In series of posts last week, I looked at Harry Browne’s Permanent Portfolio, which includes a hefty 25% allocation to gold. The reason for holding such a large amount, Browne argued, is that gold protects investors from the ravages of inflation.

The problem with this idea is that there’s no evidence that the price of gold is highly correlated with inflation—at least, not in Canada. This is one of those pieces of conventional wisdom that just doesn’t stand up to scrutiny. Gold has held its value when individual curencies have collapsed, like in Weimer Germany in the 1920s or more recently in Zimbabwe. But those are examples of catastrophic hyperinflation, which leaves people pushing around wheelbarrows of cash to buy a loaf of bread. I don’t think that’s what most people mean when they talk of gold as a hedge against inflation in their portfolio.

You can see how the idea developed in the 1970s. Inflation in Canada averaged almost 9% from 1970 through 1982, and gold would have provided an enormous safety net during this period: its annualized return (in Canadian dollars) was over 25% during those 13 years. The correlation was even higher in the United States and, not coincidentally, it was at the end of this period that Harry Browne introduced the Permanent Portfolio and declared gold a hedge against inflation.

Where’s the correlation gone?

Since the 1970s, however, the correlation between inflation and gold has disappeared. From 1983 through 2004, inflation averaged about 3%. Yet the nominal return on gold in Canadian dollars during this period was –0.3% annualized. That’s a real return of –50% over a period of 22 years. Not only was gold useless as an inflation hedge for more than two decades, it lost half its value along the way.

Of course, since 2005 gold has been the best performing asset class, with annualized returns of about 18% in Canadian dollars. You certainly would have done well if you had held 25% of your portfolio in gold during the last seven years—but this had nothing at all to do with inflation. Since 2005, the Consumer Price Index has gone up just 2% annually, less than the historical average.

How about on a short-term basis? If inflation spikes in a given a year, will gold act as hedge? Sure, there are examples of gold shooting up during calendar years with high inflation, such as 1974, 1980 and 1982. But there are just as many opposite moves. In 1975, inflation was almost 10% and gold lost 22%. From 1980 through 1982, inflation was over 10% annually, yet gold lost value over those three years thanks to a –33% plunge in 1981. In 1989 and 1990, inflation was well over 5%, while the return on gold was again negative in both years.

Clearly the price of gold has just about zero correlation with the Consumer Price Index.

Gold moves in mysterious ways

There is no tidy relationship between inflation and the price of gold, even in the 1970s. The tremendous returns the metal delivered during that period were the result of several factors, notably the United States abandoning the gold standard in August 1971. (Before that, the price of gold had been fixed at $35 USD per ounce since the Bretton Woods agreement of 1944.) People lost their confidence in stocks during the bear market of the early 1970s, much the way many investors feel today. This was also a time when central banks did not have the ability, the mandate, nor the political will to control inflation the way central banks do today. For example, the Bank of Canada set a target rate of 2% to 3% for inflation in 1991 and has done an extremely good job in this respect for the last 20 years.

That’s not to say that we can’t ever see a period of double-digit inflation again—of course, that remains a possibility. The point is that the cause of that inflation, and the tools we use to fight it, will be different. And therefore, if we experience double-digit inflation in the next decade, there’s no reason to expect the price of gold to behave the same way it did during the 1970s.

I don’t object to holding a small allocation of gold in a diversified portfolio, but it’s important for investors to be clear about their expectations. Gold can have periods of negative correlation with the US dollar, the world’s reserve currency. It can be a safe haven during crises of confidence in stock markets. If the global financial system collapses, if the Canadian dollar becomes worthless, or if the Harper government confiscates your land then, sure, you can exchange the bullion in your safety deposit box for canned beans and ammunition. But if you’re expecting gold to provide a hedge against inflation, then you’re likely to de disappointed.

In Monday’s post, I answered a reader’s question about the iShares Gold Trust, an ETF that is cross-listed on the Toronto and New York Stock Exchanges with the ticker symbols IGT and IAU, respectively. I explained that while it is possible to buy and sell this product in either US or Canadian dollars, neither version gives you any exposure to currency risk. However, that’s not the case with the Claymore Gold Bullion ETF (CGL), which also tracks the price of the yellow metal by holding gold bullion. CGL is unique among gold ETFs in that it uses currency hedging.

It’s worth pausing to think about this concept. As most index investors know, it’s common for funds that hold foreign stocks or bonds to hedge their currency exposure to protect Canadians from the effects of a rising loonie. But gold is not a foreign-denominated asset, like shares in Coca-Cola. Yes, its price is widely quoted in US dollars, but that’s not the same thing. Think about it this way: if you were buying gold bullion from the Royal Canadian Mint, would it have occurred to you to hedge your purchase against a falling US dollar?

