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Gold: Worth the Risk?

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One of the most perplexing questions facing investors these days is what to make of gold. With the cracks in the global financial system seemingly growing wider, and gold prices in the midst of a decade-long rally, more investors are wondering, do I buy? Sell? Wait until later?

With the listing of the SPDR Gold Shares, then called the StreetTRACKS Gold Trust, exchange traded fund (GLD) in November 2004, questions about gold have become more pressing. Prior to the fund’s launch, there really was no convenient way to invest in gold, and so few investors owned it. Those who wanted to speculate traded futures, and the true believers stashed coins in their attic.

Now, there is $2.1 billion in Gold Shares traded every day and it is the second largest U.S. ETF by assets — $68 billion as of October 31. Several copycat ETFs – including the iShares Gold Trust (IAU), the ETFS Physical Shares Gold Trust (SGOL), and the ETFS Physical Asian Gold Shares (AGOL) – have sprung up to tap into the demand for gold, proving the old adage that imitation is the sincerest form of flattery.

These new offerings, together with the dramatic rise in gold prices since 2005, the financial crisis of 2008 and 2009, and the massive budget deficit spending programs underway in the U.S. and Europe, have served to make gold a central topic of investor interest.

There is no shortage of opinion about where gold prices will head in the future, but nobody really knows for sure. Standard & Poor’s Equity Analyst Leo Larkin, who follows gold mining companies, believes that gold prices will reach $1,900 per ounce by the end of 2012. While that may seem attractive, it’s only a 6% gain from gold price levels that prevailed in early November 2011.

Diehard gold fans probably own gold already, so for those still asking whether or not to own gold, a better question might be whether gold would help or hurt their portfolio’s overall, risk-adjusted return.

While the merits of gold as a long-term store of value or a hedge against inflation can be argued ad infinitum, it seems intuitively clear that gold belongs to an asset class that is distinct from the equity and fixed income categories that dominate most portfolios.

That intuitive sense is backed up by the numbers as well, according to a recent report from the World Gold Council, a trade group for the world’s largest gold miners.

For the period of January, 1987 to June, 2011, the monthly returns delivered by gold had a negative correlation to most domestic equity asset classes, and less than a 0.5 correlation to all 16 asset classes studied. (Interestingly, the study found that gold has been less volatile than seven of those 16 categories, including U.S. large-cap equities, developed world equities, and real estate.)

Using these and other statistics, the report concludes that gold can improve risk-adjusted returns for portfolios made up of equity, fixed income and commodity assets, as well as those holding private equity, hedge fund, and real estate assets.

The study found that for professionally managed portfolios with 55% in equities, 25% fixed income, 5% cash and the remainder in alternative asset classes, as well as more conservative portfolios (35% equity, 50% fixed income, 10% cash and the remainder in alternative categories), gold allocations of 3.6% to 4.4% can improve risk-adjusted performance.

Whether that will prove true in the future, however, is another matter. The period surveyed included a long period of time, 1987-2004, when gold prices varied by little more than $200 an ounce, as well as a 260% rally that occurred over the last six years. Of course, that rally may be repeated in the years ahead, but then again, it may not.

Also, while that period included many unusual and unforeseen events, the central attraction to gold for many is that it holds its value during periods of inflation, and inflation was notably absent – at least from a historical perspective – during that period.

While it may be the case that an added dose of inflation would have made gold perform even better, it may also be the case that if interest rates rose in response to stronger inflation, the cost of owning gold would have risen as well, and its attraction might have waned as a result.

Yet another issue to consider is that many admirers of the yellow metal formed their opinions when there were less sophisticated hedging instruments available to individual investors. With the growth of the ETF industry, investors now have access to funds that deliver the inverse performance of a wide range of equity, fixed income, and currency-based assets.

These instruments can be targeted at specific risks, such as inflation or currency devaluation, while the same cannot be said for gold. Some, such as Treasury Inflation Protected Securities, offer a modest return even when markets move against them.

In conclusion, gold has many attributes that investors want, and since 2005 it has been one of the few assets that have delivered positive returns year after year.

For those who firmly believe that will be the case in the future as well, owning gold can make sense, especially if it is an allocation of 3% to 4%. For those primarily interested in total return, however, gold is only one of many ways to diversify and improve risk-adjusted returns.

S&P Capital IQ Senior Editorial Manager Vaughan Scully can be reached at [email protected]. Send him your ideas for ETF and mutual fund stories.