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Written by: Maxwell Gold | ETF Securities
Year-to-date gold mining stocks have surged, with the Philadelphia Stock Exchange Gold & Silver Index (“gold miners”) up over 110% as of September 23rd, setting off a new “gold rush” in the eyes of investors.
From their perspective holding gold mining equities is the same as (if not better than) an investment in gold itself. This, however, is a misconception and overlooks many deficiencies in holding gold miners as a proxy for gold within portfolio allocations.
Gold miners have long been viewed as a viable substitute for gold by US investors. This is partly linked to historical restrictions of physical gold ownership in the US and limited accessibility to the market for non-institutions. In recent years, however, markets have witnessed a visible separation in the performance between the price of gold and broad gold mining indices (Exhibit 1). This dislocation is reflective of the challenges facing gold miners since the 2008 financial crisis separate from the price of gold. It underpins a critical theme that gold miners, while indirectly linked to gold through production, are not a pure play on gold.
Unlike gold, historically gold miners have served as ineffective hedges against tail event risk and large market drawdowns.
Gold miners look like gold but act like equity
While gold miners are valid investments, they are an investment in equity not gold. Investors should view gold miners as distinct from gold allocations within portfolios in order to benefit from gold’s unique investment and risk management characteristics. Gold miners are a poor proxy for gold allocations because they depend on industry competition and company specific factors beyond the gold price. Their valuation is dependent on profitability, operational costs, financial health, and other company specific risks while industry outlook and growth prospects dictate investor sentiment. Many of these factors move independent of fundamental drivers for the gold market, but come into play for equity investors. Additionally, mining companies historically have undergone activities which have limited shareholder participation in the gold price. Activities including gold hedging programs, cost cutting measures, high debt financing, disadvantageous mergers & acquisitions, and dividend cuts (a key rationale to hold equity investments) have contributed to their underperformance to gold.
Gold miners offer inefficient sources of portfolio diversification by further adding equity factor exposure. Historically, they increased volatility and reduced returns relative to gold.
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Gold miners are not effective risk hedges
A critical investment benefit offered by gold is its role as a hedge against market turmoil and systemic risk. In this capacity gold has a proven track record with an average return of 7% during market drawdowns of more than 10% in the S&P 500 since 1987 (Table 1).
Turning to gold miners, however, their ability to hedge against large equity pullbacks is less enticing. The Philadelphia Stock Exchange Gold & Silver Index, a broad gold mining equity index, on average has posted a total return of -7.2%, offering limited downside protection against an average -21.1% drop in US equities. Of the 14 observations evaluated, gold has posted positive returns nearly 80% of the time while the gold miner index had positive returns only 29% of the time. Additionally gold has been the relative outperformer versus gold miners and beat the index 12 out of 14 periods of heightened US equity market volatility. Gold’s outperformance in the majority of these periods was by a considerable return differential (14.2% on average). It appears that gold miners have not acted as effective risk hedges in most periods compared to gold over three decades. During these market periods, gold miners have behaved more in line with equities and lacking gold’s historic downside protection qualities.
Cost cutting measures like debt and capital expenditure reduction have boosted gold mining companies’ earnings in the short term but at the expense of long term profitability.
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Gold miners are inefficient sources of portfolio diversification
Another key portfolio benefit of gold lies in its diversification capabilities. Gold historically has a zero correlation to US equities and 0.1 correlation to global equities from 01/01/93 to 08/31/16, making it a true diversifier against equity risk. Gold miners historically are highly correlated to the price of gold (0.7) over this same time period, yet lack the same diversification properties for portfolio allocations inherent to gold. By evaluating simple stock/bond portfolios, the inefficiency of using gold miners as a proxy for gold exposure becomes clear. As highlighted in Exhibit 2, a diversified stock/bond portfolio when allocated 10% to gold and gold miners respectively, sees the portfolio with gold yield a higher annualized total return (6.6% vs 6.3%)and considerably lower annualized volatility (8.0% vs 9.5%) compared to the portfolio with gold miners. Gold’s efficiency within a portfolio context is also reflected with its higher Sharpe ratio of 0.49 versus 0.38 for a portfolio utilizing gold miners. A key driver behind these results lies in gold miners’ higher correlation to equity and overall volatility (38%) since 1993 relative to volatility of gold (16%) as well as US and global equities, 14% and 15% respectively. Looking at another figure, risk contribution, highlights how much of total portfolio risk, as measured by volatility, is driven by a particular investment. For a 10% allocation to gold in a diversified portfolio, gold contributes less than its share to total portfolio risk (6.7%) while a 10% allocation to gold miners contributes an outsized 26.0% to total portfolio risk (more than 2x its asset allocation) making it an inefficient diversifier. Gold miners’ higher risk contribution is a direct result of its key drivers (or factors) being rooted in equity risk with movements closely linked to the market and economic cycle. Gold, however, stands as a stark contrast as its factors are rooted in drivers not easily replicable in other investments. Gold’s factors emanate from its diversified sources of supply and both cyclical and countercyclical sources of demand.
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The statements and opinions expressed are those of the author and are as of the date of this report. All information is historical and not indicative of future results and subject to change. Reader should not assume that an investment in any securities and/or precious metals mentioned was or would be profitable in the future. This information is not a recommendation to buy or sell. Past performance does not guarantee future results.