Do Precious Metals Shine?

An Investment Perspective
Author(s): David Hillier, Paul Draper and Robert Faff
Source: Financial Analysts Journal , Mar. - Apr., 2006, Vol. 62, No. 2 (Mar. - Apr., 2006),
pp. 98-106
Published by: Taylor & Francis, Ltd.

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 Financial Analysts Journal
Volume 62 . Number 2
02006, CFA Institute

Do Precious Metals Shine?

An Investment Perspective
David Hillier, Paul Draper, and Robert Faff

The investment role of precious metals in financial markets is investigated by analysis of daily data
for gold, platinum, and silver from 1976 to 2004. All three precious metals have low correlations
with stock index returns, which suggests that these metals may provide diversification within broad
investment portfolios. Moreover, the data reveal that all three precious metals have some hedging
capability, particularly during periods of "abnormal" stock market volatility. Financial portfolios
that contain precious metals perform significantly better than standard equity portfolios.

F or centuries, gold and silver were perceived
to be important hedging mechanisms
against economic uncertainty. Since the col-
lapse of the Bretton Woods system and the
move to floating exchange rates, however, the mar-
kets for gold and silver have changed significantly.1
We consider the following questions about gold
and other precious metals (silver and platinum):
What role does gold play in today's financial mar-
kets? Are the markets for precious metals efficient?
Do precious metals provide valuable diversifying
qualities beyond those achievable in a portfolio
devoted solely to financial assets?
We provide a comparative analysis of the roles
of gold, silver, and platinum in the capital markets.
Platinum is included to allow comparison of the
investment properties of gold and silver (tradi-
tional "investments of last resort") with those of a
precious metal used primarily for industrial pur-
poses and traded as a commodity. Platinum repre-
sents the behavior of "other metals,"' such as
palladium, nickel, and copper. If gold and silver
have become relegated in status to the same stand-
ing as other commodities, their investment proper-
ties should be similar to those of platinum.
The literature on the role of gold and other
precious metals in financial markets can be classi-
fied into five main types:
1. the investment and diversification properties
of precious metals when combined with stock
market investments in financial portfolios (e.g.,
Chua, Sick, and Woodward 1990; Jaffe 1989);
David Hillier is professor offinance at the University ofwe examined the investment properties of precious
Leeds, United Kingdom. Paul Draper is professor of
finance at the University of Exeter, United Kingdom.
Robert Faff is professor offinance at Monash University, recent bull run in gold prices as well as the
Australia.
2. the role of gold as a potential hedging variable
in intertemporal asset-pricing models (e.g.,
Rubio 1989; Davidson, Faff, and Hillier 2003);
3. the properties of the return distribution and
the possibilities for earning excess returns in
the gold and silver markets-that is, the effi-
ciency of these markets (e.g., Solt and Swanson
1981; Aggarwal and Soenen 1988);
4. the relationships of gold (and silver) to macro-
economic variables and government policy;
5. the particular features and characteristics of
gold (and silver) production and market
processes.
Chua et al. and Jaffe examined the benefits of
diversifying investment portfolios with gold stocks
and generally observed a diversifying effect for
gold. Taking a global portfolio perspective,
Johnson and Soenen (1997) found that after 1984,
investment in stocks and bonds outperformed
gold. Also of particular relevance to the current
study are the papers of Chan and Mountain (1988)
and Frank and Stengos (1989), who provided an
analysis of the pricing relationship between gold
and other precious metals. Frank and Stengos
revealed some nonlinear dependence between sil-
ver and gold prices, whereas Chan and Mountain
found a "simultaneous relationship between the
price of gold, the price of silver, and the treasury
bill rate" (p. 75).
The study reported here makes several contri-
butions to existing literature. First, we examined a
significantly more comprehensive and recent
dataset than earlier work of this kind. Specifically,
metals jointly over a 30-year period ending in mid-
2004. As a result, our analysis incorporates the
extended bear period of the 1990s. Second, our

