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Gold - Good Diversification or a Hedge That Doesn't Work?

 

The allure of Gold has been around for thousands of years, with people craving the shiny metal as a store of value and show of wealth or status. More recently, financial professionals have used Gold as a means of protecting their portfolios, as a so called 'safe haven' or simply as a means to diversify exposure from equities and bonds. But as we saw in the recent sell off, and as the chart below illustrates, Gold doesn’t always act the way it is supposed to and simply follows the other markets. Even in the financial crisis of 2008 Gold didn’t really have a big move until the market recovery was well on its way in 2009. So what’s going on here and should we just ignore Gold all together?

 

 

To explore this question, let us delve into the mechanics of holding Gold as an investment instrument. First of all, there is very little Gold to be found. By some estimates, all the Gold ever mined since the Egyptians started in 2000 BC would fit into 3 (!) Olympic size swimming pools. If you consider the global market capitalization for equities of about USD 100 trillion and global issued debt of around USD 200 trillion, you can see that Gold is actually a very small part of the investment universe.

 

But never fear, the financial services industry is very clever at creating instruments (derivatives) to build trade. So called 'synthetic structures' or 'Gold Certificates' are traded on many global exchanges in great numbers and promise like-for-like performance of the underlying asset, without having to actually hold any physical Gold. Nothing wrong with that, unless of course we all cashed in our synthetic instruments to get our physical Gold at the same time. Then some of us would be left empty handed, because there just isn’t enough of the stuff to go around. Sort of like a bank run, but in this case without the protection from a central bank or federal insurer.

 

Then there are all the storage costs (turns out renting a vault is not free), and that applies also to the synthetic holders of Gold where the costs are implied into the contract notes. There are also no dividends to placate our cash flow needs and of course there is also currency risk, as Gold is denominated and traded mainly in USD. You could hedge that with USD forwards, but that would cost about 2% per year for Sterling and almost 3% for Euro investors, given the differential in interest rates.

 

Bottom line, holding Gold for the long term is expensive and as a portfolio hedge it has proven to be very unreliable. However, if you are worried about Armageddon, then holding physical Gold is a good idea. Just make sure it is in a safe place and you can get access to it when you need it. While you are at it, you may also want to consider growing your own vegetables. Because as we saw in previous world disasters, the price of a potato can suddenly become even more valuable than precious Gold, when the supply and demand dynamics switch to survival and food.

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