Precious Metals Equity (2024)

Some of the most fascinating assets from the vantage of portfolio theory are precious metals and precious metals equity ("PME"). Of all the assets trafficked by mankind over the course of history, none has a longer paper trail than gold, with millenia of price data available to the analyst. In inflation adjusted terms, the long term return of the precious yellow is zero. This should surprise no one, as for centuries gold was money. Gary Brinson points out that an ounce of gold bought a fine men's suit in the time of Shakespeare, and so it does today. (Women's clothes are another story). Even in this era of fiat currency, the real return of gold is near zero. Consider that in 1926 the price of gold was $20.67 per ounce, and is now $380. It's return in the intervening 70 years has been 4.2% per annum -- exactly 1% higher than inflation.

However, most investors do not store bullion, but instead own shares in mining stocks, or the mutual funds which own them. What is the long term return of this asset class? It turns out that there is little usable data on the expected long term returns of PME. This is somewhat surprising, since mining shares have been traded on the major US and foreign exchanges for hundreds of years. However, I've not come across a reliable estimate of the expected return of PME. If you have, please let me know.

Why is this important? Because the return of both bullion and PME has a zero correlation with almost any other asset you might want to name. It is a superb hedge against inflation, which cannot be said of almost all other reasonably liquid assets. My portfolio simulations show that even if the long term real return of PME is zero, there is still some benefit to having a few percent of it in your portfolio.

One can cobble together a "precious metals index" which will estimate the long term return of this asset. The Morningstar database of mutual funds has a precious metals fund index which goes back to 1976, and before that the Van Eck International Fund, which started operations in 1956, became a precious metals fund sometime in 1968. Combining the Van Eck data for 1969-75 with the Morningstar data beginning in 1976 provides a 27.75 year time series -- just long enougn to provide a reasonable estimate of the "true" long term return of this asset. The results are startling -- the annualized return from January 1969 to September 1996 was 12.81%. This is actually higher than the S&P500 (11.24%), US small stocks (12.44%), and the EAFE (12.52%) for the same period. There is probably a few percent of survivorshipbias built into this data, but the fact remains that the long term returns of PME andother common stocks are probably quite similar.

Why is this so surprising? For several reasons. Firstly, it is much higher than the low return of the metal itself. (Although on further reflection, this is perfectly consistent with the disconnect between the prices of other commodities, which have been declining slowly in real terms over the centuries, and the market capitalizations of companies which produce them, which has of course been increasing in real terms.) But more importantly, it contradicts the fundamental tennet of modern portfolio theory, namely, that one is not rewarded for undertaking nonsystematic risk. Since the correlation of precious metals and other common stocks is close to zero, all of its risk is nonsystematic, since it can be diversified away. Thus, the return of precious metals should be very low. (For those of you who are MPT freaks, this is another way of saying that because the beta of PME is low, its returns must also be low.)

In the real world, of course, nobody has heard of or cares about Markowitz and Sharpe, and most investors find nothing imaginary about the nonsystematic risk of PME, and demand compensation for it. This provides profit to those who actually can ignore this nonsystematic risk. This is not to say that investing in precious metals iseasy. Inflationary/deflationary and interest rate cycles typcally occur over about 30 year periods (the so-called Kondratieff Wave) so a very long term perspective is needed. For example, for the 12 year period from January 1981 to December 1992 the return of the precious metals index was -1.27% annualized versus 14.65% for the S&P 500.

Precious metals investing has another, more subtle advantage as well. For thosewho are able to periodically rebalace their portfolios, significant excess returns are available. For example, a portfolio consisting of 50/50 S&P/PME, rebalanced annually, has a return of 13.83%, which is considerably higher than either asset alone. The "minimum variance portfolio" for these four assets (S&P, US small, EAFE, and PME)consisted of 73.6% S&P, 14.6% EAFE, and 11.8% PME and had a return of 12.57%, which was higher than any of the individual equity assets except for PME itself. Portfolio simulations for the 1969-96 period show that a "coward's portfolio" consisting of equal parts S&P, US small, EAFE, and PMEleavened for risk with the 5 year treasury index is nearly maximally efficient at all levels of risk for these 5 assets.

The lesson here is that most investors take the price volatility of high SD/low beta assets very seriously.CAPM is like Fabian Socialism. It looks good on paper, but falls apart badly in the field.Those who can shoulder risk are rewarded, be the risk systematic or nonsystematic.

Conclusions

William J. Bernstein
wbern@mail.coos.or.us

copyright (c) 1996, William J. Bernstein