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analysis improves upon earlier work by modeling
time-varying volatility to promote understanding
of the investment properties of precious metals.
Third, we undertook the analysis from both a U.S.
and a non-U.S. perspective. Fourth, we provide for
the first time a comparative analysis of traditional
investment precious metals (gold and silver) with
an industrial precious metal (platinum) to high-
light their similarities and differences. This com-
parison allows us to infer the impact of investment
activity from the core properties of precious metals.
Precious Metal Markets
Precious metal prices respond to both short-term
and long-term factors. Platinum (and, to a lesser
extent, silver and gold) supply is primarily geared
toward industrial uses, with the quantity supplied
determined by the quantity demanded by industry.
Demand, in turn, is a direct function of the well-
being of the economy. In the long term, prices of
platinum will rise if industrial activity increases
and fall if industrial activity declines.
Price movements can also be affected over
extended periods by changes in the large stocks of
gold and silver held by central banks. Among met-
als, gold is unique, in that a substantial share of
total demand is derived from nonindustrial uses.
Gold is a primary form of reserve asset held by
central banks around the globe. For example,
according to the World Gold Council, as of March
2004, the United States, Germany, France, and Italy
held approximately half of their capital reserves in
the form of gold bullion.3 In addition, in periods of
economic and political uncertainty, investors fre-
quently take short-term speculative positions in
gold and silver to hedge against perceived risks in
the equity and bond markets.
The market for gold is exceptionally liquid.
The average daily volume of gold cleared in the late
1990s by the London Bullion Market Association
(LBMA), the world's foremost precious metal mar-
ket, was 933 tons, which can be compared with total
annual world gold mine production of approxi-
mately 2,300 tons. In effect, total annual gold pro-
duction is cleared by the LBMA approximately
every 2.5 days. The total amount of silver cleared
daily is approximately 7,775 tons.4
Private investment demand for gold comes in
two forms-physical hoarding of bars and invest-
ment in financial gold securities, such as options,
futures, and warrants. Total private holdings of
gold are unknown but have been estimated to be
about 22,000 tons worldwide (Sherman 1986), nated in U.S. dollars, designed to measure the over-
which is comparable in size to total official holdings
all condition of overseas markets (from a U.S.
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Do Precious Metals Shine? An Investment Perspective
of the metal. Given the relative size of private-sector
holdings, changes in private-investor sentiment
clearly play an important role in the gold market.
Demand for silver is dominated by industrial
requirements (approximately 40 percent of annual
silver production) and jewelry (approximately 45
percent of annual silver production). The demand
for silver for private investment is not as high as
for gold; about 11 percent of total silver demand
comes from financial investment purposes
(Radetzki 1989). Official government reserves of
silver-at approximately 7,500 tons, less than one
year's production-are also considerably lower
than official gold reserves. Silver is primarily
obtained as a byproduct of gold mining; as much
as two-thirds of total world silver supply comes
from this source. As a result, the price of silver is
strongly related to that of gold.
Platinum also is jointly extracted with other
metals (especially palladium but also rhodium,
ruthenium, nickel, and chrome). Demand for plat-
inum comes primarily from industry for the con-
struction of catalytic converters for automobiles.
Private investment in platinum absorbs a small
component of worldwide supply; it contributes less
than 10 percent to the total amount demanded.
Platinum is not held by central banks in the form of
reserves, and therefore, the market for this metal is
not directly sensitive to central bank actions.
Short-term speculative price changes of these
metals and the metals' diversifying properties for
financial portfolios are the focus of this article. To
date, no study has carried out a comparable analy-
sis of this issue for the three metals. Industrial
demand being a large source of demand for gold,
silver, and platinum, however, suggests that simi-
lar factors affect the prices of all three metals (with
central bank sales providing an additional influ-
ence in the market for gold and silver). If common
factors do affect their prices, then price changes
among the metals will tend to be correlated.
Empirical Data
Our precious metal data (from DataStream Interna-
tional) are daily, continuously compounded
returns derived from the London gold bullion price
in US$/Troy ounce, the London Free Market plati-
num price in US$/Troy ounce, and the Zurich silver
price in US$/kilogram. The S&P 500 Index is the
proxy for stock market returns from a U.S. inves-
tor's perspective. The MSCI Europe/Australasia/
Far East (EAFE) Index is used as an alternative.
EAFE is a market value-weighted index, denomi-
www.cfapubs.org 99
Financial Analysts Journal

