Gold News

Gold Mining vs. Gold Bullion

What's been the better portfolio addition this year – gold miners or Gold Bullion?

SOME LUCKY INVESTORS have had a golden touch this year. Literally, writes Brad Zigler at Hard Assets Investor.

It's because they actually touched gold that they became such standout investors. Gold Bullion attained yet more nominal highs this week, making bullion one of the best-performing assets of the year for US Dollar investors.

As of Wednesday, gold has notched a better-than-17% return compared with the breakeven performance for large-cap stocks reflected by the S&P 500 Composite Index and the 5% capital appreciation in the Barclays Capital Aggregate Bond Index.

Gold Bullion isn't without its detractors, however. As gold's price rises, so too does the volume of the ongoing debate between mining stock aficionados and bullion fans.

Gold equity advocates point to the leveraged returns obtainable through shares, reveling in the outsized gains earned by gold stock indexes this year. One such benchmark, tracked by the Market Vectors Gold Miners Index ETF (NYSE Arca: GDX), has risen 22% year-to-date.

Mining stocks magnify gold's moves because of the enormous influence the metal's market price has on a company's earnings. Once bullion advances beyond production costs, price changes flow directly to a producer's bottom line.

The names populating GDX's underlying index are some of the world's biggest and best-known producers, such as Barrick Gold Corp. and Newmont Mining Corp. Nearly 90% of GDX constituents carry a market capitalization of $5 billion or more.

Another index-tracker, the Market Vectors Junior Gold Miners Index ETF (NYSE Arca: GDXJ), mirrors the performance of companies engaged in the exploration and development of mining properties. The appeal of these so-called juniors – or miners with an average market capitalization of $850 million – is their potential for high growth or as acquisition targets. That appeal has translated into a 33% gain for the GDXJ portfolio this year.

Taking a stake in the GDX portfolio is akin to buying blue-chip stocks, while the GDXJ portfolio exhibits the risk and reward characteristics of a venture capital investment. Gold Bullion fans therefore highlight the two-edged nature of leverage as a potential liability. And they have a point.

Over the past five years, the downside semivariance of the Philadelphia Gold-Silver Index – volatility's "bad half" in short – has been twice that of London Gold Bullion prices.

Bullion fans also point to the purity of a solid Gold Investment. Through direct investment in metal, one can avoid both equity market influence and management risk. But is the true measure of a Gold Investment just its return? Its volatility? Since a Gold Investment is rarely the sole asset in a portfolio, how does it fit in with other components?

In short, what's been the better portfolio addition this year – gold miners or Gold Bullion?

The so-called Sharpe ratio of a financial asset measures the risk-adjusted payback for each product. The higher the Sharpe, the better the investment on a risk-reward basis. And because, over the last 5 years, the risk (aka volatility) of holding gold was less than the return realized, the metal's Sharpe ratio is higher than those of the mining stock ETFs.

Yes, top-line performance – that is, year-to-date returns – have clearly been the junior miners' strong suit this year...rising at nearly twice the pace of bullion in 2010. But the standard deviation of the junior miners' daily returns was just a shade under that gain. Meaning exploration and development companies have been riskier than bullion in 2010.

In fact, the annualized volatility of the juniors was greater than 38%. Gold's was just shy of 18%. Because of the miners' close correlation to bullion, however, there isn't any diversification benefit derived from the extra risk. In short, miners don't provide any "zag" beyond gold's "zig".

This becomes readily evident when Gold Investments are overlaid on a portfolio made up of equal parts large-cap stocks (represented in our analysis by the SPDR S&P 500 Trust) and fixed-income securities (as tracked by the iShares Barclays Capital Aggregate Bond Index Fund).

The outcomes here may seem counterintuitive at first. Because, despite the greater stand-alone returns obtained by mining share funds this year, Gold Bullion provided the best diversification benefit when used as a portfolio component. The benefit derives from gold's more negative correlation to stocks, and its nearly flat correlation to bonds.

Of course, it's not likely that most investors would hold too large an exposure to gold. Neither is it likely that portfolios would be constantly rebalanced. A more common allocation to gold would be 5-10%, and monthly rebalancing too, is more than adequate for most portfolios. And when gold exposure is reduced to 10% and the portfolio rebalancing frequency dialed down to monthly, composite returns become nearly identical, no matter what Gold Investment is selected. The essential difference between the gold products performance as portfolio constituents lies in their volatility effect. Bullion dampened volatility better than either of the miners funds.

The takeaway from all this is that Gold Mining shares, as a class, are clearly more volatile than bullion. Sometimes, their higher risk yields compensatory rewards and sometimes not. But there's really no reason to buy mining shares if you can't get a diversification kicker – a higher portfolio return that justifies their higher volatility.

In sum, despite the stellar returns of junior miners in 2010, this has been a "not" year. Gold stocks just haven't paid off as well as Gold Bullion when used as a portfolio building block.

Get the safest gold at the lowest prices today using world No.1 BullionVault... 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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