Is Gold Unique? Gold and Other Precious Metals as Diversifiers of Equity Portfolios, Inflation Hedges and Safe Haven Investments.

Transcription

1 Is Gold Unique? Gold and Other Precious Metals as Diversifiers of Equity Portfolios, Inflation Hedges and Safe Haven Investments. Abstract We examine four precious metals, i.e., gold, silver, platinum and palladium, for their value to investors as diversifiers of equity portfolios, inflation hedge, and safe haven investment. While a portfolio diversifier and an inflation hedge provides protection to equity investors during normal times, a safe haven provides protection during highly uncertain times. We find that Gold is unique in its capacity to offer protection from unanticipated inflation and diversification benefits for US equity portfolios. While the other precious metals behave as good inflation hedges under certain conditions, generally speaking, they are not good diversifiers of equity portfolios. Our overall conclusion is that gold is a unique asset among precious metals due to its capacity to be a portfolio diversifier and an inflation hedge at all times. In addition, gold can also be used as a safe haven investment during times of high uncertainty in stock markets.

2 Is Gold Unique? Gold and Other Precious Metals as Diversifiers of Equity Portfolios, Inflation Hedges and Safe Haven Investments. While U.S. equities had lackluster returns during the first decade of the 21 st century, prices of gold and other precious metals have risen sharply. 1 This is in sharp contrast to the 1990 s when the opposite was the case. 2 Since the start of the great financial crisis of 2008 triggered by poorly performing subprime mortgages and subsequent failures of large investment banks, investment funds have poured into precious metals. A commonly heard explanation is the safe haven nature of precious metals. In addition, gold is often believed to be a good inflation hedge (e.g., Kat et al. 2006; Jensen at al. 2002). However, the 2008 financial crisis was accompanied by fears of an economic depression of a deflationary nature. Therefore, continued strong fund inflows into precious metals since 2008 suggest that investments in gold, silver, and platinum are not driven by inflation-hedging considerations but rather as safe haven investments, of tactical value in portfolio allocation. Gregoriou and Rouah (2004) report that commodity trust advisors (CTAs) generated higher performance than the S&P 500 index during periods when equity returns were negative and during extreme market events such as the Asian and Russian currency crises (1997 and 1998, respectively) and the September 11 (2001) attacks in the U.S. Their findings reveal that commodities offer great diversification benefits to an equity-only portfolio during periods of low volatility and also provide safe haven during extreme market 1 This assertion is confirmed by an examination of gold bullion prices from the London Bullion Market and the S&P 500 Composite Index. Between January 1, 2000, and December 31, 2009, the simple buy and hold return on gold bullion would have been % while an investment in the S&P 500 would have yielded a negative 24.1%. These numbers do ignore transactions and storage costs, where applicable. 2 A quick examination of gold spot prices at the London Bullion Market indicates that between January 1, 1990, and December 31, 1999, the simple buy and hold return on gold bullion would have been % while an investment in the S&P 500 Composite Index over the same period would have yielded a positive %.

3 events. Bauer and Lucey (2010) and Bauer and McDermott (2010) examine gold s role as a safe haven investment. While examining the inflation-hedging potential of commodities futures, Kat and Oomen (2006) discovered that equities and bonds are better inflation hedges than commodities. However, commodities still offered significant portfolio diversification benefits. The question of whether precious metals serve as safe haven investments or as inflation hedges is relevant in terms of investment objectives. If gold, silver and platinum investments are primarily driven by desire for capital preservation during uncertain economic times, one would attempt to use them on a tactical basis, raising portfolio allocations in favor of precious metals during periods of high uncertainty in equity markets. If these investments serve primarily as inflation hedges, then they have a strategic role in portfolio allocations, given that inflation is a long-term economic risk. 3 Precious Metals as Safe Havens Bauer and McDermott (2010) define a safe haven asset as one which is either uncorrelated or negatively correlated to equity markets during periods characterized by falling stock markets. They contrast a safe haven investment with a hedge in terms of the duration of this impact. A hedge is defined as an asset that has negative or zero correlation with the principal asset on average while a safe haven only exhibits negative (or zero) correlation with the principal asset during certain periods, such as financial crises. In order to approach the usefulness of precious metals investments in enhancing portfolio performance, we examine the following questions: Are commodities effective inflation hedges? Are they better inflation hedges than equities, bonds, real estate or even a general commodities index? 3 Some researchers also argue for a tactical allocation of an inflation hedge based on anticipation of monetary policy regimes (e.g., Jensen et al. 2002).