perspective). Our primary motivation for including
EAFE was as a robustness check-specifically, to
assess whether our findings are applicable to the
U.S. market only. The sample period extends from
1 January 1976 to 1 April 2004.5
With regard to the basic descriptive statistics
of our dataset, a number of features are worth
noting. For the full period, the mean daily returns
were all positive but small. Of the precious metals,
platinum provided the highest mean daily return
of 0.04 percent (approximately 9 percent a year).
The annualized mean return for the S&P 500 was
about 13 percent. Silver had the most volatile
return series, with a daily standard deviation of
2.15 percent-about twice the volatility of the S&P
500.6 Reflecting these volatile returns, silver expe-
rienced the highest maximum daily return over the
sample period (35.5 percent) and lowest minimum
return (-18.6 percent).7 The correlations of pre-
cious metal returns with each other and with
equity returns are reported in Table 1.
In Panel A of Table 1 for the full sample period,
three features are important. First, the returns for
all three precious metals have zero correlations
with the S&P 500 return. This result indicates that
the unconditional elasticities of the precious metal
market are close to zero.8 Second, the correlations
between EAFE and precious metal returns,
although low, are positive at around 0.14. Third,
the correlations between the precious metal
returns are high (0.5 to 0.6) but not so high that any
of the three metals is redundant from an invest-
ment perspective.
Panels B, C, and D in Table 1 present correla-
tions for various subperiods. Through all subperi-
ods, the correlations between the S&P 500 return
and the precious metal returns remain close to zero.
Interestingly, a downward trend over time is visi-
ble in the correlation between returns to EAFE and
returns to the precious metals. In addition,
although the precious metal correlations remain
high throughout all the subperiods, they tend to
display a similar downward trend.9
Research Method
We began our analysis of precious metal returns by
considering the conditional variance properties of
each series and applying the standard GARCH (1,1)
model.10 In unreported results, we found that the
model fit the three precious metal return series well
and that all coefficients were positive and statisti-

Table 1. Correlation Structure of Gold, Silver, cally significant.11

Platinum, S&P 500, and EAFE Returns We examined the diversification properties of
precious metals by estimating market model-type
Gold Platinum Silver S&P 500 EAFE
regressions:
A. Full sample period, 1976-2004

Gold 1.00 0.58 0.55 -0.03 0.14 RPMt = aPM+ PpMRm,t + 6PMt (1)
Platinum 1.00 0.50 0.01 0.14
where RpM,t is the daily return on the precious
Silver 1.00 -0.02 0.11
metal (PM) at time t and Rm,t is the daily return on
S&P 500 1.00 0.23
the S&P 500 (or EAFE) market (M) index for the
EAFE 1.00
corresponding period. An asset almost totally
B. 1976-1984 devoid of any diversifying properties will have an
Gold 1.00 0.67 0.61 0.06 0.29 elasticity (regression slope coefficient) that is signif-
Platinum 1.00 0.55 0.05 0.27 icantly positive and the R2 of the regression (Equa-
Silver 1.00 0.01 0.25 tion 1) will approach +1. If an asset has nearly
S&P 500 1.00 0.14 maximum diversifying properties, its elasticity will
EAFE 1.00 be significantly negative. The more negative a
metal's elasticity, the greater the diversification
C. 1985-1994
benefits achievable from including that metal in a
Gold 1.00 0.62 0.52 -0.12 0.07

Platinum 1.00 0.54 -0.03 0.13

portfolio.
Silver 1.00 -0.04 0.05 This approach is unconditional and may

S&P 500 1.00 0.17 obscure some potentially useful insights into the
EAFE 1.00 more subtle diversifying properties of precious
metals. To capture such effects and accommodate
D. 1995-2004
conditional diversifying features, we estimated a
Gold 1.00 0.26 0.31 -0.09 0.04
modified version of Equation 1 that differentiates
Platinum 1.00 0.29 0.01 0.03
between periods of high and low (market) volatility:
Silver 1.00 -0.05 0.03

