Amid all the anxiety over the recent market sell-offs and recessionary fears, you may be asking yourself: How do I protect myself from falling stock prices? In this you are not alone, as the biggest institutional investors also grapple with the thorny question of how to hedge their considerable portfolios.
More often than not, they turn to gold. Gold has been the most popular hedge against political and economic volatility for centuries.
Here we will examine the reasons why this is the case, the recent performance of gold as an asset and how retail investors can gain exposure to the precious metal.
Why gold?
Gold is considered to be the safe haven asset in times of uncertainty. Generally, the price of gold is inversely correlated with the U.S. dollar and therefore with dollar assets like U.S. equities.
But this is not always the case. For example, in early 2016 the dollar and gold rose in tandem over fears that the Chinese economy was slowing down. In more general terms, gold is a hedge against systemic risk, i.e., against large-scale disruptions to the global economy.
This is well-understood by large institutional investors who need to take a macro view of markets. BlackRock, the world’s largest asset management company, with $6.29 trillion in assets under management, has been steadily increasing its gold exposure (via exchange-traded funds) over the last six months.
An unusual 2018
Gold had a surprisingly subdued performance last year, given the political turmoil. The strength of the U.S. dollar, a consequence of the Federal Reserve’s interest rate hikes, exerted downward pressure on the metal and kept the price relatively range-bound. But this may be changing. Since August 2018 (the yearly low), gold is up an average of 10% against all major currencies. This has broadly coincided with the uncertainty that has developed over the last six months.
The rising gold price reflects market expectations that central banks may return to a fresh round of monetary stimulus to avert an economic crisis. Even if this does not happen, central bankers are likely to be relatively conservative with future hikes in order to not upset a monetary system that is looking increasingly fragile, making the downside risks of owning gold relatively low.
How to gain exposure
Well, this is all well and good, but how can an ordinary investor hedge themselves with gold? The most straightforward way to do so is to buy bullion or gold coins. Although this offers the purest and most direct form of exposure, physical gold has the obvious downside of being very inconvenient to store and transport. Additionally, you may have to pay a premium to the gold dealer if you are buying in small amounts.
Another method is to buy gold certificates or receipts that can be redeemed for physical gold. This gives the investor a direct proxy for gold, without having to deal with the hassle and costs of storage. More risk-seeking investors can also explore derivatives like gold futures and options. However, we would caution that these are complex instruments that offer considerable leverage, magnifying both gains and losses. As such, they are best left to professionals.
For many retail investors, gold ETFs offer the most convenient way to hedge. By buying shares in a fund like the SPDR Gold Trust ETF that holds bullion, you can get reasonably good exposure to the market for physical gold. An additional benefit to buying ETF shares is that the market for them is highly liquid.
Finally, stocks of gold mining companies are often used to indirectly bet on rising gold prices. The share price of large miners like Fresnillo (OTCPK:FNLPF) is to a certain extent correlated with the price of the metal itself. However, as miners are often themselves hedged against falling gold prices, the extent to which their value will rise or fall is often mitigated. As such, an investment in a gold miner is more accurately an investment in the profit margins of that particular company, rather than in gold itself.
Verdict
A prudent investor needs to protect themselves and their portfolio against market downturns, both expected and unexpected. Gold offers an excellent hedge against both known unknowns and unknown unknowns. Moreover, retail investors now have many different ways to invest in gold, most of which do not require actually holding the metal. In such uncertain times, peace of mind is as valuable an asset as any.
(This article was co-authored by Stepan Lavrouk, director of research at Atreides Capital LLC and a former research analyst for Almington Capital Merchant Bankers.)
Disclosure: No positions.
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