An extra layer of risk

So what’s going on with CGL? Claymore has designed its ETF to deliver to Canadian investors the returns of gold in US dollars. In practice, CGL’s returns should be the same for Canadians as the returns of the iShares Gold Trust (IAU) are for Americans. Since it launched in February 2010, it has done a very good job in this respect:

What investors need to understand is that CGL not only gives them exposure to gold, but also to the US dollar. If the greenback loses value versus the loonie, then a Canadian holding CGL would get a boost in returns. Indeed, since its debut early last year, CGL has dramatically outperformed the TSX-listed version of the iShares Gold Trust: it has increased over 43%, versus 30% for IGT. However, a surging US dollar will detract from the returns of the Claymore ETF, regardless of the price of gold.

While hedging is usually designed to reduce currency risk, CGL actually adds a layer of risk that wouldn’t otherwise exist. Buying IGT or IAU (or coins or bullion) makes you long gold. Buying CGL makes you long gold and short the US dollar.

If this discussion sounds familiar, it’s because the same strategy is used in the Claymore Broad Emerging Markets ETF (CWO), which I wrote about in a previous post. CWO invests in stocks that are denominated in a basket of overseas currencies, but adds hedging against the US dollar.

Doubling down

Using currency hedging in a gold ETF is an interesting strategy, because historically the US dollar and gold have been negatively correlated: when one goes down, the other tends to go up. So for a Canadian holding CGL, a declining US dollar could be doubly good: it would likely correspond with a rise in the price of gold, and the hedging would mean even higher returns in Canadian-dollar terms. If the US dollar were to surge, then CGL might suffer losses on both the gold and the currency.

One would think this relationship would make the price of gold in Canadian dollars more volatile. However, the Fact Card for CGL quotes data from 1994 that shows the standard deviation of gold returns is actually slightly lower in Canadian dollars (14.69%) than in US dollars (15.15%). Whether that would hold up over longer periods, I don’t know.

What I do know is that investors who decide to buy a gold ETF need to understand the role it plays in their portfolio. I think it’s fair to say that most retail investors who own CGL do not understand the currency exposure they are getting. They are likely unaware that they are not just buying gold, but also making an active bet that the US dollar will fall. Hating the US dollar is a popular pastime these days, but it’s a hard decision to justify in a long-term portfolio.

For investors who prefer to get pure exposure to gold and leave the currency plays to the speculators, Claymore launched an unhedged version of its gold ETF (CGL.C) in March. It should be expected to perform in line with IGT, although at 0.50% its management fee is double what iShares charges.

Disclosure: I do not CGL, IGT or any other gold ETF in my own portfolio.

Q: The iShares Comex Gold Trust (IGT) trades on the Toronto Stock Exchange, but I can’t find it on your page of Canadian ETFs. It’s also not listed on the iShares Canada website. Can you tell me why? — Jim O.

The iShares Comex Gold Trust is an exchange-traded product that tracks the price of gold. Like its competitor, SPDR Gold Shares (GLD), the trust is backed by gold bullion held in a vault by a custodian.

But although IGT is listed on the Toronto Stock Exchange, it is not a Canadian product. It’s simply a cross-listing of the iShares Gold Trust (IAU), which is domiciled in the US and traded on the NYSE. That’s why I haven’t listed it in my directory of Canadian ETFs and why it isn’t included on the iShares Canada site.

If you’re not familiar with cross-listing, it’s a common practice among large corporations that want their shares to trade in more than one currency (and sometimes more than one time zone). For example, while Research in Motion is a Canadian company traded on the TSX, you can also buy its shares in US dollars on the NASDAQ. There are many other examples of companies with dual listings, including Potash Corporation, Canadian Natural Resources, and all of the big banks.

When shares of a company (or a product like the iShares Gold Trust) trade in two different currencies, there is no benefit to buying one or the other, except for the convenience of not having to convert your currency. At the market close on July 22, for example, the last trade in IGT was made at $14.86 CAD, while the last trade in IAU went through at $15.65 US. At the current exchange rate, those two amounts were identical.

Why have they performed so differently?

IAU was launched early in 2005, and the cross-listing was added in December of that year. If you enter both ticker symbols in a stock chart, they seem to have performed very differently. Over the last five and a half years, IAU shows a much higher return: almost 211% versus just 152% for IGT:

You might conclude from this chart that you would have been better off holding IAU. But this is an illusion: the returns of IAU are expressed in US dollars, while those of IGT are given in loonies. To an investor measuring her returns in Canadian dollars (as most of us do), the returns of the two versions would have been the same. The apparent difference is entirely the result of the USD/CAD exchange rate.