S&P 500 1.00 0.34 RpiM, t M = PpM+ BRm,t + yVolDumt (2)

EAFE 1.00 + rjRetDumt + ?PM,t

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 Do Precious Metals Shine? An Investment Perspective

where VolDum is a multiplicative dummy variable Table 2. Diversification Properties of

equal to the market return when the GARCH (1,1) Precious Metal Returns, Data for
S&P 500 return volatility series for a period was January 1976-April 2004
more than 2 standard deviations (2a) above mean Gold
market volatility; VolDum is equal to zero in all Bullion Platinum Silver
other periods. RetDum is a multiplicative dummy A. S&P 500 as market proxy
variable equal to the market return when the mar- Constant 0.0059 0.0056 -0.0017
ket return was more than 2 standard deviations (0.59) (0.39) (-0.10)
lower than the mean market return; RetDum is zeroS&P 500 return -0.0673*** -0.0286** -0.0476***
in all other periods. (-9.43) (-2.37) (-3.97)
Equation 2 allows four basic cases with Durbin-Watson statistic 2.10 2.02 2.22
respect to precious metal elasticity (as an indicator
B. EAFE as market proxy
of diversification properties). The base-case elas-
Constant -0.0014 0.0008 -0.0049
ticity, PPM, represents times of "normal" stock
(-0.14) (0.06) (-0.28)
market volatility and relatively high market
EAFE return 0.0848*** 0.1462*** 0.1020***
returns. From an investor's perspective, such a
(9.34) (10.40) (6.70)
period represents "good/stable" times and is not
Durbin-Watson statistic 2.10 2.03 2.22
a situation in which diversification benefits (low
Notes: The model was estimated from Equation 1. The model was
or negative correlations) are of great value.
adjusted for GARCH (1,1) effects in the precious metal return
Indeed, investors would hope to avoid the "offset- series. For the Durbin-Watson statistic, refer to Durbin and Wat-
ting" effects of other investments because, in this son (1951).

scenario, such offsets would more than likely rep- **Significant at the 5 percent level.
resent a reduction in overall portfolio return ***Significant at the 1 percent level.

(hence, wealth). In an "unstable" scenario, when

equity market volatility is abnormal (more than 2
standard deviations from the mean) and returns With regard to the S&P 500, note that all the
are "poor" (more than 2 standard deviations elasticities are significantly negative (with gold and
below the mean), the potential diversifying bene- silver significant at the 1 percent level). This result
fits of other investments are desirable. In this set- suggests that from an overall perspective, all three
ting, investors would want a negative precious precious metals are potentially valuable diversify-
metal elasticity (given by PPM + y + rl). These four
ing assets as part of an investment portfolio. How-
cases are summarized as follows: ever, the economic impact appears modest: The
magnitude of all three negative betas is less than 0.1.
Volatility The major contrast between Panel A and Panel
B (EAFE results) is that in Panel B, the return betas
Stable Unstable
Equity Retums (< 2o from mean) (> 2ay
are significantly from
positive. mean)
This change no doubt
Good (> pt + 2c) PM PPM + 7 reflects the considerable role and influence that
Poor(<pt-2a) PPM+ri PPM+7+II gold/gold mining has in the non-U.S. markets, in
contrast to its role in the U.S. economy. Neverthe-
less, the betas are far less than unity.
This analysis gives rise to the following
In summary, Table 2 suggests that some diver-
hypotheses about the diversifying benefits of pre-
cious metals: sifying benefits are provided by precious metals,
particularly with reference to the S&P 500.
Ho,: y < O
H02: r < 0 Diversification in High-Volatility/Poor-
Performance Periods. Diversification is most
H03: Y + r1 <?0
important to investors when equity markets are
experiencing high volatility and poor performance.
Basic Diversification Properties "High volatility" is defined here as market volatil-
Table 2 reports the estimation of market model ity of more than 2 standard deviations above mean
regressions for each precious metal's return on the volatility, and "poor market performance" is
S&P 500 return (Panel A) and on the EAFE return defined as periods when the market return exceeds
(Panel B). The regressions provide a simple mea- 2 standard deviations below the mean return. The
sure of the diversification properties of the pre- results of our conditional analysis based on these
cious metals. definitions are reported in Table 3.