4 Methodology: Commodities as an inflation hedge: To investigate the merits of various investments as an inflation hedge, we examine their buy-and-hold investment returns over overlapping 3-year holding periods, month by month, over the entire sample period. Each month s computed return includes any price changes and cash distributions to the asset during the month and is based on asset values on the last trading day of the month. Then, we analyze the relationship of these returns to changes in the CPI index. We examine whether precious metals perform better than other investments, on average, on a riskadjusted basis. Hence we estimate the following regression: R ct = α + β c R mt + β e I t + β s U t + ε (1) where R ct is the monthly spot price returns for gold, silver, platinum and palladium and R mt is the contemporaneous equity market index return. Each return is calculated as: R it = (P i,t P i,t-1 )/ P it. I t is the expected level of inflation defined as the prior month s change in CPI index. U t is the unexpected component of inflation defined as the difference between the contemporaneous change in the CPI index and the prior period s percentage change. The sign and statistical significance of the coefficients β e and β s will indicate whether commodities offer any inflation protection beyond the broad equity market index, on an unsystematic basis. Commodities as a safe haven (preservation of capital during uncertain times): This analysis is also repeated over various phases of the business cycle as identified by the growth in GDP. In addition, to gauge volatility of equity prices, we use the VIX index provided by the Chicago Board of Options Exchange (CBOE). The VIX is the option implied volatility of the S&P 500 Index and hence is a forward looking measure of stock market

5 volatility. Using the VIX allows us to examine the behavior of precious metals investments during periods when expected volatility of equity investments is relatively high, i.e., greater than two standard deviations above its average and periods when it is not. All data used in this study is obtained from Datastream database. Datastream compiles information from many sources for spot commodity prices. The London Bullion Markets provide the most consistent source for spot market prices for commodities. We are able to obtain spot prices for gold and silver dating back to 1970, platinum from 1976, palladium since The stock market volatility index (VIX) data is available from1990. Hence our sample period is restricted by the availability of data but, at a minimum, spans a couple of decades. Results: The results of our analysis are presented in Tables 1-3. Table 1 shows the regression results of Equation 1 for gold, silver, platinum, and silver spot price returns against the S&P500 index returns, which is our proxy for equity market performance, along with measures of expected and unexpected inflation. As noted in Table 1, gold is unique among precious metals in that it offers investors both protection against unexpected inflation and diversification benefits for an equity portfolio because of the low correlation between gold and equity returns. All precious metals appear to offer some degree of protection from inflation in that when unexpected inflation is high, precious metals returns are also high cushioning the loss in purchasing value of the dollar. Panels A and B of Table 2 show that while gold, silver and palladium offer protection from inflation during periods of negative GDP growth, only gold provides a consistent hedge for

6 unanticipated inflation and statistically significant diversification benefits for US equities during both phases of the economic cycle. Once again, we confirm that gold is unique among precious metals in its ability to provide both diversification opportunities and inflation hedge, regardless of phase of business cycle. Finally, we examine the performance of precious metals during periods of moderate and high expected levels of volatility in US equity markets. As we may infer from Table 3A, when stock market volatility is less than one standard deviation above its long-term mean, gold performs well both as an inflation hedge and as an equity market diversifier. Palladium exhibits similar tendencies as well. However, as one may note from Table 3B, gold and palladium are no longer a good inflation hedge when stock market volatility is high. However, the two metals continue to act as good stock market diversifiers. Silver is the only precious metal that provides an inflation hedge during these volatile times but it loses its role as an equity index diversifier. Conclusions: It appears that among the precious metals examined (i.e., gold, silver, platinum and palladium), gold is unique in its capacity to offer protection from unanticipated inflation and diversification benefits for US equity portfolios. While the other precious metals behave as good inflation hedges under certain conditions, generally speaking, they are not good diversifiers of equity portfolios. Gold s unique dual role prevails during both periods of positive GDP growth and negative growth in GDP. Gold (along with palladium) remains a good equity portfolio diversifier even during periods of high volatility in US equity markets and hence can be used as a safe haven during periods of high uncertainty. However, none of these metals can be considered purely a safe haven investment because the hedging potential they offer is not limited to high

