The most important portfolio factor for many investors is diversification. Lowering portfolio risk while generating yield is something that every investor should strive for.
One asset class that engenders a multitude of emotions but has no yield is precious metals and gold in particular. Gold equity ETFs have a dividend yield of less than one per cent. But it’s also the asset class that over time has a very low correlation with the traditional asset classes like equities and bonds. Correlation is a statistical measurement that explains how the price movement of one asset influences the other. Gold tends to have a slightly negative correlation to equities and a slightly positive correlation to bond prices over time. Long bonds tend to behave similar to gold in a risk-off environment. There is also a higher correlation with the Japanese yen, which is a risk-off currency (due mostly to hedge fund flows).
My point is that it’s helpful to understand how to diversify your portfolio across asset classes. The first table shows the current annual rolling correlations, but these correlations change over time.
Over the past few years, you can see that the correlation between global stocks and gold has been both negative and positive for over various time periods. Currently, the correlation is close to zero, which means that the price movement of gold has little or no influence by the price movements of equities. In both scenarios, the overall correlation when positive or negative is relatively low. That low correlation over time provides maximum diversification benefits.
Long bonds tend to act as a risk-off asset class most of the time and tend to correlate higher with gold, though given that gold bullion does not yield anything, it also competes with bonds as a safe haven asset. When bond yields rise (prices fall), bonds get more attractive at some point on a yield basis versus gold, which has no yield. They both have a relationship with inflation expectations as well. As a rule of thumb, when inflation expectations are rising, equities tend to do well, but bonds do not. Gold tends to do well in a rising inflation environment, too, but currently are thought to be competing with bonds as yields are expected to rise.
From a portfolio standpoint, we put together a simple equal weight portfolio to show the benefits of diversification. Global equities (VT), a gold ETF with a cover call overlay to generate yield (GLDI.OQ), high yield bonds (HYG), and long-term US Treasuries (TLT.OQ).
The standard deviation of the equal weight portfolio over the past few years is about 8.8 per cent, far less than the individual holdings showing that there is a significant diversification benefit. The current yield of the portfolio is about 4.5 per cent. While we set up this portfolio to be an equal weight, we could include a 20 per cent allocation to a money market fund to be used to further reduce risk and increase opportunity, taking a little money off the table (or rebalancing) when sector weights get 10 per cent higher than equal weight and putting money into sectors that have a better return adjusted for risk outlook.
And finally, looking at the current catalysts for gold. The tightening FOMC is a clear and present negative. The question is: When is it priced in and time to go the other way? Gold has been underperforming equities and high yield for all of 2017. The current position in the futures market show speculators are the least long they have been since early 2016. Key technical support around US$1200 is likely to be tested this week with Fed Chair Janet Yellen likely to talk about reducing stimulus and raising rates. Seeing some of these longs capitulate will likely be the next best opportunity to add some gold exposure to your portfolio. Buying when the opportunities are attractive and maintaining a diversified portfolio will serve investors well in the long run.