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Financial Analysts Journal
Table 3. Diversification Properties of
Precious Metals in Periods of High
Volatility and Poor Performance,
Data for January 1976-April 2004
Gold
Bullion Platinum Silver
A. S&P 500 as market proxy
Constant 0.0064 0.0039 -0.0032
(0.63) (0.27) (-0.18)
S&P 500 return -0.0605*** -0.0166 -0.0282
(-5.29) (-0.98) (-1.56)
Volatility dummy -0.0726*** -0.0811*** -0.1345***
(-2.93) (-3.15) (-3.15)
Market return dummy 0.0055 -0.0240 -0.0215
(0.39) (-0.82) (-0.88)
Durbin-Watson statistic 2.10 2.02 2.22
B. EAFE as market proxy
Constant -0.0064 0.0041 -0.0140
(0.57) (0.26) (-0.73)
EAFE return 0.1055'* 0.1487*** 0.1384***
(7.57) (6.90) (5.93)
Volatility dummy {0.1298*** -0.1913*** 0.2000***
(-3.24) (-3.04) (-3.03)
Market return dummy 0.0297 0.0172 -0.0527
(-1.59) (0.57) (-1.56)
Durbin-Watson statistic 2.10 2.03 2.22
Note: The model given in Equation 2 was estimated.
***Significant at the 1 percent level.
In Panel A of Table 3, the base-case precious
metal elasticities, PPM (i.e. the elasticity of normal
more complex, in that investors switch to a hybrid
stock market volatility with relatively high market
retums), for the S&P 500 are all negative, and for
gold, the elasticity is statistically significant. The
betas for EAFE reported in Panel B are significantly
positive. These findings mirror those reported in
Table 2. Of greatest note, however, is that the esti-
mated coefficient on the volatility dummy is nega-
tive and statistically significant for all three
precious metals in the case of both market indices.
It is largest in magnitude for silver.
The negative coefficient on volatility in Panels
A and B is a striking result. It indicates that, over
the full sample period, all three precious metals
provided considerable diversifying benefits in vol-
atile markets when held in a portfolio of U.S. or
global stocks. During periods of high market risk,
precious metals were more negatively correlated
with stock market returns. For example, in the case
of both silver and platinum relative to EAFE, the
reduction in elasticity amounted to around 0.2
units. Such a reduction is clearly economically (as
well as statistically) important. The fact that this
finding is robust to use of EAFE as a substitute
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market benchmark for the S&P 500 should allay any
concerns that the negative effect is peculiar to the
United States-for example, that it is some manifes-
tation of "dollar weakness" over the sample period.
The estimated coefficient on the return dummy
is not significant for any metal, which points to a
limitation in the diversifying role of precious metals.
In summary, Table 3 shows that all three pre-
cious metals have some hedging capability, partic-
ularly during periods of abnormally high stock
market volatility. The unconditional model given
in Equation 1 was unable to reveal findings of this
nature.
Increased Portfolio Efficiency? In previous
sections, we showed that the inclusion of precious
metals in an equity portfolio can reduce systematic
risk, particularly during turbulent periods of the
economy. A related issue concerns the efficiency of
portfolios that contain precious metals and the
reward that investors gain from holding such a
portfolio.
With the issue of portfolio efficiency in mind,
we consider two strategies that investors may fol-
low: a buy-and-hold strategy and a "switching"
strategy. In the buy-and-hold strategy, investors
construct a portfolio at the beginning of the test
period with a specified holding in a precious metal
and the rest of their wealth in the market. The
investor holds the portfolio until the end of the test
period without rebalancing the weights of each
portfolio component. The switching strategy is
metals-and-market portfolio in periods when the
diversification properties of precious metals are at
their greatest (during periods when market volatil-
ity is higher than 2 standard deviations from the
mean standard deviation). In all other periods, the
market portfolio only is held.
Our measure of portfolio efficiency is the rela-
tive reward-to-risk ratio, X, defined as
x
Rm k%'m
/(52 (3)
where Ri is the mean return on the hybrid metals-
and-market portfolio during the full sample period
and Rm is the mean return on the market portfolio
(as proxied by the S&P 500 or EAFE) during the
same period. The variables a2 and ay2 are, respec-
tively, the mean GARCH (1,1) variance estimates of
the portfolio and market proxy return.
The variable X represents the relative change in
reward-to-risk ratio that a hybrid portfolio can pro-
vide to investors, with X > 1 signifying an improve-
ment in the efficiency of a portfolio and X < 1
02006, CFA Institute
 Do Precious Metals Shine? An Investment Perspective

