From the September 2006 issue of Wealth Manager Web • Subscribe!

September 1, 2006

Minting Money

The quest for superior risk-adjusted portfolio returns knows no bounds in the 21st century. Investors routinely look beyond the traditional mix of stocks, bonds and cash. Commodities, hedge funds and private equity are among the more popular choices in the search for alternative asset classes. The amorphous category of art and collectibles is also gaining attention. Does that mean that rare coins are worthy of a spot in strategic asset allocation?

The question invariably leaps to mind after reading a recent study by Robert Brown, chief investment officer in the Encino, Calif. office of Genworth Financial. After crunching data on 62 years of price history through 2003, Brown concluded that rare coins are "a highly attractive complementary asset category that even with a small allocation provides good diversification for a well-diversified portfolio...," according to his study, published in August 2005 on the Journal of Financial Planning's Web site ("Rare Coins: A Distinct and Attractive Asset Class," www.fpanet.org/journal/BetweenTheIssues/Contributions/080105.cfm).

Recently, Brown updated the research, adding two additional years of performance data through last November. The long-term performance record still looks impressive. His proprietary index of rare coins posted a mean 9.8 percent return for the 64 years through the end of November 2005. That compares with 12.2 percent for the S&P 500 and 5.6 percent for long-term Treasury bonds, the study reports, although on a risk-adjusted basis, coins ranked higher than stocks as well as bonds (see "The Rarity Factor, page 70).

His yet-to-be-published follow-up paper takes a step beyond its predecessor's mandate by identifying the main variables driving rare coin prices, the author explained in a recent interview with Wealth Manager. Three factors stand out, says Brown, a CFA who earned a Ph.D. in finance from Northwestern. The leading driver is economic growth, followed by long-term Treasury bond returns, with silver prices in third place, he says.

Brown--a private coin collector himself--advises that the collectibles represent "a critical component of my wealth management solution." As CIO of Genworth, however, he cannot recommend rare coins officially. The reason? The firm isn't prepared to make collectibles recommendations--at least not yet.

But for advisors inclined to put a slice of client portfolios into the likes of an 1808 large U.S. cent (among Brown's prized pieces), Genworth's CIO offers ammunition to the case for using rare coins in asset allocation plans.

Why did you revise your earlier study?

Two reasons: First, I updated the data, which adds two more years of numbers, with performance through November 2005. I also focused on causality from the standpoint of drawing conclusions about what drives rare coin prices, and under what conditions rare coin investments do well. The results are somewhat instructive [in that] there appears to be an explanatory connection between rare coin prices and three variables: How fast the economy's growing, performance of long-dated bonds, and the inflation-adjusted behavior of precious metals, measured by silver.

How did you determine that those three variables are so influential?

Simple statistical tests. Initially, I looked at about 25 explanatory variables. Most were asset categories, along with some economic variables like population and gross domestic product per capita. The three that came out on top were the statistically strongest variables. And in my mind, they fit with intuition.

Rising GDP, for example, makes sense. The faster the economy's growing, the more wealth there is for investing in collectibles. And vice versa. If a recession or depression hits, you'd expect a pullback in the wealth available for collectibles.

As for long Treasuries, if interest rates are relatively high, and bonds are doing well and posting solid returns, people are going to start viewing bonds as a practical alternative for their wealth. In turn, that pulls money away from collectibles.

The third component driving rare coin prices is precious metals, which I suppose is a proxy for people looking for physical assets instead of securities. And silver usually dominated gold in this respect.

Why is that?

Perhaps gold reflects other phenomena, like fear factors, which is a confusing element [for analyzing rare coin prices] and so I didn't use it.

So silver is a superior predicator of rare coin prices over gold?

Yes, clearly so.

What about equities? How do they fit in, if it all, to your model?

I was expecting that equities would appear with an inverse relationship to rare coin prices. That is, when equities did well, they'd take assets away from coins. But the data didn't support that assumption. During an isolated time period, sure, there's a seeming relationship. But it's not there over the 64-year period I studied.

What's the worst-case environment for rare coin investing?

A period similar to 1980-1993, for example, when interest rates kept falling. Those years generated larger and larger profits for bonds because fixed-income securities prices appreciated as inflation kept surprising on the downside.

Does that mean that rising inflation helps rare coin prices?

I looked at whether inflationary surprises on the upside do a better job of predicting, forecasting or directing rare coin prices. The answer is no. Bond returns did a much stronger job of directing rare coin prices.

What's the bottom line for rare coin investing?

