Is Investing in Gold a Good Idea?
by John Elder, PhD, CFA, FRM
Commodity prices have been extremely volatile over the last several years. In 2008, the spot price (the price for immediate delivery) of crude oil (the particular type of crude oil I am referring to here is West Texas Intermediate) reached an all-time high, exceeding $130 per barrel. More recently, the price of gold reached an all-time high, exceeding $1,400 per ounce. Many other commodities, including other metals and agricultural products, have exhibited similar price trends.
Investors naturally have wondered whether they can benefit from this price appreciation through investments similar to those in the stock market. The answer is that they might, to an extent.
Although it is not typically feasible for investors to hold the underlying commodity directly, since contracting for delivery and paying for storage is too cumbersome for most investors, there are several investment products designed to mimic changes in various commodity prices. These products, however, come with some very important caveats.
One important caveat that applies to all commodity investments is that they don’t produce income in the form of dividends or interest, as do stocks and bonds. In fact, commodity investments, rather than producing income, typically involve some embedded cost related to storing the underlying commodity. An investor must therefore rely on pure price appreciation, in excess of storage costs, to generate returns. This and other issues can be illustrated by taking a closer look at two popular commodity investments that are available to investors as exchange trade funds (ETFs).
ETFs are, in some ways, similar to mutual funds in that the investor owns “shares” in an underlying pool of assets. One of the most popular commodity ETFs over the last several years has been the United States Oil fund, with the ticker USO. USO gains exposure to oil prices by purchasing commonly traded contracts for delivery of oil (typically West Texas Intermediate) in the near future, typically at horizons of one or two months. The price of these futures contracts tends to vary with the spot price of West Texas Intermediate crude, so the share price of USO tends to vary with the spot price of oil.
The price variation, however, is not perfect, in part because USO does not take physical delivery of the oil. Each month, the fund must sell its current futures contracts and buy new futures contracts with delivery dates one month further into the future. For example, during the month of January, the fund sells contracts for delivery of oil in February and buys new contracts for delivery of oil in March. The fund must therefore continuously “roll over” the nearby futures contracts to gain the desired price exposure.
A significant issue with this strategy is that the new futures contracts being purchased typically have been more expensive than the old futures contracts being sold. This may be due to several technical issues—such as the cost of storing the underlying oil, interest rates or the desire of firms in the oil industry to hold physical oil.
For the long-term investor, the end result can be quite surprising. Figure 1 plots the price of West Texas Intermediate crude and the share price of USO from 2006 through 2010. To facilitate comparison, both prices are normalized to zero at the beginning of the sample. The two prices tend to move together, but the share price of USO tends to lag, as the costs associated with rolling the futures contracts and running the ETF erode returns. Over this five-year period, the end result is quite dramatic. The spot price of oil has increased by more than 20 percent, while the share price of USO has declined by more than 50 percent!
Some of these problems can be avoided in a popular ETF that is designed to track the price of gold. This ETF, with the ticker GLD, purchases and warehouses physical gold. As investors buy more shares in the fund, the fund purchases and stores more gold. Storing gold is not without cost, however. The fund’s expenses are about 0.5% of assets each year, so the share price of GLD still lags the spot price of gold, although not as dramatically as USO has lagged the spot price of oil.
If we evaluate the underlying gold asset as a long-term investment, the historical record is mixed. Like oil, gold does not pay dividends or interest—rather, it is costly to store. Often, investors claim to purchase gold as a hedge against inflation, but the price of gold has not historically had a strong tie to the level of inflation. To illustrate this, Figure 2 plots the spot price of gold and the consumer price index since 1980, the peak of the last gold craze. Surprisingly, an investor who purchased gold in 1980 would, after 20 years, have found their investment down 50%, while consumer prices would have doubled! This investor would have waited 25 years to break even—longer if we include storage costs—all without the benefit of dividends or interest. As it turns out, this investor would have been much better off had they purchased gold in 1970, but that does not detract from my point that the relationship between gold and inflation appears either very weak or nonexistent. As an aside, many agricultural products have comparable historical returns, with technological progress fueling gains in productivity that have caused prices to stagnate for decades.
Gold has therefore not been a particularly good hedge against inflation. Indeed, there is little reason to believe it should be a better inflation hedge than a diversified stock investment (since overall inflation may have no net effect on a firm’s profitability) or bonds that include an explicit inflation adjustment, such as Treasury Inflation Protected Securities (TIPS).
In conclusion, commodity investments recently have drawn much attention. Their historical performance as long-term investments is decidedly mixed. Commodity investments produce no income, they are costly to store and their prices have tended to stagnate for decades. Their performance is even worse than the past decade has been for stocks! Moreover, existing vehicles for investing in commodities may significantly underperform the target spot price.
This essay has touched on just a few prominent issues related to commodity investments. Many other issues, such as evidence that commodities may help diversify traditional stock and bond portfolios, are worthy of consideration. This essay, however, does help illustrate why commodity investments should be evaluated carefully by long-term investors. It also illustrates why, at Bell State Bank & Trust, commodity investments are used judiciously to enhance a long-term investment strategy, which focuses on competitive returns with less than market risk.
Dr. Elder, an Associate Professor of Finance, Daniels Fund Faculty Fellow and Dean’s Scholar in the Department of Finance and Real Estate at Colorado State University, is a member of the Investment Committee for the Trust & Investment Division at Bell State Bank & Trust. He formerly taught at North Dakota State University.
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