signifying a decline in efficiency. Transaction costs
are not considered; as a result, reported X's for the
switching strategy overstate the efficiency
improvements of the metals-and-market portfolios.
We report X estimates for a variety of portfolios
in Table 4. As previously, the results are divided
between the S&P 500 cases and EAFE cases, with a
further division for gold, silver, and platinum as
the strategic metal. Various weightings, Wg, were
tested for each metal.
Note, first, for the gold portfolios that for low
weightings of gold, the efficiency improvements
are small in the buy-and-hold strategy but greater
weights in gold lead to substantial improvements
in the efficiency of these portfolios.
During the period studied, the optimal weight-
ing of gold in a hybrid buy-and-hold portfolio was
approximately 30 percent when the S&P 500 was
the market proxy and about 20 percent when EAFE
was the market proxy. Although the switching
strategy did provide some efficiency improve-
ments for the investor at higher gold weightings,
they were small.
An investment in a hybrid silver portfolio also
provided efficiency gains, but they were generally
inferior to those for the gold portfolio. When the
S&P 500 was used (Panel A), a buy-and-hold silver-
based strategy with a holding of 15 percent pro-
vided an efficiency gain of approximately 15 per-
cent. With greater weightings in silver, hybrid
portfolios were dominated by the S&P 500 market
portfolio, although a switching strategy relative to
EAFE (Panel B) provided marginal outperformance.
Buy-and-hold portfolios that contained hold-
ings in platinum provided performance similar to
that of the gold portfolios-with an efficiency gain
of 23 percent relative to the S&P 500 at a weighting
of 20 percent platinum. As with gold and silver, the
switching strategy for platinum did not provide
significant efficiency gains.
This analysis provides several insights. First,
for our sample period, gold was the optimal metal
in which to invest as part of a hybrid strategy.
Second, platinum portfolios performed better than
those containing silver, but their efficiency gains
did not reach the level of gold portfolios. Third, the
switching strategy universally performed worse
than the buy-and-hold strategy, despite transaction
costs being ignored. The most likely reason is that
the diversification benefits provided by the metals
during periods of high market volatility are not

Table 4. Relative Efficiency of Financial Porffolios Incorporating Various Weights of Specific

Precious Metals, Data for January 1976-April 2004
Market Proxy
and Strategy Wg = 0.01 Wg = 0.02 wg = 0.05 Wg = 0.10 wg = 0.15 Wg = 0.20 Wg = 0.30 Wg = 0.40
A. S&P 500 as market proxy
Gold portfolios
Buy and hold 1.015 1.029 1.074 1.147 1.216 1.276 1.339 1.296

Switching 1.000 1.001 1.004 1.009 1.012 1.015 1.018 1.017

Silver portfolios

Buy and hold 1.016 1.032 1.075 1.128 1.147 1.126 0.979 0.768

Switching 1.000 1.000 1.001 1.002 1.002 0.999 0.991 0.979

Platinum portfolios
Buy and hold 1.016 1.032 1.080 1.151 1.206 1.235 1.199 1.055
Switching 1.000 1.001 1.002 1.003 1.005 1.004 0.999 0.991

B. EAFE as market proxy

Gold portfolios
Buy and hold 1.010 1.020 1.049 1.093 1.128 1.151 1.150 1.081

Switching 1.002 1.004 1.011 1.021 1.031 1.040 1.057 1.071

Silver portfolios
Buy and hold 1.010 1.018 1.038 1.046 1.019 0.967 0.811 0.631
Switching 1.001 1.003 1.006 1.012 1.016 1.020 1.023 1.021

