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September 29, 2009
As expected, GLD exhibits a low correlation to large-cap stocks (SPY), small-cap stocks (IWM), and even a fairly low correlation to precious-metal producers (VGPMX). Gold is supposed to provide a hedge against inflation, so it is reassuring that GLD correlates more highly to inflation-protected bonds (TIPS) than to nominal bonds (AGG). It also makes sense that the correlation between GLD and AGG (which has a moderate sensitivity to interest rates) is higher than between GLD and TLT (which has high sensitivity to interest rates). DJP tracks the Dow Jones AIG Commodity Index, a component of which is gold.
Including gold in a portfolio is attractive because of gold’s low correlation to major asset classes. By adding an asset class with low correlations and positive expected returns to a portfolio, investors can increase expected return without increasing risk. That outcome is contingent upon gold having a positive expected return, of course, but also upon a manageable level of volatility. As we consider gold as an investment, it is important to have a sense for the basic portfolio statistics:
Historical statistics for three years through August 2009 (Beta is with respect to the S&P500)
Over the past three years, the volatility of GLD has been very close to that of the S&P500, around 20%, but the average return on GLD has been almost 16%, beating all other major asset classes. This, of course, is a big reason why so many investors are interested in gold. Money flowing into asset classes tends to chase performance.
Gold in a Monte Carlo framework
Alternatively, we can look at a Monte Carlo projection for these asset classes that have been calibrated so that the projected volatility for the S&P500 is consistent with long-dated options on SPY (and otherwise using all default settings and the same three years of data as input). This approach provides useful insights into the relative pricing of risk.
Monte Carlo Projections
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