You can access gold in a capital-efficient way
In an investment portfolio with finite assets, implementing a diversification strategy can mean de-allocating from potential exposure that has embedded long-term gains, ultimately producing a suboptimal mix of strategies. Similar to currency-hedged equity investing, gold-hedged equity investing “overlays” a core investment, such as US equities, with long gold futures. This approach provides a portfolio with notional exposure to an amount of gold with a value approximately equal to 100% of the underlying stock portfolio’s value, using a small additional up-front cash outlay.
This approach contrasts with other ways of obtaining gold exposure because it preserves the use of capital while being able to match notional dollar weights. For instance, if you have $1 million in S&P 500 exposure and want to match it with $1 million in gold, the total investment necessary would be $2 million. Products that track gold futures overlaid on market cap-weighted stock indices would only require $1 million to get the same exposure. Gold overlay indices, such as the S&P 500 Dynamic Gold Hedged Index and the FTSE Emerging Gold Overlay Total Return Index, reflect the theoretical performance of this capital-efficient way to capture gold’s return streams without having to deallocate from a core US and developed market large-cap equity portfolio.
Unlike incorporating other diversifying factor indexes, incorporating gold does not require a deallocation of the existing portfolio, yet it retains and enhances the effect of diversification. The improved performance of combining two assets that both have positive historical returns should be obvious-but the risk adjusted return profile may also increase where the assets are diversified. For example, the Sharpe ratio since 1999 of the S&P 500 Total Return Index has been 0.36 compared to the S&P 500 Dynamic Gold Hedged Index’s Sharpe of 0.56.[1. Based on daily returns from 1/1/1999 – 9/30/2016. The Sharpe ratio has been calculated assuming a risk-free rate of zero.] The Sharpe ratio is a common metric used to describe historic return per unit of risk.
Why not access gold directly?
Gold (GDX) (GDXJ), often considered just a metal with limited financial benefits, is gaining popularity lately. As a financial asset, it offers a wide range of investment opportunities for investors to hedge in times of market volatility or distressed economic scenarios. We saw this in Part 2 of this series.
Due to its uncorrelated nature with the equity market, gold has performed well in a volatile market. Gold can be accessed through various approaches such as buying physical gold, buying futures and options contracts, investing in gold mining companies and ETFs, and investing through gold hedges.
Gold can be accessed through various approaches such as buying physical gold, buying futures and options contracts, investing in gold mining companies and ETFs, and investing through gold hedges.
Accessing gold (SPGH) through all these options either requires you to pay an upfront amount by deallocating assets in your existing portfolio or by agreeing to buy the asset in the future through a futures contract.
What is gold-hedged investing?
Gold-hedged investing is a capital-efficient way to get maximum exposure to gold without affecting your portfolio mix. This strategy gives you simultaneous exposure to a market cap index and gold futures for the same cash outlay.
A common approach is to augment the SPDR S&P 500 ETF (SPY) with the SPDR Gold Shares (GLD). The total expense ratio of this product is ~0.50%. A more efficient investment would be the Rex Gold Hedged S&P 500 ETF (GHS), which provides the same exposure while using half the capital and still paying only 0.48% in management fees.
In this case, exposure to the stock market is kept intact, and additional gold exposure is available through futures contracts. The benefit of this kind of investing is that it helps preserve capital. The strategy is that the notional value of the gold futures contract is comparable to the value of the asset allocated to the equity market while using the same cash outlay up front. This ultimately helps retain the effect of diversification without altering the portfolio mix.
Evidence suggests exposure to gold can generate higher returns
Gold overlay indexes such as the S&P 500 Dynamic Gold Hedged Index and the FTSE Emerging Gold Overlay Total Return Index reflect the performance of this capital-efficient way to capture gold’s return streams without affecting the portfolio. We looked at this in Part 1.
You can get exposure to other ETFs such as the ones in the above table. These ETFs have generated staggering returns this year. However, gold-overlay ETFs can provide the same exposure with less management fees overall.