Gold Investment


GOLD'S ROLE

There is voluminous academic and sector sponsored research that supports the notion that a small allocation to gold is an important part of a diversified investment portfolio. Typically recommended allocations of 2-12% are meant to protect against inflation, currency devaluation and various systemic risks. In simple terms, for most individuals, gold represents an insurance of sorts. The most common methods of gold investment are direct ownership (coins and bars) and exchange-traded funds (ETFs). Both have specific pros and cons (see below), but both are categorized as passive long. As such, the profit and loss (P&L) profile is linear: if the price of gold rallies 10%, you make 10%; if the price of gold falls 20%, you lose 20%. As we see it, this is potentially problematic in both directions.
The issue is fairly straightforward. Small traditional allocations to gold don’t deliver great participation to the upside. Increasing the allocation also increases potential losses to the downside. Simple linear gold expressions represent either insufficient upside exposure, or excessive downside risk. Non-linear expressions function as superior forms of portfolio insurance.


CURRENT LANDSCAPE

The prevailing environmental factors for gold – improving economic data, impending tapering of QE, ETF liquidations, stellar equity market performances – represent significant headwinds and challenges that may render passive long investment ineffective, or worse – detrimental. Examining various methods of gold investment help illustrate the point.

Comparison of various methods of gold investment


In 2013, gold performance was down more than 28% and considered too volatile to be an insurance asset. According to the World Gold Council, the premier authority on global gold supply and demand, the first three quarters of 2013 witnessed astonishing record gold ETF outflows of 698 metric tonnes. The most dominant ETF is the American SPDR Gold Shares (GLD). Last year the GLD’s holdings hit their all-time record high of just over 1353 tonnes. Currently they are down to less than 830 tonnes.


WHAT'S NEXT?

The future looks uncertain. With equity and real estate bubbles looming around the world – we are in uncharted territory. The potential for unintended consequences of expansive monetary policies cannot be dismissed. Even the most well-researched and experienced academics and financiers cannot predict with certainty if or when the demise of the US Dollar will occur or how rapidly it take place. If part of the reason for an investment in gold is to hedge against a scenario like this - in an attempt to truly preserve purchasing power - then it is unlikely that passive long investment (linear P&L) will deliver a sufficient return. A tail risk payout requires leveraged upside exposure.
The financial markets are evolving rapidly, and the gold market is no exception. Electronic trading and efficient arbitrageurs (algorithm and human) produce a robust options marketplace with tight markets and healthy liquidity. Efficient position entry and exit, low transaction cost, and effective risk management are now achievable in ways that were previously not possible.


THE SOLUTION: OPTIONS

An asymmetric risk return profile, one that focuses on capital preservation when gold trades sideways or down and leveraged upside exposure when gold rallies substantially, is exactly what an investor is looking for in their portfolio. This can only be found in the options market, as options are unmatched in their flexibility and diversification - and unrivaled in specific P&L profile construction.

Gold Profit and Loss Graph: Profile Comparison


The above P&L graph clearly highlights what can be achieved with a carefully constructed options position - a modest absolute return emphasis when gold moves little, where both small gains and losses are possible, matched with clearly defined desirable performances when gold moves a lot. Mandates of capital preservation and tail risk payout potential can elevate the efficacy of gold exposure. Consider how valuable a gold strategy that didn’t suffer losses in 2013 could be. Are you investing in gold because you think it is going higher in the next twelve months or does it represent a desire to mitigate other losses at some indeterminate time in the future?
Passive long gold investment can lead to severe losses (more than an insurance asset should) AND fail to deliver sufficient protection when needed. If an insurance-like payoff is desired, invest in a vehicle that has the potential to deliver such a return - in amounts of 10x, not 10%. Using options, a more efficient gold exposure can be achieved delivering downside risk mitigation and unmatched tail risk payout to the upside. After careful consideration, we expect sophisticated investors that are interested in true preservation of purchasing power to enlist the unique functionality of the options market to improve the efficiency of their gold exposure.