7 stock market volatility. Hence, our overall conclusion is that gold is a unique asset among precious metals due to its capacity to be a portfolio diversifier and an inflation hedge at all times. In addition, gold can also be used as a safe haven investment during times of uncertainty.

8 Table 1 Precious metals as inflation hedge and equity portfolio diversifiers R ct = α + β c R mt + β e I t + β s U t + ε Coefficient Gold Silver Platinum Palladium Equity Index * 0.35* 0.35* Expected Inflation Unanticipated Inflation 2.75* 3.62* 3.48* 3.98* * Coefficient is statistically significant with p 0.05 Table 2A Hedging role of precious metals during periods of positive GDP growth Coefficient Gold Silver Platinum Palladium Equity Index * 0.28* 0.17 Expected Inflation Unanticipated Inflation 2.17* Table 2B Hedging role of precious metals during periods of negative GDP growth Coefficient Gold Silver Platinum Palladium Equity Index Expected Inflation Unanticipated Inflation * * Coefficient is statistically significant with p Coefficient is statistically significant with p 0.10

9 Table 3A Hedging role of precious metals during periods of moderate stock market volatility VIX μ + 1σ Coefficient Gold Silver Platinum Palladium Equity Index * 0.28* 0.07 Expected Inflation Unanticipated Inflation 2.59* * Table 3B Hedging role of precious metals during periods of high stock market volatility VIX > μ + 1σ Coefficient Gold Silver Platinum Palladium Equity Index * Expected Inflation Unanticipated Inflation * * Coefficient is statistically significant with p Coefficient is statistically significant with p 0.10

10 References: Bauer, D. and B. Lucey (2010), Is Gold a Hedge or a Safe Haven? An Analysis of Stocks, Bonds and Gold, The Financial Review, Vol. 45, No. 2, pp Bauer, D. and T. McDermott (2010), Is gold a safe haven? International evidence, Journal of Banking & Finance, Vol. 34, No. 8, pp Garrett, I. and N. Taylor (2001), Portfolio Diversification and Excess Comovement in Commodity Prices, The Manchester School, Vol. 6, No. 4, pp Gregoriou, G. and F. Rouah (2004), Performance of the Largest CTAs in Negative S&P500 Months and Extremen Market Events, Journal of Wealth Management, Vol. 7, No. 1, pp Hillier, D., P. Draper and R. Faff (2006), Do Precious Metals Shine? An Investment Perspective, Financial Analysts Journal, Vol. 62, No. 2, pp Jensen, G., R. Johnson and J. Mercer (2002), Tactical Asset Allocation and Commodity Futures: Ways to Improve Performance, Journal of Portfolio Management, Vol. 28, No. 4, pp Kat, H. and R. Oomen (2006), What Every Investor Should Know About Commodities Part II: Multivariate Return Analysis, Alternative Investment Research Centre, Working paper #0033, City University, London, U.K., pp Mull, S. and L. Sonen (1997) U.S. REITs as an Asset Class in International Investment Portfolios, Financial Analysts Journal, Vol. 53, No. 2, pp Rzepczynski, M., C. Belentepe, W. Feng and P. Lipsky (2004), Black Gold Trading Crude Oil for Greater Portfolio Efficiency, Journal of Alternative Investments, Vol. 7, No. 2, pp