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Hedging against currency risk
It's taken a mere 12 months for the G10 members to slash their interest rates by 1790 basis points. By any historical comparison, this has been a unique phenomenon. During this process, we've seen the majority of world currencies exposed to similar risks as the pound. When you add Quantitative Easing (QE) to the heady brew of recession and de/inflation, the result is a set of conditions which makes it quite difficult to hedge against currency risk within client portfolios. When the pound is so weak, where do you go?
With the decision by the European Central Bank to go with the flow and implement QE, it is clearly no longer possible to treat the Euro as a safe sterling hedge. As we have said on many previous occasions, these dilemmas are an inevitable by-product of 'fiat currencies', where the value of money resides only in the financial strength and creditworthiness of the issuing government. So what do you buy under such conditions?
The answer is gold. And here's how to buy it:
- Gold mining shares - in our opinion a somewhat risky play, based upon a number of factors relating to the mine in question
- Gold ETFs - this has some attractions in terms of costs, but if the aim is to hedge against financial insecurity, it does not make much sense to select an asset-wrapper which could, possibly, go bust. If you do favour this approach, then opt for a Gold ETF which is 100% backed by physical gold in a vault.
- Physical gold - preferably stored in Zurich. In our opinion, the easiest way to achieve this is via BullionVault which you can access via an online trading platform.
Below, we provide a chart of a suitable Physical Gold ETF. You are no doubt already aware that the Chinese Government has been dumping currencies and international bonds (that'll cause problems for the US!) and buying gold which is likely to push the price up.
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Kevin Moss, 30/04/2009 |
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| | Paul Lewis | 05/05/2009 09:17 | | yes I agree with the ETF opinion if one is hedging against financial insecurity
and BullionVault will be offering Silver later this year
do you have an opinion on GoldMoney
| | | Duncan Orr | 21/05/2009 13:11 | | It might seem like gold offers refuge from scary markets. In the late seventies when inflation and oil prices were up, currencies down, and the economy slumping, gold prices peaked. We don't have seventies-style stagflation these days but we have a weak dollar, high oil prices, war, and volatility. And again, gold prices have risen, returning around 26% over the past two calendar years.1
Gold is one of those "alternatives" to stocks and bonds that seem to get more attention when economic prospects seem most dicey. Maybe the real question isn't whether gold is a terrific asset class, but whether gold or any alternative instrument really offers safe harbor from shaky capital markets and economic catastrophe. Can investors reliably protect themselves from risk and still capture capital market returns? Is this the legitimate goal of the long-term investor?
If gold seems like a stable refuge from economic disaster, think again: gold isn't particularly stable. Since Bloomberg's index inception of January 1970, gold has had an annualized standard deviation of 19.64% versus 15.41% for the S&P 500.2 In spite of its greater volatility, gold returned only 7.48% per year versus 11.29% for the S&P 500. Omitting the seventies paints a bleaker picture: over the last twenty calendar years, gold returned 1.77% per year versus 13.23% for the S&P 500.
Past isn't prologue, though, and financial principles speak louder than historical data. Which means we should have reasons for our investment decisions—reasons rooted in economic logic and portfolio theory. Principles of modern finance suggest that the primary components of a diversified portfolio should have expected return. Only projected earnings can generate expected return. Because gold doesn't produce anything, it has no projected earnings stream and therefore no expected return. Gold is just a metal.
So with good cause, people rarely talk about gold as an asset class with positive expected return. Instead they talk about it as a "diversifier"—some form of protection against economic harm. Specifically, investors seem to view gold as a hedge against inflation and currency devaluation. Maybe they see gold itself as de facto currency. After all, gold has been used on and off as money across many civilizations through history, sometimes surviving other local coin.
But modern finance suggests that, like metals and other commodities, currencies are not investments with expected return. Currencies don't produce anything; and though they fluctuate relative to each other, the fluctuation is unpredictable. There's no economic reason to expect any currency to be worth more tomorrow than it is today. As Ray Charles said, currency is really just a little piece of paper (or stamped copper, or electronic transmission)—worthless without a social contract to the contrary. People have to agree it's worth something.
On some level, the same can be argued about any financial asset, which may be why speculating is so often confused with investing. Things are only as valuable as everyone agrees they are. The whole system relies on consensus; the bank has to agree you gave it money earlier, and society in general has to agree that the agreement between you and the bank is real and binding (which is why respect for property and rule of law are primary conditions for including a country in a solid emerging markets strategy). In times of political and economic uncertainty, this social agreement can seem tenuous, like a house of cards. And since gold is tangible and has so much history it might seem less prone to collapse.
Uncertainty is scary, but it's a fact of life investors accept. Fortunately, modern finance gives us a way to parse uncertainty. Asset pricing teaches us that some risks are more worth taking than others. The risks most worth taking are those that come with expected return. With stocks and bonds, investors put their money to work in the capital economy. The money they invest helps power enterprises that generate growth and productivity. This is what earns expected return. Simple commodities like gold don't create economic growth. "Investing" in gold is at some level just speculating: you hope the price will go up but have no real reason to expect it to.
Understandably, people want to flee uncertainty. But modern finance teaches us that this is not the task of the investor. Periods of volatility weed speculators out from investors. A belief in the efficacy of markets keeps us from confusing the inevitable periods of poor performance with a failure of markets and capitalism. The disciplined, long-term investor does not react to short-term variance in markets by seeking alternative, protective "asset classes," but instead develops a cynical muscle that recognizes the urge to flee as a call to greater vigilance. Long-term investors accept—even embrace—the risk that comes with expected return.
Gold is down again this year, so we might not be hearing as much about it. And the fact is, there's nothing wrong with putting some assets in gold or any other commodity as long it's not in reaction to recent markets or an arbitrary shift away from the instruments with expected return that comprise the bulk of a plan. Understanding what you're doing and why is the real key to successful investing. Principles of modern finance help point the way by offering a theoretical framework for distinguishing investing from speculating. They clarify our motives so that we can make clear, rational decisions and stick to the fundamentals of long-term investing—in the face of a gold rush or other forms of false refuge.
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