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Sharpe Up Your Portfolio: Enhancing 60/40 with Gold

Topic: Gold
Publication Type: Investment Cases
Sharpe Up Your Portfolio: Enhancing 60/40 with Gold

The 60/40 portfolio, a strategy of dividing assets between 60% large cap equities and 40% bonds, has long served as the de facto benchmark for risk adjusted returns.  The sizable equity allocation allows for decent upside capture and long-term growth, while the fixed income pool dampens the volatility inherent to stock ownership.

Gold Bars

The strategy is simple, and more importantly, ruthlessly effective at budgeting risk. The eternal fear of any financial engineer is that their latest miracle strategy will only manage to fall short of the time-tested 60/40, an all too common occurrence.  For instance, not one of the Ivy League endowment funds, renown for their heavy focus on alternative investments, managed to outperform the humble 60/40 over the last 10 years,[1] let alone on a risk-adjusted basis (as if this were not an effective critique of higher education overall: high cost, lack-luster return).

The ability for gold to act as a diversifying asset is strikingly powerful, as layering gold into a 60/40 portfolio in any amount over the past 15 years would have improved portfolio risk/return characteristics.
A New Gold Standard Portfolio?

As formidable a standard the 60/40 may be, it turns out this unofficial gut check could have been easily bested with one simple change—adding gold.  The ability for gold to act as a diversifying asset is strikingly powerful, as layering gold into a 60/40 portfolio in any amount over the past 15 years would have improved portfolio risk/return characteristics.  This is an incredibly compelling result.

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The diagram below displays the efficient frontier of adding gold in graduated amounts to a 60/40 portfolio, with consistent and continuous gains to further gold allocations.  The chart pits mean annualized returns on the vertical axis against the portfolio’s volatility (standard deviation of returns) on the horizontal axis; consequently points towards the upper left corner are the most attractive and towards the lower right the least.  Significantly, the blue line shows the range of attainable efficient portfolios from combining the 3-month treasury with the optimal stock/bond/gold mix the line intersects.

Notes: Time period under analysis is 12/31/2003 to 12/31/2018. Performance of stocks is represented by the S&P 500 Index, and 60/40 is allocated between 60% of the former and 40% of the Bloomberg Aggregate Bond Index. Past performance is not guarantee of future returns. Sourced from Bloomberg data and GraniteShares Research.

The benefits to adding gold to a 60/40 portfolio at the expense of fixed income exposure were noticeable with allocations as small as 1% gold.  Strikingly, this analysis indicates the optimal amount of gold over this 15-year period were not the default 5% weighting many traders use, or even a more weighty 10% allocation; efficiency occurred at a whopping 35% gold, 5% fixed income structure.  This conclusion is not to suggest that all portfolios should carry 35% gold; strict optimization exercises often create “academic” portfolios impractical from a real-world perspective.  Rather, this analysis demonstrates that gold does not have to be confined to a token, single digit portion in the portfolio, as gold carries the potential for powerful results at substantially larger allocations.

The benefits to adding gold to a 60/40 portfolio at the expense of fixed income exposure were noticeable with allocations as small as 1% gold. 

From quantitative perspective, including gold clearly outclassed the conventional 60/40 model.  For instance, the mathematically optimal 35% gold weight outperformed a 60/40 portfolio by 121 basis points for the same level of risk, or alternatively, reduced risk by 145 bps for the equivalent performance. Even a more modest 15% gold allocation achieved 84 bps more performance at comparable risk, or decreased risk by 105 bps with the same return. 

Moreover, at performance levels equal to a straight equity portfolio, the 35% gold allocation model accomplished 78% more risk reduction effect beyond what the 60/40 does. Indeed over this time period, any gold/fixed income mixture was superior to relying fixed income alone in a 60/40 model, even a complete substitution of gold for fixed income.  As crazy as it may seem, tens of billions of dollars are spent each year on managers to come up with more expensive solutions that have performed far, far worse than a 60/40.[2]

The Sharper Image

As compelling as these numbers seem, the truly fascinating aspect is that they are not the result of referencing a specific time period favorable to gold. Over the past 20 years adding a 5% gold allocation has had a 79% chance of delivering equal or superior Sharpe ratios compared to a standard 60/40 portfolio.  In other words, there is nothing magical about the selected 15-year period above; it is simply a round number that covers a full market cycle. It may even be reflective of the potential benefits of a long-term gold exposure.

Notes: Past performance does not guarantee future returns. Sourced from Bloomberg data and GraniteShares Research.

The figure above depicts the year by year effect on Sharpe ratios of adding 5% gold to a 60/40 strategy since 2000, yielding an average improvement of 0.007.  The reason the Sharpe ratio is an important metric is that it measures how much risk-based return an investor captures for the level of risk they are taking. In layman’s terms, it is your dollars to doughnuts ratio for risk budgeting; if you take another 1% risk, how much more return can you expect? Significantly, the slopes of the blue lines in the efficient frontier diagram capture the Sharpe ratio in graphical form, and the steeper the better.

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What is important about the above graph is that helps dispel many myths surrounding gold in the portfolio, as adding gold enhanced Sharpe ratios across a wide range of market conditions. Steady improvements were seen to a 60/40 strategy through the 2000’s, when the market experienced both high and low interest rates, and the sharpest improvement occurred during gold’s current stretch of range-bound performance.  Curiously enough, the four-year period where gold negatively impacted Sharpe ratios captures gold at its strongest price performance—an over $800 price jump—as the volatility to the upside reduced gold’s ability to act as a diversifier.

Golden Lesson

This conjecture may challenge the conventional wisdom surrounding gold; historically the asset was most useful for portfolios when flat over a multi-year horizon and most damaging when surging in price.  Underlying this phenomenon is gold’s ability to diversify away market risk, to act as a shock absorber against fluctuations in the stock market.  It is this zero-correlation feature that may earn gold its place in a portfolio, any price return being very much an ancillary benefit.

The Art of Rethinking the 60/40 with Gold

Part of the challenge with properly diversifying is that the human brain does not naturally think in terms of correlations, instead gravitating towards picking which assets will perform best.  Adding gold to a 60/40 strategy can achieve such striking outcomes because it introduces another axis to portfolio returns, independent of both stock and bond market risks.  This is not to say gold does not experience volatility, it does, but merely that the risks to gold ownership are unrelated to those of investments.

Not only are there situations when both stock and bonds fall in value, but gold in and of itself is extraordinarily robust in moderating the excesses of the stock market.  Combined, these features enable risk to be deployed more effectively overall, the real objective of any portfolio, compared to wonton performance chasing, as is only too often the case.

      [1]. Julie Segal, “Not One Ivy League Endowment Beat a Simple 60/40 Portfolio over Ten Years,” Institutional Investor, 11/29/18,

       [2]. Hedge funds managed $2.88 trillion in 2018, and the Credit Suisse asset-weighted analysis finds hedge funds returned 5.01% on an annualized basis over the last 10 years, versus 10.66% for a 60/40 portfolio structure.  If even only half of hedge fund assets underperformed, an exceptionally generous estimate, $26 billion would be charged annually on a 1.8% fee basis, and the 20% performance fee would add an additional $14 billion per year.  AQR is a prime example of a fund underperforming at high expense in 2018, generating $1.14 billion in fee revenue: see Alexandra Stratton and Miles Weiss, “AQR Annual Profit Plunges 34% in Rough Environment for Quants,” Bloomberg, 4/2/2019,