There’s nothing like a bracing splash of reality to put things in the proper perspective. Last week, we examined the efficacy of various hard asset exposures—gold, oil and broad-based commodities—on portfolio performance (see “How Good Is YOUR Hard Asset Investment?“) and found that gold did the best job of boosting yields and lowering risk over the past year. On paper, that is.
You’ll remember that when we took a 10 percent bullion allocation out of the fixed-income side of a stock-and-bond portfolio, we enhanced our returns 2.2 percent with only a 0.3 percent uptick in risk. But that was the view from 10,000 feet. The picture’s quite different from the ground.
First of all, because the example assumed constant—i.e., daily—rebalancing of the portfolio. That’s unrealistic for most investors. To maintain a constant 10 percent allocation, bullion would have to be sold on days when the metal’s price advanced more than the stock and/or bond allocations. That’s both impractical and expensive.
Rebalancing is costly, both in terms of hard transaction charges and bid/ask spreads. You pay the freight for rebalancing in yield—at some point, frequent rebalancing stops paying for itself.
The other consideration is liquidity—the ability to transact immediately. Daily bullion dealing just isn’t practical for most investors. However, dealing in bullion proxies, such as exchange-traded gold trusts, is.
So, let’s turn our attention to a real-world portfolio—one with a more manageable rebalancing schedule and that uses investment vehicles available to John or Jane Q. Public. Let’s rejigger our portfolio allocations monthly, instead of daily. And let’s use exchange-traded trusts, funds or notes to obtain our exposures.
The Many Faces Of Gold
In the real world, investors can obtain exposure to the gold market through bullion itself or through gold mining stocks. A bullion-based investment is “purer” in the sense that it’s just gold. Mining shares are, after all, stocks. As such, they provide exposure to both gold’s price and the stock market.
There’s more than one kind of gold miner, too. Some gold producers are in the business of cranking out actual bullion from their operations—that is, they produce revenue—while other junior shares explore and develop prospective gold fields. Junior mining shares are more speculative and—no surprise here—more volatile.
We’ll use the SPDR Gold Shares Trust (NYSE:GLD) as our proxy for bullion, the Market Vectors Gold Miners ETF (NYSE:GDX) to stand in for gold producers and the Market Vectors Junior Gold Miners ETF (NYSE:GDXJ) to represent E&D outfits.
We’ll also employ a monthly rebalancing schedule to maintain our target allocations. The base for our portfolio—as before—is a 60/40 mix of stocks and bonds. We’ll keep 60 percent of our capital in broad-based large-cap domestic stocks through SPDR Depository Receipts (NYSE:SPY). We’ll carve our hard asset exposure from our 40 percent bond allocation, as represented by the iShares Barclays Capital Aggregate Bond Index ETF (NYSE:AGG).
Adding a 10 percent dollop of gold—or, more properly, carving a 10 percent allocation from our portfolio’s fixed-income allocation—didn’t change the one-year performance of the portfolio much. That is, the portfolio ended up pretty much in the same place with or without gold—somewhere around a 12 percent compound return.
But it’s how the portfolio got there that’s telling. Take a look at the volatility endured over the past 12 months.
Gold Overlay With Monthly Rebalancing
Bullion exposure provided a barely perceptible yield pickup with no reduction in portfolio risk. Instead, it was the miners that gave our portfolio a goose; in particular, junior miners. Surprisingly, the more volatile stocks provided the greatest risk reduction. That’s because the mining stocks provided a more leveraged “zag” to the base portfolio’s “zig.” The juniors bestowed better diversification over the past year—producing a significant improvement to the portfolio’s reward-to-risk ratio.
Now let’s see about using oil exposure instead.
Oil Two Ways
It’s obviously impractical to hold physical oil as a portfolio asset. But you can gain exposure to crude oil’s price through shares of an exchange-traded fund that holds oil futures. The oldest of these is the United States Oil Fund (NYSE:USO), which maintains constant exposure to the front-month NYMEX West Texas Intermediate contract.
Holding a constant long futures position comes with a complication—contango. Contango describes a price structure in which longer-dated futures are more expensive than near-term deliveries. When, for example, May futures trade for $108 a barrel and June sells for $109, we say there’s a $1 contango. That extra buck represents the storage, insurance and financing costs to carry the oil cargo for a month until delivery.