First, you want a robust economy--rapidly growing, ideally. You also want rising interest rates because it undermines the opportunity cost because you're probably losing money on bonds. And you'd like to see investors focus on physical goods. When you have those three things conspiring, historically that's when rare coin prices have done their best.

Are you surprised by your latest findings?

Before I saw any of the results, I was fairly neutral on the whole thing. Before running the statistics, I expected that inflation, inflation expectations, or inflationary surprises would be one of the leading variables, but they weren't. There were other surprises, too. I was surprised by how high the returns were for rare coins versus other asset categories. Over the 64 years through last November, rare coins had a considerably higher return per unit of risk compared to about two-thirds of the other asset categories I studied (see "The Rarity Factor," at left).

In your study, one-year Treasuries post the best return/risk ratio in your ranking of 18 investment categories. Your reaction?

Short-term Treasuries did so well because their risk level is so low. Those Treasury returns are higher than their standard deviation, and that's why they look so good. That doesn't mean you should build a portfolio only with one-year Treasuries, because if you do, you'll end up giving up much on the return side.

That said, rare coins not only have a very favorable return per unit of risk; they also have a fairly high absolute historic return: 9.8 percent a year over time on a geometric basis. I was surprised at how high rare coins returns were.

How did you build your index of rare coins?

I used prices published in the so-called 'Blue' and 'Red' books [The Official Bluebook Handbook of United States Coins and A Guide Book of United States Coins, respectively] as far back as they went, which is to 1941. For each year, I took a sample of 650 coins. The universe was equally weighted by coins, and it was redefined each year based on what was in the next book. I chose the highest grades of coins available in the books for each year. To oversimplify, my index is made up of the 650 non-gold coins that represent the highest quality coins across the various denominations. I excluded gold because I didn't want any confusing element from gold pricing.

Does the fact that your rare coin index performs impressively over time suggest that investors should own rare coins?

Yes, but with some qualifications. The first is that someone should ask the question, 'Why on earth are rare coins generating these kinds of returns and with such consistency?' I think it comes down to the fact that we've got robust economic growth, and as long as that continues--a reasonable presumption--then you can check that box. The other issue is that there's a serious question regarding acquisition and storage costs, along with the information required to build a coin portfolio. Acquisition costs are significant.

Define acquisition costs.

How much you have to pay for a coin over its fair-market wholesale value. And that mark-up can be fairly high. There's nothing wrong with that, but it says something about your holding period; it has to be considerably long in order to justify the acquisition cost. In addition, there's the information hurdle. One either has to have the knowledge base or work with people who have the knowledge base to go after the attractive opportunities.

Then does all this suggest that investors should steer clear of rare coins?

Sometimes I hear the comment that the acquisition costs are so high, and the information so difficult to acquire, that it makes rare coin investing unpalatable. But I think the two are connected. One of the reasons that the acquisitions costs are relatively high is because if you're doing this right, part of what you're acquiring is the knowledge base. That means that you find the dealers with the knowledge, the connections, the ethics, the pricing, and so they're the agents working on your behalf. Yes, there's a search process involved, but I'm not sure it's any different than building a portfolio of rental properties. You'd have to go out and get expertise and pay fairly for it. I'm not sure collectibles are any different.

What's your recommendation on holding periods for rare coins?

There are two issues. One is, what point in the cycle are we in? The other, what's the time horizon? Rare coins had a rough time from 1980 to about 2003. That made for a marvelous entry point. Since then, there's been a shift of attention toward physicals, as expressed by the rising prices of precious metals and real estate. But even if you buy at the right spot in the cycle, you probably still want to wait a dozen years or more before selling because of acquisition and disposal costs.

As we speak, in the middle of 2006, is it still a good time to buy coins?

Yes, absolutely. If one asks, 'Is the cycle with us or not?' It certainly is neutral, and probably still favorable.

How long have you been collecting coins and how did you get interested?

I've been collecting for about 25 years.

Collectibles has always been an interesting area. And in my position as chief investment officer, I'm always asking the question, 'What are the asset categories, how do they behave, and what are the alternatives?' [Coins] started purely as a hobby for me, and now has progressed to being a critical component of my wealth-management solution. I see it as part of the retirement game.

How big a share are coins in your overall investment portfolio?

About 9 percent.

What's one of your more prized coins?

It's probably an 1808 large U.S. cent, in very nice condition.

As chief investment officer of a financial planning firm, are you recommending that clients put money into coins?

No, because we haven't structured ourselves to make that a product offering. Our business model is working with advisors, as opposed to the end clients. We provide turn-key, client-ready wrap accounts, investment solutions to our advisor clients, including broad asset allocations using mutual funds, ETFs, and individual stock selection through outside managers.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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