Spot Gold and Gold Miners Are NOT Two Sides of the Same CoinSpotGoldandGoldMinersAreNOTTwoSidesoftheSameCoin

Recent 13F regulatory filings for public equity ownership shows that institutional investors like state-owned and public pension funds are allocating to gold and gold miner equity ETFs. But does it matter how an investor obtains exposure to gold?

The performance of gold miner equity shares not only includes exposure to the spot gold price, but also exposure to firm-level idiosyncratic characteristics like production costs, exploration and development, management expertise, financial leverage and hedging strategy. These characteristics help differentiate mining companies and may become more important when gold prices are relatively high, or low. Gold miners also have the responsibility of decommissioning and covering the reclamation costs of closed mines.

In contrast to US equities (S&P 500), which returned -12.1% YTD (as of 5/13/2020), both gold and gold miner equities had positive performance. A gold ETF returned 13.1% and a gold miner equity portfolio ETF (containing approximately 50 miner stocks) returned 16.4%. Over the past 14 years, (i.e., since inception of the gold miner equity ETF), the correlation of monthly returns between the two ETFs is high (0.8).

In Institutional Gold!, published last year, we showed that from January 1978 to January 2019 monthly total returns for gold miner equities were more correlated with spot gold returns than with US equity returns (correlation of 0.7 vs. 0.2). However, despite the high correlation between spot gold and gold miners, the volatility of miner returns was double that of spot gold (36.4% vs. 18.8%). And, despite the higher volatility, gold miner equities had average annual returns that were only slightly higher than spot gold (6.5% vs. 5.2%).

This year some institutional investors have also invested in gold royalty and streaming agreements. In return for an upfront payment to a miner, a royalty agreement gives the investor an interest in the mine’s future production. Streaming agreements are metal purchase agreements that provide, in exchange for an upfront investment, the right to purchase at a preset price all, or a portion, of a mine’s annual production.

In Institutional Gold! we suggest that the performance of such investments may be comparable to a strategy of investing in gold royalty and streaming companies. These companies have unique traits such as a low debt-to-equity ratio, high gross profit margins, and high revenue per employee that can be grouped more broadly as “high earnings quality.” Some royalty companies can also have a direct ownership interest in mining operations and, so, may also be broadly considered as gold miners. Consequently, an investor could consider a high earnings-quality gold miner equity portfolio as a proxy for royalty agreements.

As of 5/13/2020, since 1995, high earnings-quality gold miner equities (8.4%) have performed better than low earnings-quality miner equities (-1.6%). The volatility of high-quality gold miners during the period was also lower (33.6% vs. 38.7%). YTD, high-quality gold miners returned 21.7% whereas low-quality gold miners returned -13.9%, a difference of 35.6 percentage points. This relative performance differential is also observed in the broader equity market. As the risk-off environment continued this year, higher-earnings-quality equities did better than low-earnings-quality equities except for the industries in severe stress such as oil and gas, airlines and hotels and gaming. However, the equity market and industry-level performance may remain volatile depending on the market expectations around post-pandemic recovery.

^*Article written for LinkedIn by Harsh Parikh, Principal, PGIM Institutional Advisory & Solutions.

Sources of Data: PGIM IAS, S&P Capital IQ, and Datastream, as of 5/13/2020.