Goldy Stocks, Not Just For the Bears

by Olivia Engel, CFA, Head of Active Quantitative Equity, APAC

Adding exposure to a higher risk industry like gold stocks does not necessarily increase portfolio
total risk.
Gold stocks exhibit significant diversification benefits in our portfolio.
Allocation to gold stocks has contributed to return and improved portfolio risk characteristics.
*The State Street Australian Equity Fund has increased exposure to Gold over the past quarter,
outperforming the S&P/ASX 300 Accumulation Index by 3.4%1 (net of fees). The Fund was ranked
5th for the quarter vs the Morningstar Australian Equity Large Cap Universe of 320 managers.

Gold has been one of the best performing asset classes year to date; returning 16.7%* while the
broader commodity index returned -1%# and Australian equity market was down 2.6%^. Our fund
added exposure to gold stocks during the second half of last year and so far, the holding has been a
positive contributor to total return. But considering the historical volatility of this sector, we have
often been asked: why gold stocks?
The main objective of the State Street Australian Equity Fund is to maximise returns while at the
same time explicitly managing portfolio total risk Gold is no different to other sectors when it
comes to achieving this overarching goal. Opportunities arise when we can identify 1) an ability for
gold stocks to add to overall portfolio returns, or 2) provide material diversification benefits and
reduce portfolio risk, or ideally 3) both.
Contributing to return
While a stronger gold price (measured in AUD) did contribute to outperformance of Gold stocks over
the last 12 months, stock-specific reasons were also present. Our investment process does not
attempt to forecast gold prices when building a portfolio. Rather, the focus is on selecting quality
stocks that exhibit stable and strong internal cash generation ability while avoiding paying too much
for them. Gold stocks that are favoured by our process exhibit a few of these characteristics:

They tend to have simple operations (sizeable deposits by established mines)

They operate within a stable environment (majority of mines located in Australia)
They are able to generate strong positive cash flows at the current or even lower gold prices

Figure 1 shows the Free Cash Flow (FCF) and cash earnings (proxied by earnings before interest, tax
and deprecation (EIBTDA)) of Australian gold stocks within the ASX 300 universe. As a sector, their
earnings and cash generative power has improved noticeably. Coupled with a reasonable market
valuation, this type of improvement in fundamentals if deemed sustainable - can be a valuable
addition to our portolio.

Reducing risk
Gold stocks have historically been more volatile than other listed equities. Gold miners need to
constantly spend money to explore and develop mines. The long lead time and exploration risks
combined with the volatile gold price that is influenced by all sorts of macro variables contribute to
the higher risk. Figure 2 shows the estimated risk2 of gold stocks versus the ASX 300; they can be up
to five times riskier. However, adding gold stocks to a portfolio (using ASX 300 as an example)
doesnt necessarily increase the portfolio total risk. This attribute can be explained by the
observation that their prices are not perfectly postively correlated with other drivers of equity
return. The diversification ratio in this chart measures whether having a small allocation to Gold
stocks would reduce or increase the risk of the aggregate portfolio. A ratio higher than one indicates
a risk reduction. Despite their small weighting within the S&P/ASX 300 Index (~1.5%) as at 31 March
2016, Gold stocks correlation characteristics versus the market provides diversifying power and we
have seen this benefit increasing noticeably in recent months.

Another way to look at the diversification benefit is by observing the beta of gold stocks against the
broader market. As can be seen in Figure 3, the median beta of gold stocks has fallen significantly
since the middle of last year and in the past few months became almost completely uncorrelated.
We note that the beta of some stocks have even fallen into the negative territory. Therefore,
depending on the composition of a portfolio, adding Gold stocks does not necessarily increase risk it could in fact reduce overall portfolio risk when appropriately executed.

Our process continually reviews the return potentials and risk characteristics of all stocks in the
investment universe. As long as the risk diversifying benefits and return potential of gold stocks
exist, the Fund will not shy away from adding a bit of gold exposure to the portoflio.
State Street Australian Equity Fund
During March, the State Street Australian Equity Fund returned +2.27% gross (+2.21% net). The
S&P/ASX 300 Index posted a +4.78% return. Banks posted a market-topping gain of +6.5% despite
ANZ and WBC announcing increased provision charges for Bad and Doubtful Debt. We remain

underweight Financials as we prefer opportunities in other sectors and to maintain a well-diversified

portfolio.
Over the past twelve months the fund has outperformed the S&P/ASX 300 Index by 9.93% gross
(9.13% net), returning 0.66% gross vs a -9.26% return for the benchmark. Underweight positions in
Financials names, whilst favouring Utilities and Industrials were key contributors to outperformance.
Strong stock picking within Consumer Discretionary names was also a key contributor.

Sources:
1

Source: SSGA, Factset

*Gold London PM Fixing (USD/ozt) index; Source: Factset
# Bloomberg Commodity Index in USD, Source: Bloomberg
^ S&P/ASX 300 Accumulation Index, Source: S&P/Factset
2
Annualised standard deviation of returns as estimated by Axioma Australian Fundamental MH risk model.

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