Gold is getting a lot of attention from investors, in large part because it has outperformed all major asset classes over the past several years.  There are also other, more fundamental reasons why investors are looking towards gold.  The looming specter of inflation and a weaker dollar tends to motivate interest in real assets.  The long-term perspective on precious metals typically focuses on the low correlation between gold and other asset classes.  Indeed, when investors are selling off equities, they often pile into precious metals, as we have seen in recent years. 

There is considerable debate, however, among academic experts on what role, if any, precious metals should play in long-term asset allocation.   Financial theory has trouble categorizing gold as an asset class because nothing about it inherently gives reason to expect a long-term real positive return.  (see here)

That said, gold has provided a ‘store of value’ and has historically delivered attractive returns, especially from the standpoint of the recent ‘lost decade’ in equities: Years through 2008

Historical returns from holding gold (in USD, no cost of carry)

Gold goes through extended periods of high or low performance.1  The correlation between successive months’ returns on gold is highly statistically significant over the last fifty years.  The annualized standard deviations in returns (formed using monthly data) thus tend to understate the risk associated with gold, since the serial correlations tend to fatten the tails of a distribution.  The annualized standard deviation in returns on gold over the 50-year period using 12-month returns is 22% (vs. 18.5% shown above). 

All of this cautions against simply looking at historical returns from gold. 

There are good reasons for investors to maintain a long-term strategic allocation to gold, which has clear, positive portfolio benefits (due to low correlation to other asset classes).  That said, gold is in an historic run-up in value and has been generating unsustainably high returns.  Because of its high price and rising volatility, there is significant tactical risk in gold. 

How, then, can one pragmatically maintain exposure to gold while limiting downside risk? Take a small leveraged position using options on GLD.  This provides exposure to the upside, in case gold continues to climb, but also creates a floor on losses if gold tanks.

Historical correlations and volatility

How do we rationalize the positive returns from simply holding a physical commodity such as gold?  For many investors, gold provides protection against the contingency of rampant inflation.  As such, one might argue that the long-term returns for holders of gold are rational because the financial system rewards those who provide access to this ultimate form of reserve currency.  But even if this is the case, there must be some rational way to value gold—it cannot be a great investment at any price. 

The creation of the gold ETF (GLD) has made it far easier to invest in gold as a pure commodity.  In fact, GLD is the sixth-largest holder of bullion in the world (see here).  GLD provides a useful way to explore gold as an investment, not least because it has exhibited far lower volatility than the CBOE Gold Index (^GOX), which tracks the performance of gold-mining firms. (see here)  GLD was launched in late 2004, so it now has a sufficient track record to provide some interesting insights.

Based on three years of trailing data through the end of August 2009, the correlations between GLD and a series of ‘core’ asset class funds are shown below:

GLD and core asset class funds

1 In technical terms, this means that gold has serial correlation in returns