Wednesday, February 14, 2018

Taking a second look at gold during a financial crisis

What would have protected investors during the turmoil of last week?  With all of the major asset classes falling, not much. Declines were a just a matter of degree. There were some selected instruments that did well, but the "correlation to one" effect, albeit not absolutely true, kicked-in for many assets that were supposed to provide strong diversification. However, there was a protection instrument that did provide safety, gold. Although slightly under bond returns for the Barclay Aggregate index through the first twelve days of the month, it has generated gains for the year and certainty beat long-term Treasury bonds.
I have had ambivalent investment views on gold because the research on gold as a safe asset or an inflation hedge has been mixed. It has never been as strong an inflation hedge or safety asset as the gold supporters would have you believe, yet it has been a more effective diversifier than many financial assets.

For an asset that has been studied so closely, there are not definitive answers as to the value of gold investing. However, we can say that it generally does provide diversification benefit given a return profile that is not easily factorized like other asset classes. 

It not the case that gold will match changes in inflation expectations or that it will show positive returns during periods of market extreme. Gold miners do not have the same characteristics as gold. Nevertheless, during extreme down equity periods and financial crises, gold will not follow the same return pattern as financial assets.

Two research pieces are worth reading, one recent work that is mildly supportive of gold as a diversifier albeit with caveats and another that has a more skeptical view. The recent work is "All That’s Gold Does Not Glitter" Gerald R. Jensen, CFA, Robert R. Johnson, CFA, and Kenneth M. Washer, CFA which is coming out in the Financial Analyst Journal this yearThe skeptical view can be seen in the work, Erb, Claude B., and Campbell R. Harvey. 2013. “The Golden Dilemma.” Financial Analysts Journal, vol. 69, no. 4 (July/August): 10–42. 

The recent piece provides some good food for thought. One, the link between gold and inflation is very weak. The relationships with macroeconomic variables are not significant. There is little correlation with the VIX and a slight negative correlation with exchange rates. It will, however, offer some protection with respect large down moves in stock; however, this comes with the cost of limited returns during equity gains. In general, gold goes its own way.

Gold could be a good diversifier but it should not be viewed solely as a buy and hold. There are situations when it is worth holding as a store of value but like any asset this should be based on a sense of value.

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