For the USO portfolio to maintain constant exposure to the nearby crude oil futures, it must roll its position forward ahead of each contract’s expiration. In other words, the soon-to-expire contract must be sold and replaced by purchasing the next-available delivery month. When the market’s in contango—as it’s been since June 2008—that means selling the low-priced expiring contract and buying the higher-priced near-term one, a cost that effectively reduces the oil return.
To combat contango’s effect, the United States 12-Month Oil Fund (NYSE:USL) was launched. Instead of holding just the front-month contract, USL holds a year’s worth of deliveries—the spot month and the 11 subsequent months.
You can see the dramatic effect contango would have had on your portfolio if you’d used USO as your hard asset allocation last year.
The first thing you notice, of course, is the diminution of returns resulting from an oil allocation. In either case, the 12-month return of a basic stock-and-bond portfolio would have been higher without oil. The loss was clearly magnified by contango.
Oil Overlay With Monthly Rebalancing
The oil carve-out, however, did dampen portfolio volatility, making the yield give-up—at least the one suffered with USL—more palatable. Notice that the USL-enhanced portfolio actually outperformed the basic stock-and-bond mix for most of 2010, due to the interplay of a generally rising oil price and a widening contango.
To wrap up, we’ll turn to broader-based hard asset exposure—that obtainable through commodity index funds.
More Ways To Skin Commodities
Investors can gain access to a broad spectrum of commodities through a number of index-based futures funds and notes. We’ll look at three representative exchange-traded products:
- The GreenHaven Continuous Commodity Index ETF (NYSE:GCC): GCC tracks an index of 17 equal-weighted futures contracts. Sectorwise, agriculturals and softs are the heftiest, comprising nearly half the benchmark’s weight. Metals make up about a quarter, with energy and livestock splitting the balance.
- The iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSE:DJP): This Barclays Bank-issued note mimics a benchmark of 19 futures weighted primarily for trading volume and secondarily based on global production. Energy carries the topmost weight, followed by metals, agriculturals, soft commodities and livestock.
- The iShares S&P GSCI Commodity-Indexed Trust (NYSE:GSG): This fund is designed to replicate the performance of the S&P/Goldman Sachs Commodity Index, a production-weighted benchmark of two dozen commodities adjusted for liquidity and investability. Currently, the S&P/GSCI is most heavily weighted in energy products.
Broad-Based Commodity Overlay
The primary difference between these exchange-traded commodity products is the relative influence of energy. It’s unlimited in the GSG fund, but capped, to one degree or another, in the other two. Because of the equal-weighting scheme of GCC’s underlying index, energy exhibits the least influence in this product, giving more heft, relatively speaking, to “softer” commodities. It’s that de-emphasis on energy that accounts for GCC’s effect on our portfolio’s return. The 12-month return for the GCC-enhanced portfolio was closer to the base portfolio than those of the other products.
Broad-Based Commodity Overlay With Monthly Rebalancing
While there’s no apparent pickup in returns at the end of a yearlong investment horizon, the portfolio with a GCC carve-out did outperform the base portfolio for all but the last two months.
Summing The Numbers
Looking back at the past 12 months, the best-performing portfolio—ranked by its reward-to-risk ratio—was one enhanced with junior gold mining shares. Adding a dollop of gold producers improved the portfolio’s ratio, too, but mostly due to a ratcheting down in volatility, rather than an improvement in the yearlong return. However, it’s worth noting that the GDX did provide a return enhancement for most of the period studied; it was only at year’s end that producers began to flag:
Hard Asset Overlays With Monthly Rebalancing
Bullion, proxied by the GLD trust provided the second-best return enhancement, but offered no appreciable risk reduction. That put the GLD-augmented portfolio near the bottom of the roster.
This is not to say that gold bullion has little value in diversifying a portfolio. After all, we’re talking about only 12 months here. Neither does this experiment make a case for a permanent preference for gold mining shares. Keep in mind that the equity market was buoyant for most of the time studied here.
What this does point to is that when carving out a space for hard assets in a portfolio, investors must be mindful of potential volatility impacts as well as hoped-for return enhancements. What we see here is that it’s rare to get both risk reduction and a return boost with one allotment.
HardAssetsInvestor.com (HAI) is a research-oriented Web site devoted to sharing ideas about hard assets investing. The site has been developed as 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). The site will focus on hard assets investing without endorsing or recommending any particular investment product.