The mettle of precious metals

With gold trading at approximately $1000 (£592) an ounce and the S&P Metals and Mining ETF (XME) trading near all-time highs, investment exposure to precious metals has certainly helped some investors weather the turmoil in equity markets.

It is reasonable to ask then whether precious metals tend to improve portfolio performance in general, on both an absolute and risk-adjusted basis. If so, what is the best way to include precious metals into your portfolio, and when is a good time to do it?

Research by Mitchell Conover, Gerald Jensen, Robert Johnson, and Jeffrey Mercer suggests that from January 1973 to December 2006, a significant allocation of up to 25 per cent precious metals, particularly indirect investments in the form of equities of global firms in the precious metal sector, improved portfolio performance substantially. Moreover, the benefits of precious metal investments have primarily accrued during periods of monetary contraction.

The proliferation of sector exchange traded funds and mutual funds substantially lowers barriers to gaining exposure to precious metals. So, the practical implications of this research are more pronounced now than they would have been even five years ago.

Over the 34-year period studied, the price of an equally-weighted portfolio of gold, silver, and platinum appreciated at 8.3 per cent annually as measured by the London bullion prices of these commodities, according to Datastream International. This performance compares unfavourably to 10.8 per cent for US equities generally. Moreover, these precious metals exhibited higher volatility than US equities. Nonetheless, precious metals may represent a valuable addition to an otherwise broadly diversified equity portfolio if their returns are weakly or negatively correlated with market returns.

In fact, these commodities were virtually uncorrelated with US equities. A portfolio that allocated 25 per cent of its value equally among gold, silver, and platinum and the remaining 75 per cent to US equities exhibited a slightly higher geometric return than an all-equity portfolio and a substantially lower standard deviation. Smaller allocations to precious metals offer similar, but smaller, diversification benefits.

An alternative to investing in bullion directly is investing in the equities of firms in the gold, silver, and platinum sectors. This form of indirect exposure had a greater return and comparable standard deviation to returns of the precious metals themselves. Its correlation with equity returns overall was also very low, but not quite as low as direct investments.

The improved risk-return profile of equities of precious metal companies reflects their exposure to general market forces in addition to the commodity itself.