Precious metals vital to portfolio: CFA Institute

By Mark Noble | March 12, 2008 | Last updated on March 12, 2008
5 min read

Investors could significantly improve long-term performance and downside risk in their portfolios by increasing their holdings in precious metals, particularly precious metal equities, a new report by the CFA Institute concludes.

Using data compiled between 1976 and 2004, the authors of the report write that portfolio performance improves if precious metals are added.

According to the report, a portfolio constructed purely of U.S. equities would have had compound annualized returns of 10.83% during the study period. A portfolio with a 75% exposure to U.S. equities and 25% to precious metals commodities would have seen annualized returns of 11.01%. This result is even further amplified if the 25% precious metals allocation is all in precious metals equities — the annualized returns would be 12.48%.

The increase in percentage performance may be moderate, but with nearly three decades of compounding growth, the difference in nominal terms is staggering. The study highlights that $1 invested in 1976 in U.S. equities would have grown to $38, while $1 invested in a portfolio composed of 75% U.S. equities and 25% precious metals equities would have grown to $65.

Robert Johnson, the deputy CEO of the CFA Institute and one of the co-authors of the study, says the growth differential between precious metal equities and base metals is substantial, particularly during periods when the U.S. Federal Reserve is lowering interest rates. Equities in general tend to do well in periods of expansion, but precious metals equities fare even better and are not as deeply affected by restrictive periods.

According to the study, precious metals stocks had annualized returns of 16.41% during historical periods of expansion versus 16.25% for all U.S. equities, 4.56% for precious metals commodities and 0.98% for gold itself. During a restrictive period — when interest rates are rising — precious metals returned 13.29%, while U.S. equities rose only 3.87%. However, precious metals equities delivered a 11.06% return.

Johnson notes that the ability of precious metals equities to maintain performance in both markets allows them to substantially outperform over the long term. In a best of both worlds scenario, the investor benefits from good company management while at the same time getting heavy exposure to precious metals, which have historically had an inverse relationship to equity markets.

“We believe that when you invest in a commodity, you’re really investing in the value of the commodity. When you invest in the precious metals equity, you’re actually investing in a company,” he says. “You’re not just relying on the price changes in the commodity but [on] decisions made my management.”

Nick Barisheff, president of the Bullion Management Group, advocates a 25% allocation to precious metals in a portfolio but says investors should not confuse actual physical metal holdings, like bullion, with precious metals equities. He says only bullion can provide true non-correlation to equity markets. Today’s current market conditions are proving this.

“It’s not a valid assumption that producers will follow the prices of precious metals. Right now the most glowing example of a kind of disconnect is platinum prices and platinum producers,” he says. “Platinum equities as an asset class are suffering from a variety of things, but most of all, an energy shortage. The price of platinum is skyrocketing while the companies can’t produce it.”

Barisheff also gives an example of how commodity producers like oil giant Exxon-Mobil and mining company Newmont are significantly lagging the performance of both oil and gold. Their product may in fact be rising in price, but other considerations like rising production costs — or in the case of Newmont, a massive environmental lawsuit — affect their stock prices.

“We have a different market dynamic than what has existed in the past. That’s why we are not having the correlation between the commodities and producers,” Barisheff says. “The price and cost of production are rising very rapidly due to the rising price of oil, which is usually the biggest expense category for many mines.”

Barisheff says the devaluation of the U.S. dollar has negatively affected the balance sheet of Canadian mining companies.

“In some cases, you’ve got Canadian companies where they are paid in U.S. dollars for the gold, but their expenses are in Canadian dollars. Last year you would have a currency exchange difference of over 20% on your expenses,” he says.

Barisheff also thinks the CFA Institute’s data on precious metals equities is slightly misleading because there are few precious metals companies that have managed to survive intact during the period of study.

“I would be hard-pressed to look at the long-term performance of mining stocks because most of the companies from the 1970s are either not around or have been purchased by someone else,” he says. “Homestake is one of the oldest ones and they got bought by Barrick a few years ago. Even then, in the ’70s, Homestake rose by about 900% and the price of gold, 2300%. There are many juniors that have gone up huge amounts, but how would you [account for that] and what would you use [to evaluate their performance]?”

Barisheff notes that right now we are in a period of expansion, but gold has been steadily rising since 2005 compared to all currencies because money is being printed at rapidly increasing rates, particularly in developing economies like China, India and Russia.

“Initially in this bull market from March 2002, gold was rising because the dollar was dropping. You didn’t have a gold bull market; you had a U.S. dollar bear market. From 2005 until today, we’ve seen the price of gold rise in all currencies,” he says.

Johnson concedes that today’s period of expansion does not correspond to the study’s historical data.

“The expansion period started in August when the Fed started to cut interest rates. Market performance since August has been poor. Having said that, this period is not over yet,” he says. “I suspect it will continue for many months — although I don’t know that. The jury is still out on how this period will look compared to history. If this period were to end today, it would obviously be inconsistent with the previous results.”

The CFA Institute study can be accessed here.

In addition to Johnson, the co-authors of this study are C. Mitchell Conover, associate professor of finance at the University of Richmond School of Business; Gerald R. Jensen, Ph.D., professor of finance at Northern Illinois University College of Business; and Jeffrey M. Mercer, associate professor of finance at the Texas Tech University College of Business.

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Mark Noble