Updated Thursday, July 31, 2014 as of 5:28 AM ET
Precious Metals: Equities vs. Metals Themselves
Friday, July 11, 2014
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I've made the case that owning gold could be a good alternative asset as a part of a portfolio, but how does owning gold compare to owning precious metals equities (PMEs)?

As can be seen in the graph taken from William Bernstein’s book, Skating Where the Puck Was (data from Ken French “gold” series), PMEs also have a low correlation to stocks.

Bernstein notes that the lowest correlations occurred in the 1990s when only “stout-hearted, disciplined investors who knew that the asset class’ miserable recent returns had produced compelling valuations, and, moreover, who would not sell out during a generalized rout.” Correlations, of course, increased in following years as PMEs produced great returns.

Because PMEs are far more volatile than gold and other precious metals, they come into and out of favor more quickly. For example, the Van Eck Gold Miners ETF (GDX) has an annualized three-year return of -24.5%, and an annualized standard deviation of 30.6%, according to Morningstar. This compares to gold itself as measured by the SPDR Gold Shares (GLD) which tracks gold of a -5.5% three-year annualized return and with a 21.3% standard deviation.

Though it might seem like the better returning, less volatile gold is a better bet than the equities, remember that volatility can be a good thing if correlation is low or negative. It smoothes out total portfolio performance. I posed the question of owning gold versus PMEs to Bernstein. His response: "I’d rather own 2% PMEs than 4% gold."

Another case for owning PMEs are tax consequences. Gold and gold ETFs are taxed by the IRS as collectibles at the 28% tax rate, whereas PMEs qualify for the 15% long-term capital gains rate.

While no one knows how PMEs will perform going forward, Bernstein says that, as a result of recent awful performance of PMEs, “the suckers have mostly cleared out, and it's mainly the strong hands who are left." "Suckers" increase correlation with other risky assets, while "strong hands" decrease them, he says.

And Bernstein appears to be right, as Morningstar now shows the correlations between PME ETFs and the S&P 500 having dipped into negative territory.

One thing is clear, however, owning PMEs takes nerves and makes stock investing look boring by comparison.

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