Platinum portfolios
Buy and hold 1.011 1.022 1.052 1.091 1.109 1.102 1.017 0.870
Switching 1.002 1.003 1.007 1.014 1.019 1.024 1.031 1.033

Note: Relative efficiency is given by the reward-to-risk ratio calcula

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Financial Analysts Journal

strong enough to offset the return performance of
the hybrid portfolio. Fourth, the results for the S&P
500 as the market proxy are not much different
from the results for EAFE as the market proxy,
which reinforces the robustness of the findings.
Finally, we found evidence of a broad similarity
among all the metals used in the efficiency gains of
hybrid metal-and-market portfolios, which sug-
gests that gold and silver need not be viewed sep-
arately from other metal commodities.
We performed one final analysis to explore the
potential efficiency gains delivered by precious met-
als. We constructed an optimized portfolio that
included gold and a mix of regional market indices-
indices for the United States, the Pacific, the Far East,
Europe, EAFE, and Canada. We used a bootstrapped
mean-variance optimized portfolio algorithm
(BMVP) to estimate the optimal portfolio asset
weights. The procedure is based on a conventional
quadratic optimization subject to two constraints:
Portfolio weights must sum to unity, and each com-
ponent weight must lie between 0 and 1. The BMVP
optimization randomly samples, with replacement,
24 months of asset returns from the previous 60
months of data to generate estimates of expected
return, standard deviation, and the covariance
matrix to generate optimal portfolio weights. The
optimal portfolio is that with the highest Sharpe
ratio. This process is repeated 1,000 times to con-
struct an empirical distribution of optimal portfo-
lios and their weights. The overall optimal portfolio
is generated from an equal-weighted average of the
1,000 portfolio weights. We used the relevant opti-
mal portfolio weights to calculate portfolio returns,
standard deviations, and Sharpe ratios. Optimiza-
tion was carried out on a monthly basis from Janu-
ary 1987 to July 2002 to construct a time series of
optimal portfolios. The results of this analysis are
reported in Table 5.
Several features of Table 5 are notable. First,
the dominant weighting in the optimized portfolio
is the United States (mean weighting of 42 percent).
Europe also has a considerable mean weighting.
Second, gold, with a mean weighting of 9.5 percent,
maintains an important presence in the portfolio.
In comparison with Table 4, this weighting sug-
gests gold is of less importance in the composition
of the hybrid portfolio. Nevertheless, the portfolio
containing gold apparently does provide incre-
mental efficiency gains beyond the benefits of an
optimized portfolio that does not include gold. This
finding is the most important result reported in
Table 5, which is reflected in the relative efficiency
ratio of 1.185.
Conclusions
Through analyzing daily data for the 1976-2004
period, we showed the following:
* Gold, platinum, and silver have the potential
to play a diversifying role in broad-based
investment portfolios.
* The precious metals exhibit some hedging
capability, particularly during periods of
abnormal stock market volatility.
* Financial portfolios containing a moderate
weighting of gold perform better than portfo-
lios consisting only of financial assets.
From the standpoint of portfolio management,
an interesting question is whether precious metal
investments are better tactical plays or strategic
commitments.12 Although a definitive answer is
not possible, we believe that the idea of a purely
tactical role for precious metals may not fully reflect
the potential (long-term) benefits they can offer in
investment portfolios. Specifically, our finding that
the buy-and-hold strategy (a long-term approach)

Table 5. Unconditional Porffolio Optimization Based on Historical Returns:

Analysis of Weight Changes, January 1987-July 2002
Percentage of Percentage of Percentage of
Changes Changes Changes
SD Weight > 1% of Asset > 5% of Asset > 10% of Asset
Asset Mean Weight Changes Weights Weights Weights

Equity

United States 0.422 0.168 36.90% 9.63% 1.07%

Pacific 0.048 0.062 11.23 0.00 0.00
Far East 0.098 0.106 16.58 2.14 0.53
Europe 0.234 0.075 34.76 6.41 0.53
EAFE 0.019 0.025 5.35 0.00 0.00
Canada 0.083 0.059 24.06 1.07 0.00
Gold 0.095 0.057 31.01 1.60 0.00

Notes: Portfolio holdings refer to optimal po

were measured in percentages. The relative reward-to-risk ratio, X, of the optimized portfolio is 1.1850.

