(Article written by Kimberly Rios, CFA, CMT)
For centuries, gold has maintained its status as a precious commodity. Across the globe, early civilizations and modern markets alike valued the metal for its rarity and consistency. This has positioned gold as the safe haven for investors. Particularly in times of ambiguity, the idea that gold is a reliable, steady asset is exemplified as investors pour into the commodity.
We're seeing this in the current market: when uncertainty abounds, gold tends to rise. But the idea of investing in gold to hedge against market downturns doesn't always work to an investor's favor. The convergence of distinct factors can in fact push gold prices into fluctuation, creating volatility in an assumed-steady market. The current market landscape is just one example of such a scenario.
The policies implemented by the Federal Reserve since the financial recession, including quantitative easing, have created a marketplace unique to current times. The impact of these measures on "safe-haven" assets such as gold should not be overlooked. The next Federal Open Market Committee (FOMC) meeting is less than two weeks away. Since 2008, there have only been three rate hikes of .25% each. In all three instances, gold was impacted in both the days preceding and following the Fed's decision.
The following chart shows the performance of gold from October 2015 through May 2017. Leading up to all three rates hikes, gold declined. Shortly after each hike, gold rebounded quite rapidly. If history repeats, investors should expect a downturn in gold over the next two weeks, then expect gold to rally if rates rise.
Given this pattern, it is challenging to accurately "time" gold and buy into the asset at the bottom of the dip. Rather than playing this guessing game, hedging gold may be a better alternative, given the amount of price fluctuation around the rate hike dates. Investments in gold that seek absolute returns, rather than the traditional long-only, can provide this exposure rather than just holding gold outright or the ETF of gold (NYSEARCA:GLD).
Traditionally, gold has aligned with buy and hold strategies. Investors tend to think of the commodity as a stable asset. However, over the past 10 years, gold has experienced periods of high growth, in some cases nearly tripling in value, alongside periods of substantial drops. Currently, the value of gold is down about 33% from its 2011 highs. Long-only strategies expose investors directly to these drastic price fluctuations in an asset that is supposed to provide steady growth.
Holding gold outright, rather than seeking opportunities to hedge or achieve absolute return, creates a standard deviation, or dispersion from its mean, bigger than one would likely assume. According to Morningstar, the 10-year standard deviations on GLD and SPY are 19.32 and 15.19, respectively. This is apparent in the poor performance of the commodity space. Morningstar has the Long Only Commodity group at -4% for the past 10 years and Commodities Precious Metals at -5.01% over the past five years.
Hedging with options can provide a solution to navigating this volatility within gold prices. This is even more relevant in today's market. Investing in gold directly, or a fund that tracks the value of the asset at face value, does not necessarily provide protection.
Hedging, particularly with options, on the other hand, exposes investors to gold, but not necessarily the face value and wild ride. For example, one option strategy is a calendar spread. Investors can have exposure to gold, without being at the mercy of face value price fluctuations. One option is sold and one option is bought, so essentially hedging the trade.
Another way to benefit if expecting an increase in gold over time is to purchase gold calls outright when gold volatility is low, rather than doing so when gold volatility is high. The cost is the amount paid for the option and one can have potential benefits if gold price or volatility rises. These strategies can be traded leading up to the announcement allowing an investor to participate in potentially volatile periods without needing to make an accurate guess as to the bottom of the dip, timing of the trade, or knowing how much is at risk.
In times like these, gold, the once safe-haven asset, can't guarantee investors the protection it once did. Flocking to gold as a port in the storm now, as history shows, may lead to portfolio volatility and potentially drawdowns. In these modern times, investors can seek alternative exposure to this asset, reaping the benefits of the time-old precious metal, without assuming all of its volatility, and some mutual funds even offer a yield, which GLD does not provide.
Kimberly Rios, CFA, CMT is the portfolio manager of the Catalyst Hedged Commodity Strategy Fund
Disclosure: I am/we are long AND SHORT PUT AND CALL OPTIONS IN GOLD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Mutual Fund (CFHAX) holds long and short put and call options in Gold. Personally hold GLD.