Here’s how the math works, with the numbers rounded for simplicity:

• In December 2005, $1 US was worth $1.16 CAD. A Canadian investor could have bought $100 USD worth of IAU, or $116 CAD worth of IGT. These amounts would have bought an identical number of shares.

• By July 2011, the value of IAU had increased by 211%, so $100 USD would have become $311 USD.

• Meanwhile, an investor in IGT would have enjoyed a 152% return, turning $116 CAD into $292 CAD.

• During this period, the value of the US dollar declined from $1.16 to $0.94 CAD.

• If both sold their shares in July 2011, the IAU investor would have received $311 USD, while the investor in IGT would have pocketed $292 CAD. At the current exchange rate ($1 USD = $0.94 CAD), those two amounts are equivalent.

This should make intuitive sense when you remember that IAU and IGT are the same fund, holding the same gold bars in the same vaults. A gold bar is a gold bar, no matter what country you live in or what currency you use. If you buy an ounce of gold in Windsor, Ontario, and then drive across the border to sell it in Detroit—or vice-versa—you can’t expect to make a profit.

Or to use a different example, if you buy 100 shares of a cross-listed company like Research in Motion on the TSX, wait for the loonie to go up 10%, and then sell them on the NASDAQ, you won’t make a 10% profit. You’ll just have 10% more US dollars, each of which is worth 10% less.

The bottom line for investors is that if you want exposure to gold and you have Canadian dollars in your account, then buy IGT. If you have US dollars in your account, then you can use IAU. Either way, your exposure to gold is the same, and your exposure to the US dollar is zero.

Got a question about index investing? Send it to mail@canadiancouchpotato.com and it may be answered in a future installment of “Ask the Spud.” Answers are provided as information only and do not constitute investment advice.

The table below shows the tracking error of Canadian bond and commodity ETFs in 2010.

To make sure you understand these numbers in their proper context, see my earlier post on tracking errors for Canadian equity ETFs.

Notes:

1. The 3.3% return of CLF is based on the fund’s net asset value (NAV). The return on market price was just 2.8% — a significant difference. With bonds so unpopular these days, the forces of supply and demand may have driven down the price of this fund.

2. Several of BMO’s bond ETFs launched in 2010, so these returns do not cover a full year.

3. CGL’s return based on market price was 29.12%, two and a half percentage points higher than its return based on NAV, and only eight basis points off the spot price of gold. Just as an aversion to bonds seems to have lowered CLF’s price, the continuing gold mania helped this ETF trade at a premium in 2010.

4. Silver was the big winner of 2010 and investors in the Horizons BetaPro COMEX Silver ETF would have been dancing in the streets with their 77% return. But the large tracking error here shows that precious metals ETFs using futures contracts (as opposed to those that hold gold or silver bullion) can carry significant frictional costs. They may not closely track the spot price of the commodity.

Postscript. Horizons ETFs sent me this response regarding HUZ: “The tracking error is primarily due to the fact that the silver futures contracts are priced in U.S. dollars and HUZ doesn’t hedge intraday currency fluctuations; HUZ rebalances the FX hedge at the end of the day. We believe this accounts for most of the 4% difference in the performance of the ETF versus the performance of  its index. Please keep in mind that any ETF, whether it is physically backed or futures-backed, will likely be subject to this currency differentiation.”

I recently had the privilege of interviewing Rick Ferri, founder of Portfolio Solutions, an investment management firm in Troy, Michigan. Rick is the author of several excellent books on ETFs, index funds and passive investing, including one of my favourites, All About Asset Allocation (McGraw Hill, 2010), which has just been released in a second edition.

One of the issues Ferri and I discussed was the outrageous popularity of investing in gold. SPDR Gold Shares (GLD) is now the second-largest largest ETF in the world, with more than $56 billion (US) in assets, something that would have been inconceivable five years ago. One of the most common reasons people give for buying gold is that it offers security in the event of financial or economic catastrophe. Here’s Ferri’s take on that logic:

“Everybody is putting their money into GLD. But it’s a piece of paper: they are not going to issue you gold bars. If the banking industry collapses, how are you going to get your gold? If Armageddon comes along you might say, ‘That’s OK, because I own gold.’ But you don’t own gold, you own GLD. I suppose you could go to the vault in London with your piece of paper and ask for your gold — assuming that airlines are still flying. Good luck with that.

“So you say you don’t trust the banking system, and the whole world is going to crap, you don’t trust anything except gold, but then you own GLD? Everything was fine up until the point where you said you own GLD.”

Would you invest in a pile of bricks?

