both individual and institutional investors interested in learning more about commodity equities, commodity futures, and gold – the three major components of the hard assets marketplace.

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