Gold is considered unique in the investment world due to its high demand. It is used for reserve assets, investments, and as a luxury good. However, gold can also be used as a hedge that can compete with other commonly used hedges.

Analyses have found that hedging choices are more reliable than portfolio diversification without hedging. Gold provides the best returns when compared to other hedge options, and is considered the optimal hedge in the long run.

Gold provides liquidity and protection during risk-off periods. It is especially useful following major events that shake up the stock market. When stock sell-offs occur rapidly, the correlation between risk-assets rises and seemingly “diverse” portfolios become prone to drawdowns.

When these events occur, gold is typically sold off and this often leads to temporary liquidations. Gold experienced a slightly negative, but mostly flat correlation to the stock market during the recent COVID-19 stock sell-off.

However, gold becomes more negatively correlated when the stock market drops significantly. This makes it a desirable hedge compared to other options.

Volatility hedges

Volatility-related hedges typically revert to their long-run mean. This means a one-time selloff event will not affect the hedge’s value over time.

However, owning VIX short term futures can erode your portfolio performance and require constant monitoring. This problem does not occur with passive hedging strategies.

Gold is a balanced hedge

Gold is unique because it is positively-correlated during risk-on periods, and becomes more negatively correlated during risk-off periods. This trend has been observed for many decades and can be expected to occur in the future.

Gold also has no credit and is boosted by high-inflation. This means it provides great annual and cumulative returns compared to financial assets. Gold is not very effective for reducing portfolio volatility, but it does provide the best returns when looking at risk-adjusted metrics.

 

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