Ferri went on to say that the whole concept of owning gold as a currency of last resort presumes that you own physical gold. But even then, he argues that gold and other commodities are not good long-term investments, comparing them to a pile of bricks:

“You can take a bunch of bricks and pile them in your backyard and look at them every day and say, ‘Go up in value, go up in value.’ But you can’t say, ‘What kind of dividends are my pile of bricks going to pay me this year?’ Because it’s zero. How much interest am I going to get from my pile of bricks? None. Is my pile of bricks going to become two piles of bricks over the next 10 years? No, it’s going to be one pile of bricks a year from now, 10 years from now, and a hundred years from now. You’re just hoping that someone comes along who thinks that pile of bricks is worth much more than you paid for it.

“I want to invest in things that have cash flow. That’s the bottom line. If I’m going to invest for the long term, and not just trade, then all of the asset classes I have are going to have cash flow. They are all going to pay either interest or dividends, or if it’s real estate they’re going to pay rent. With growth stocks, the idea is that they are going to pay dividends in the future. That’s investing: you invest for future cash flow.

“A pile of bricks has no cash flow. To include them in your portfolio, you would have to know something about the supply and demand for bricks. You would have to know that the market for bricks is going to change, and thus the future value of your pile of bricks is going to be more than it is now, even after adjusting for inflation. Unless you are a brick producer, I don’t know how you would know that — and I don’t even think the brick producers would know that. But everybody buying gold seems to know. They know that the economics are changing, and therefore the value of gold is going to be higher in the future. Even though 90% of these people have never owned an ounce of gold in their lives, all of a sudden they are experts on the supply and demand for gold.

“If I am going to have commodity exposure, I would rather own the companies that make money from commodities. Because the company can become more productive or more efficient. The company pays dividends. The company can make money even when the underlying commodity isn’t. There are times when gold does much better than gold mining stocks, but in the long run you’re much better off buying precious-metal mining stocks — and in Canada, you’ve already got that if you own a broad-market index fund.”

Unless you’ve been in a coma, you know that gold has been the hottest commodity of the last decade, quadrupling in value since 2000. That’s in US dollars, but even measured in loonies gold is up more than 164% over the last ten years.  Those are impressive returns during a period when investing in stocks often felt like feeding cash into a paper shredder.

Claymore’s Gold Bullion ETF (CGL) began trading on the TSX on Tuesday, giving even Couch Potatoes an easy way to invest in physical gold. Is it time to add some of the shiny metal to your portfolio?

Let’s consider the main arguments in favour of investing in gold:

• It’s a hedge against inflation, and it retains its value even if a nation’s currency becomes devalued.
• Unlike stocks and bonds, gold has virtually no risk of becoming worthless. That makes it a safe haven in the event of financial Armageddon.
• Gold is not highly correlated with stocks, bonds or real estate, so it plays a diversification role in a portfolio.
• Gold’s price tends to move in the opposite direction of the greenback. This can protect Canadian investors who hold securities denominated in US dollars, such as the Vanguard ETFs recommended in many of our Model Portfolios.

The arguments against gold in a portfolio are also compelling:

• Gold purchased from a dealer will have a large mark-up, and it is expensive to store and insure.
• There are more precise ways to hedge against inflation. Real-return bonds are specifically designed so that their interest payments and principal value rise in lockstep with the Consumer Price Index.
• Investments in “paper gold” — including Horizons’ COMEX Gold ETF (HUG) — do not offer the safety of physical bullion.
• Gold pays no dividends or interest and has no potential for growth: its long-term inflation-adjusted return is approximately zero. According to Jeremy Siegel, “One dollar invested in stocks in 1802 would have grown to $8.8 million in 2003, in bonds to $16,064, in treasury bills to $4,575, and in gold to $19.75.”
• Canadians already have significant exposure to gold through the stock market. Of the 60 companies in the S&P/TSX 60 Index, at least eight are gold miners — notably Barrick, Goldcorp, Kinross and Teck Resources — and they make up more than 13% of the index.

The Claymore ETF overcomes a couple of these drawbacks: rather than tracking the price of gold with futures contracts, CLG holds honest-to-goodness bullion in a Scotiabank vault (although you can’t exchange your shares for gold bars). It also makes buying gold bullion inexpensive, with a management fee of just 0.5% and no need to rent a safe deposit box.

At the same time, both the Claymore and Horizons gold ETFs negate one of the potential benefits: they are both hedged to Canadian dollars, so they offer no protection against a falling US dollar. If you don’t hold any US-denominated stocks, this may be a good thing. But if you do have greenbacks in your portfolio, consider a US-listed ETF such as iShares COMEX Gold Trust (IAU) or SPDR Gold Shares (GLD). Both hold physical bullion, not paper gold, and are priced in American dollars.

So, should you add some gold to the stocks, bonds and real estate in your Couch Potato portfolio? It’s not essential, but a small allocation of 5% or 10% can be good diversifier, and perhaps some insurance against factors that can derail other asset classes. Whether you should buy gold now—with the price near its all-time high—is a question I’ll leave to the market timers.

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