Why Are Large Hedge Funds Investing in Gold?

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Includes: ABX, AEM, GLD
by: Band of Analysts

Gold is considered a hedge against inflation, while critics argue that it has no commercial use and earns no income, so fundamentally there is no "value anchor". Nevertheless, gold has been rallying despite deflation and continuing deflationary pressures.

In fact, gold works more as a hedge against poor policy rather than a hedge against inflation per se. If the economy is humming along and we experience a healthy 1-2% inflation, then gold will underperform, because investors will rotate to investments that produce dividends and/or growth. In this case, gold's lack of earnings power comes to fore and investors use it as a source of cash to generate higher returns elsewhere.

However, when there is high uncertainty about the fundamental strength of the economy, coupled with uncertainty regarding the government's ability to deal with economic issues, gold becomes a preferred investment and outperforms. Therefore, gold should be thought of as a hedge against uncertainty, regardless of the expected progression of the economy and interest rates. Whether the economy enters a deflationary or an inflationary spiral, gold should do well. That's because during these times, investors worry first and foremost about capital preservation. In a deflationary environment, prices go down, so something you buy today will be worth less tomorrow. In an environment of unhealthy inflation, prices go up, but not enough to compensate the investor adequately.

Currently, indeed there is too much liquidity in the system and people have been building their savings, but there are no viable investment opportunities and too much uncertainty, because the economy has not demonstrated fundamental and sustainable improvements. Should I put my cash in equities -- what if the market drops off a cliff again; what if the government pulls back on its support of the market and it craters? Should I invest outside of the US -- but where, since all economies are so interconnected? Should I buy commodities -- what if we go through deflation for the next 2 years, as long-term interest rates indicate? In the meantime, it is very painful to watch the value of your cash drop as the government effectively debases the currency.

Perhaps this currency devaluation will soon reverse, right? That's unlikely, because the US is currently running at zero percent interest rates and it has injected all the cash it can into the market in the form of pushing down cash reserves to the banks, so the final (and perhaps only reliable) way to fight deflation is through currency devaluation: import prices are guaranteed to go up, and thus investors should start anticipating inflationary pressures and get more confident in the success of the program.

We are in a situation where the macro picture is too uncertain. You may be able to identify robust investment opportunities with a bottoms-up analysis, but last year was a great wake-up call for those bottoms-up investors that ignored the macro picture. Therefore, with no better alternative, many investors prefer to put their holdings in gold.

Some skeptics still argue that gold is not a good asset to store value, because it doesn't earn income. The counter-argument is that cash is not a good store of value either, especially now that the government has demonstrated that it will print as many dollars as necessary in order to support the economy, thus subtracting from the value of cash. Governments right now are at opposition with investors: the former want to make sure that their economies don't enter a deflation, so they are willing to depreciate their currency and inflate their economies; the latter want more certainty about capital preservation. The actions that governments contemplate precisely devalue capital.

In this kind of uncertainty, it's hard to blame someone putting at least a small allocation in gold. For those that prefer putting money in equities to gain exposure to an asset, look at companies like ABX and AEM (higher leverage to gold prices), or the GLD exchange-traded fund. One idea of a hedged trade that we have heard is to go long someone like ABX and buy out-of-the-money puts on AEM, because if gold goes down AEM's stock price should respond much more than ABX.

Disclosure: no positions

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