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Gold Was True Source of Diversified Return, Unlike Smart Beta

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Like gold, equity allocations that track factors such as growth, value, dividend yield, and minimum volatility have proven to have shown positive returns over time. However, they lack the characteristics of a gold overlay during market drawdowns. In other words, they perform well when markets rise but fall with the market during drawdowns.

Through the first three quarters of 2016, gold has lived up to its role as a diversifier as well as a safe haven, gaining 23.9% compared to the S&P 500 Total Return Index’s 7.8%, with a -0.3 correlation to the S&P 500 Total Return Index. That correlation comes into perspective when you compare it to leading smart beta indexes such as the Russell 1000 Growth Index, the Russell 1000 Value Index, the Dow Jones Select Dividend Index, and the MSCI USA Minimum Volatility Index. All four indexes had correlations with the S&P 500 above .80 during this same period.[1. During this time period, the Russell 1000 Growth Total Return had a correlation of 0.98, the Russell 1000 Value Index Total Return had a correlation of 0.97, the Dow Jones Select Dividend Index had a correlation of 0.85, and the MSCI USA Minimum Volatility Daily Gross TR USD had a correlation of 0.88. Source: Bloomberg.]

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That kind of similarity should not come as a surprise to investors because the overlap between index components of these smart beta indices and index components of the S&P 500 is very large. Gold, on the other hand, arguably has zero overlap simply because it belongs to an entirely different asset class with differing risk and return drivers.

During the year, we have seen two main drawdown periods for the market:[2. Reflects the two largest peak-to-trough drawdowns for the S&P 500 Total Return Index during the 2016 calendar year through September 30, 2016.]

  • China Downturn (Jan 4-Feb 11)
  • Brexit (June 8-27)

In both cases, gold was a safe haven. However, as the market rebounded, gold managed to preserve much of these gains year to date.

Market Realist

Smart beta ETFs or gold: Which is better?

Smart beta ETFs track factors such as growth, value, dividend yield, and minimum volatility. Recently, they’ve been buoyed by a strong market sentiment after the US elections. But they haven’t really been a diversified source of returns. They’ve been correlated with the S&P 500.

The ETFs in the graph above track the Russell 1000 Value Index (IWD), the Russell 1000 Growth Index (IWF), the MSCI USA Minimum Volatility Index (USMV), and the Dow Jones Select Dividend Index (SDY). They have all had correlations above 0.80 with the S&P 500 in the first three quarters of 2016. They perform well when markets rise but fall with the market during times of distress such as the drawdown periods of 2016.

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During the major drawdowns of 2016, gold (SGOL) (UGLD) was a superior addition to a market-cap-weighted equity allocation. Gold’s performance isn’t affected during market drawdowns, since gold isn’t correlated with the stock market or any other asset class. In the first three quarters of 2016, gold has proved this by generating returns of 23.9% compared to the S&P 500 Total Return Index’s returns of 7.8%. That showed a -0.30 correlation to the S&P 500 Total Return Index.[3. Source: Bloomberg]

Smart Beta ETF investors pay for too much overlap

The positive relationship between the S&P 500 and smart beta indexes isn’t a surprising factor. That’s because the overlap between index components of these smart beta indexes and index components of the S&P 500 is vast.

The indexes hold many companies that are already part of the S&P 500, which doesn’t let you achieve the benefits of a proper diversification for your portfolio. Below are the overlap percentages of these ETFs with the S&P 500:

  • iShares Russell 1000 Growth (IWF): 54.0%
  • iShares Russell 1000 Value (IWD): 55.0%
  • SPDR S&P Dividend ETF (SDY): 19.0%
  • iShares MSCI USA Minimum Volatility (USMV): 40.0%

But this is not the case with gold. Gold (UGL) has a zero overlap because it belongs to an entirely different asset class and thus can provide you with better diversification benefits.

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How has gold performed during high interest rate environments?

As we move away from a secular low interest rate environment, it’s important to know how gold has performed during markets that are characterized by high interest rates. The above table shows how gold outperformed smart beta ETFs in a high interest rate environment. The high interest rate periods were 2000, 2001, 2002, 2006, and 2007. Low interest rate periods were 2011–2015. This relationship is enhanced when inflation expectations are on the rise as they are now.

 Growth and dividend stocks suffer the most, which is understandable since dividend stocks have a duration risk. Even though gold has taken a step back since the US elections, the SPDR Gold Shares (GLD) has risen 9.8% YTD (year-to-date), and the iShares Gold Trust (IAU) has risen 10.0% YTD as of December 6, 2016.

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