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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.

A portfolio with a 25 per cent allocation split equally among the equity of firms in the gold, silver, and platinum sectors and the remaining 75 per cent to US equities exhibited a significantly higher return than an all-equity portfolio and lower standard deviation. Therefore, investing in the equities of precious metals companies proved more beneficial than investing directly in the precious metals.

Gold is often cited as the archetypical precious metal, and its stand-alone risk-return profile has in fact been superior to either silver or platinum. However, its diversification benefits to an equity portfolio are more modest than either a direct or indirect investment in all three commodities.

Overall, the benefits of precious metal investments prevailed throughout most of the 34-year period studied with the exception of the bull market in the late 1990s in which precious metals would have imposed a performance drag. Because the stock market is known to perform better when the Fed is easing than when it is tightening, the authors examined whether the diversification benefits of precious metals was related to Federal Reserve monetary policy.

They look for opposite-direction changes in the Fed discount rate to define a change in monetary regime. For example, the first decrease in the discount rate following one or more increases marks the beginning of an expansive policy. Likewise, the first increase following one or more decreases signifies a restrictive policy. Over the sample period, there are seven expansive regimes and eight restrictive regimes, lasting on average 32 and 23 months, respectively.

Unlike the equity market in general, direct investments in precious metals perform significantly better in restrictive monetary environments than expansive environments. The counter-cyclical nature of returns to precious metals therefore provides valuable diversification benefits to an equity portfolio. Indirect investments in precious metal equities provide similar diversification benefits during periods of restrictive Fed policy. The significant risk and return benefits are limited to periods of Fed tightening, however.

The relationship between returns to precious metals and monetary policy inspires the authors to test a tactical asset allocation trading strategy that invests 75 per cent of a portfolio in US equities and 25 per cent in precious metal equities during expansive periods and the reverse those proportions during restrictive periods. They measure returns assuming the tactical asset allocation changes are implemented two days after an announced policy change and continue until one day following the subsequent change. This approach is conservative in that it ensures that an investor could have actually implemented the strategy in real time.

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

* Note: Returns are geometric averages

Table 2 – Performance by Monetary Environment

* Note: Returns are geometric averages

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