HardAssetsInvestor

Written by Brad Zigler  |

May 28, 2008

Hedging Gold's Volatility

Details

I presented a hedging strategy for gold mining stock buyers at the recent Hard Assets Conference in New York.

By request, here are highlights of the presentation:

Gold Stocks Do Not Equal Gold

Gold bullion and gold mining stocks, while closely correlated, do not move in lockstep with one another. Sometimes gold moves faster; at other times, stocks do.

Gold mining stocks can be collectively monitored through indexes such as the Philadelphia Stock Exchange's Gold/Silver Index (XAU). The benchmark for gold bullion pricing has long been the daily price fixing through the London Bullion Market Association.

As an example of the disparity in gold and mining stock prices, look at the returns earned by XAU and London gold between May 2005 and January 2006. Propelled by an ebullient equities market, gold stocks ran up nearly 74% though bullion appreciated only 26%. The opposite condition prevailed in this year's first quarter as stocks sold off against a rising bullion market.

Why Buy Gold Stocks?

The essential question you should address when considering gold mining stocks is this: What do you hope to gain through the stock investment that you couldn't get from owning gold itself? If you want to capture gold's price movement, there are now low-cost and transparent means to gain gold exposure without also taking on equity risk. If you opt for mining stocks instead, your choice should be based upon your willingness to accept and exploit the risk of investing in a particular company's management.

Professional Strategy

Isolate stock "alpha" (management value)

by

Suppressing gold "beta" (risk)

Professional investors describe the return earned over a market benchmark's as "alpha." The market return is represented as "beta." We can adapt those terms to our gold mining investment model by ascribing the return earned by a firm's management as "alpha," while the return earned from gold itself is deemed "beta."

Relative Values

Alpha is not easily obtained in any market and tends to be incremental. Beta, on the other hand, is readily available through low-cost index products.

Tactic

We can isolate the management value of a gold mining stock (or a fund of gold mining stocks) by coupling long exposure in the stock with short exposure to gold. The mining company's management skill can then be distinguished from the vagaries of the gold market. If, for example, you originally decided to commit $40,000 of risk capital to gold mining stocks, you might instead put only $20,000 into the stock (or fund) and use the rest of your capital to buy exchange-traded notes that simulate a leveraged short position in a gold futures index.