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 Do Precious Metals Shine? An Investment Perspective

is clearly superior to a switching strategy (a short-
term, dynamic approach) underscores the potential
importance of a strategic focus.
Including precious metals in a passive buy-
and-hold strategy improved the efficiency of port-
folios in the study. Furthermore, our results sug-
gest that over the past 25 years, the optimal weight
of gold in broad-based international equity portfo-
lios was approximately 9.5 percent, significantly
higher than is currently seen in most funds' equity
portfolios today.
In recent years, the performance of conven-
tional equity and debt portfolios has been cause for
options, futures, and other derivatives, however,
could be developed to the benefit of portfolio man-
agers. From a risk management standpoint, pre-
cious metals are possible alternatives to financial
derivatives and are clearly of more importance in
those countries where derivative markets in equi-
ties have not been established.
Considerable work remains to be done in the
area of alternative investments. Possible areas of
investigation include the diversification benefits of
such commodities as energy products. Another
area for future research is the incorporation of our
methodology into an analysis of the long-term per-

considerable concern. Hybrid portfolios combining formance of precious metal portfolios. Greater

precious metals with equity may provide a better understanding of the macroeconomic and market

performing alternative. For most metals, the under- forces driving the hedging properties of commod-
lying market is unlikely to absorb large changes in ities is also of interest.

demand from private investment. Strategies com-

This article qualifies for 1 PD credit.
bining precious metal-backed securities with

Notes
1. The Bretton Woods system of managed exchange rates
lasted from 1944 to the 1970s. On 1 April 1978, the U.S.
Congress allowed the dollar to be statutorily undefined
with reference to gold or silver for the first time since 1792.
The move followed several other changes in the way gold
was treated by investors. U.S. government regulations have
made other major contributions to the change in the status
of gold. Under the Gold Bullion Coin Act of 1985, Congress
authorized the issue of gold coins to the public at a price
equal to the market value of the bullion at the time of sale
7. Deflated by the U.S. Consumer Price Index to take into
account the effect of inflation, the values for the 1976-84
subperiod fell sharply. The reason is the high inflation
regime during the preceding subperiod. Use of real returns
in the tests revealed qualitatively similar results to those
derived from using nominal returns.
8. Elasticity here is simply used to denote the responsiveness
of the precious metal return to the given proxy for the equity
market return.

plus costs of minting and distribution.
2. This five-way characterization should not be taken to imply
that each area is independent of the others. Indeed, varying
degrees of overlap characterize the various papers.
3. For more information, see www.gold.org/value/stats/
statistics/gold_reserve/index.html.
4. For more information, see www.lbma.org.uk/statistics_
current.htm. The volume of precious metals cleared by the
LBMA is confidential, but in January 1997, the LBMA
released these figures for the final quarter of 1996.
5. We arbitrarily partitioned the full sample period into three
9. As an additional test, we examined the correlation between
gold price returns and the dollar/sterling exchange rate to
determine whether the correlations reflected a "dollar
effect." The correlation was 0.002 for the full sample period,
suggesting no relationship between the strength of the dol-
lar and the price of gold.
10. GARCH stands for generalized autoregressive conditional
heteroscedasticity (Bollerslev 1986).
11. Details are available from the authors on request.
12. We are grateful to an anonymous referee for posing this

approximately equal subperiods to permit an assessment of
the uniformity of our results across time.
6. The attempted corner on the silver market in 1979-1980
caused prices to peak at $48 per ounce. Within two years, the
price had fallen to a cyclical low of $4.88, 10 percent of the peak.
question. This issue is brought into particular focus when
one recognizes that precious metals are not renowned for
earning positive real returns (see Davidson et al.), which
suggests that gold is more likely to be of benefit tactically
than strategically.

March/April 2006 www.cfapubs.org 105

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Financial Analysts Journal

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