Servant Financial has long held a certain portion of its model portfolios in a precious metal fund – Central Fund of Canada (NYSE symbol: CEF). We have found that not only can a portfolio allocation to gold and silver provide a source of diversified returns, but precious metals may also serve as a good hedge against market volatility in their historical role as safe haven assets.
In January of this year, CEF was acquired by another fund manager and was renamed Sprott Physical Gold and Silver Trust. Accordingly, we think that it is a good time to review the new management of CEF, as well as revisit the benefits of an allocation to precious metals within a diversified portfolio.
Sprott is a global asset manager, with over 30 years of experience, managing over $10 billion in precious metals and real assets. Based in Toronto, Sprott has several precious metals trust funds, holding physical bullion in storage allocated to each individual investor. The Sprott Physical Gold and Silver Trust (CEF) is a closed-end trust that invests in unencumbered and fully-allocated physical gold and silver bullion in London Good Delivery bar form. Each unit of CEF equals 0.0066 ounces of gold and 0.2984 ounces of silver that is held and stored in trust by the fund. Therefore, each CEF unit should directly track changes in the prices of the precious metals it holds. The value of each CEF unit is represented by approximately 63% gold and 36% silver holdings. CEF shares are also redeemable (over certain value thresholds) for delivery of actual bullion. Aside from CEF, Sprott also manages PHYS – Sprott Physical Gold Trust (100% gold), PSLV – Sprott Physical Silver Trust (100% silver), and SPPP – Sprott Physical Platinum and Palladium Trust.
What are the benefits of investment in precious metals like gold?
Servant's investment philosophy focuses on broadly diversified portfolios which invest in a number of asset classes, geographies and sectors. Diversification spreads out the risk inherent in any single investment – when one asset or sector suffers a decline, another may outperform. In this way investors can mitigate asset specific risks and lower the volatility of the overall portfolio and lowering the chances of wild swings in performance compared to an investment in a single asset portfolio. An allocation in precious metals is one of ways to diversify a portfolio as well as provide a hedge against unexpected downturns in other highly correlated asset classes. The price appreciation in gold historically has had a negative correlation to the returns of equities – meaning that when stocks go down, the price of gold tends to go up. However, over time, gold can also outperform equities even when the returns for stocks are also positive.
The chart above (provided by Sprott) compares the historical change in the spot price of gold with the cumulative returns of the S&P 500 index including dividends since 2000. While the total return for the S&P index has more than tripled at a compound annual growth rate (CAGR) of 6.32%, the spot price of gold has increased almost five-fold during the same time period, yielding a CAGR of 9.65%.
Looking forward, there are currently many good reasons to hold precious metals. These mainly revolve around the possibility of the U.S. dollar (USD) weakening, which usually corresponds with increases in the value of gold, as well as the use of precious metals as a safe-haven investment in times of geopolitical risk or other times of great uncertainty.
The chart below shows how gold and U.S. dollar tend to have an inverse relationship to each other. It compares the daily LBMA fix gold price (orange line and left price scale) with the daily closing price for the broad trade-weighted U.S. dollar index (blue line and right price scale) over the last 10 years. You can see that gold tends to perform best when the U.S. dollar weakens.
Currently there are many looming risks to the value of the dollar. After many years of low inflation below the Federal Reserves target rate of 2%, we are finally seeing inflation rise. In 2017, the average inflation rate in the U.S. was 2.1%. The current inflation rate for the twelve months ended March 31, 2018 was 2.4%. Hence, we have seen the Federal Reserve become much more aggressive in raising interest rates with 2-3 more rate hikes expected this year in an effort to keep inflation rates from overshooting further the Fed's target 2% rate.
If a central bank is able to effectively keep inflation in check by raising interest rates, it is generally good for a country’s currency. However, if inflation continues to increase (despite the Fed waving its magic wand), or factors such a weakening trade balance or out-of-control debt levels come into play, the dollar will likely depreciate relative to other currencies and precious metals. Current rhetorical threats of tariffs and the dissolution of current trade agreements such as NAFTA have raised the specter of possible trade wars which could lower demand for our exports around the world. The possibility of destabilizing global trade has heightened uncertainty in global markets, and this has manifested as increased currency volatility in 2018.
The strength of the dollar may also be adversely affected by our ever-growing national debt levels. As of March, 2018, the U.S. national debt reached over $21 trillion. According to a report released last month by the non-partisan Committee for a Responsible Federal Budget, the Tax Cuts and Job Act of 2017 will increase our debt to $29.4 trillion by 2028. Many fear that the debt levels of the U.S. are unsustainable as they have become untethered from our underlying domestic output or gross domestic product (GDP). U.S. debt is growing much faster than our national wealth and productivity. Similarly, since the 2016 election, the S&P 500 has increased 7 times faster than GDP, and 45 times faster than corporate profits. While the rise in equity markets shows a great deal of optimism for future growth, this euphoria may easily be tempered by bad news, such as lower-than-expected growth in GDP and/or corporate earnings.
There are many scenarios in which owning precious metals can be a good alternative investment to provide some stability to a well-diversified portfolio: whether the U.S. dollar weakens as a result of inflation, trade wars, or unmanageable debt levels; or if equity markets are shaken by disappointing economic results, earnings reports or unforeseen global threats. Servant currently allocates between 4% - 6% of its model portfolios in CEF.
This blog article was contributed by Helen Dospod, Servant's analyst responsible for individual ETF and fund research and portfolio risk analysis.
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