Canadian Investment Review

Good as Gold?

Written by Jonathan Jacob on Tuesday, January 28th, 2014 at 6:22 am

714720_golden_eggAnyone looking to add a gold weighting to their portfolio must first answer the question: what is the best way to invest in the asset class? Two common options for most investors are to invest directly in the commodity or buy gold equities. In this article, we explore the relationship between gold and gold equities, uncovering the benefits and drawbacks of each option.

As expected, gold prices are a major performance driver of the S&P/TSX Gold Index. Revenues for companies in the index are directly impacted by the direction of the price of gold. The share price performance of gold mining companies is predictably correlated with the underlying commodity prices.  From time to time, however, various factors can cause a breakdown of the correlation between gold equities and the price of gold. Operational challenges experienced by the companies can negatively impact profits if output is lower than anticipated (i.e. unplanned mine outages) or if costs rise faster than revenues (i.e. rising wages, taxes or materials costs). Furthermore, as commodity prices reach new highs, previously unprofitable projects are often undertaken, fueling a rise in operating costs.

As these operational challenges occur, the equities often underperform the commodity prices, leaving investors disappointed. Investors are sometimes surprised by the lack of upside due to diminished correlation between commodity prices and their underlying equities. For example, say an investor has a positive outlook on the price of gold. They should not assume gold equities will keep pace with the price of gold.

Figure 1 depicts a strong link between gold and gold equities. In fact, between mid-2002 and mid-2014, the correlation of gold and gold equities was very high – on average, at 0.77. However, it is not safe for any investor to expect that the correlation will stay at 0.77. The correlation is in a continual state of flux and rose as high as 0.94 in September 2009 before falling as low as 0.50 in September 2011. Therefore, an investor can never know in advance how closely an investment in gold equities will track the underlying commodity, since the relationship is always changing.

Figure 1 (Click to enlarge)

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Source: Bloomberg, Greystone

Figure 1 shows that, from 2004 until late 2008, the performance of gold equities and gold were closely linked. However, by the end of 2008, the two began decoupling. As the price of gold kept rising, gold equities no longer fully participated in the bull run. Part of the reason for this breakdown is that investors saw the strong performance of gold as unsustainable. Thus, further gains were no longer being priced into equity valuations.

In Figure 2, we examine the relationship between gold and gold equities as a ratio. The line represents the ratio of the price of the S&P/TSX Gold Index (Total Return in US$), divided by the spot price of gold (in US$ per troy ounce). The chart indicates the value of the equities has fallen dramatically since 2003, relative to gold. At the start of 2003, it took approximately 2.9 ounces of gold to buy the index. By mid-2014, only 1.3 ounces of gold were required to purchase the index.

Figure 2 (click to enlarge)

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Source: Bloomberg, Greystone

Figure 3 shows the percentage return differential calculated by taking the gold spot return and subtracting the return of the S&P/TSX Gold Index (Total Return). This data shows that gold and gold stocks rarely have the same percentage returns over time. In fact, the returns are often significantly different. Gold equities outperformed gold by 22% in 2003; however, recent returns are much less spectacular. From 2011 to 2013, gold outperformed gold equities by 29%, 18% and 20%.  In short, investors who bought gold at the end of 2010 would have achieved superior returns compared to investors who bought gold equities.

Figure 3 (click to enlarge)

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Source: Bloomberg, Greystone

Gold and gold equities are not perfectly correlated and it is not safe to assume that buying gold equities will provide the same risk/return as buying gold. While gold equities can have more torque than gold in a rising market, investors eventually stop benefiting from gold advances. This is partly because equities do not fully price in extreme moves in the commodity, particularly when gold price moves are parabolic. Investors considering gold as a future investment option should be aware that gold and gold equities can behave very differently, and invest accordingly.

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