The mettle of precious metals

As it turns out, the tactical asset allocation strategy is quite comparable to a strategy of maintaining a steady 75-25 balance between US equity and precious metals equities. The benefits of both approaches accrue almost entirely while the Fed is tightening.

The debate over precious metals is particularly poignant in the current market environment. Although the risk-return profile of precious metal investments on a stand-alone basis is less attractive than US equities, precious metals provided substantial diversification benefits to an otherwise diversified equity portfolio over a recent 34-year period. Moreover, the benefits of indirect investments in the equities of precious metal companies were generally greater than direct investments in the commodities themselves, particularly during periods of restrictive monetary policy.

The diversification benefits were most pronounced during periods of restrictive monetary policy, however. When the Fed is easing, neither direct nor indirect investments in precious metals have been particularly beneficial. Despite the differences between policy regimes, a tactical asset allocation strategy that emphasizes US equities during expansive regimes and precious metals during restrictive regimes provides only modest incremental benefit over a strategy that maintains a steady 75-25 balance between US equity and precious metals equities. This study suggests that diversification with precious metals is worth considering.

Table 1 – Returns and Risk for U.S. Equities and Precious Metals, 1973 through 2006

	US Equities	Precious Metals Commodities	Gold	Precious Metal Equities
Annualized Return	10.83%	8.33%	6.64%	14.11%
Standard Deviation	15.37%	23.11%	20.90%	24.81%
Coefficient of Variation	1.42	2.77	3.15	1.76
Correlation with U.S. Equities	1.00	-0.01	-0.03	0.08

* Note: Returns are geometric averages

Table 2 – Performance by Monetary Environment

	US Equities	Precious Metals Commodities	Gold	Precious Metal Equities
Restrictive Period Return	3.87%	13.29%	14.02%	11.60%
Expansive Period Return	16.25%	4.56%	0.98%	16.41%
Difference	-12.39%	8.73%	13.04%	-4.81%

* Note: Returns are geometric averages

Robert R. Johnson and Stephen M. Horan are CFAs of CFA Institute