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Gold: Diversification by Disinvesting

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Stockholm (HedgeNordic) – Gold is often considered a hedge against inflation, but Ned Naylor-Leyland of Jupiter Asset Management argues it is more accurate to consider gold as protection against the loss of purchasing power, which is reflected in – currently negative – real interest rates. “Gold is the risk-free instrument in the system, not treasuries,” asserts Naylor-Leyland, who is Head of Strategy, Gold & Silver, at Jupiter Asset Management. When real yields – the nominal yield on a security after accounting for inflation – turn lower or even negative, money will flow into the yellow metal proven to preserve purchasing power.

“Gold is the risk-free instrument in the system, not treasuries.”

“Gold on its own is disinvesting,” Naylor-Leyland tells HedgeNordic. “If you buy physical gold, you are essentially removing your capital from financial markets and leaving it in the corner of the room to come back to it in the future,” he explains. “That is why central banks have enormous gold reserves. Unlike treasury bonds, gold bars do not have credit ratings exactly because they are risk-free.”

“If you buy physical gold, you are essentially removing your capital from financial markets and leaving it in the corner of the room to come back to it in the future.”

“Bear in mind that gold does not go up or down at all. Gold is just gold,” asserts Naylor-Leyland. “While people may buy gold for the right reason, they do not understand that about 90 odd percent of the daily turnover is making an FX opportunity cost decision.” Although “gold is just gold,” the U.S. dollar or Euro value of gold changes depending on the relationship between interest rates and inflation. “Discussions about inflation on its own are entirely meaningless. It should be banned in the finance industry to talk about inflation if you are not going to subsequently talk about rates,” says Naylor-Leyland. “If you will get 4 percent on your deposits in the bank in the future but with inflation at 29 percent, how are you going to feel about the four percent then?”

Three Assumptions Driving Gold and Silver Prices

According to Naylor-Leyland, monetary metals such as gold and silver are driven by changes in real interest rate expectations. “The bond market creates price discovery for the metals through real interest rates,” says Naylor-Leyland. At the moment, “gold and silver are priced off three observations in the real interest rate world.” These three observations or assumptions explain the recent performance of both gold and silver. “First, market participants are assuming inflation is transitory,” starts the fund manager. “Second, we are assuming that central bank tapering is coming in November, it will be the size that we expect and it will not be withdrawn,” he continues. “Third, we are getting rate hikes starting next year.”

  • Inflation is transitory;
  • Central bank tapering coming in November;
  • Interest rate hikes starting next year.

“That is what is priced in. I would say though that it is much more likely that all three are wrong than all three are right,” Naylor-Leyland tells HedgeNordic. “Only one needs to be wrong for gold and silver to be going way higher,” he adds. “But I do think it is very likely all three of those assumptions are wrong. The body of the bond market is still positioned for inflation to just disappear and normalization in terms of rates and policy in the future. Gold and silver are constrained by the relationship between the bond market, the FED and the guidance about where we are going even though, at the margin, people realize it probably isn’t happening.”

“Only one needs to be wrong for gold and silver to be going way higher. But I do think it is very likely all three of those assumptions are wrong.”

“Ultimately, the last 12 months have given people a fantastic opportunity to invest in this asset class as a hedge at really discounted levels. We will get momentum in due course,” says Naylor-Leyland. An allocation to an actively managed gold and silver strategy can offer investors a hedge against negative real yields and thereby represent a good diversifier for their portfolios. As Head of Strategy in Jupiter’s Gold & Silver team, Naylor-Leyland oversees the management of Jupiter Gold & Silver Fund, which caters to the investors seeking to preserve the purchasing power of some of their wealth.

Jupiter’s Gold & Silver Fund

Ned Naylor-Leyland describes Jupiter Gold & Silver Fund as a well-designed, time-tested lifeboat. “We all know we need a lifeboat right now. The question is whether you want a lifeboat at the last minute in a scrum from Costco or would you like one which has been designed over 20 years by genuine experts who have the appropriate materials, equipment, technology and everything else,” says Naylor-Leyland. “That will give you a better chance of actually finding land when you hit the iceberg. But at the end of the day, any old lifeboat is a lifeboat.”

“We will typically have between 15 and 20 percent in physical silver and gold. I see this allocation as a cash proxy.”

Jupiter Gold & Silver Fund usually allocates between 30-50 gold and silver mining companies in addition to holding a portion of the portfolio in physical silver and gold. “We will typically have between 15 and 20 percent in physical silver and gold,” explains Naylor-Leyland. “I see this allocation as a cash proxy. It is a way to make the customer feel relaxed about the overall portfolio,” he continues. “In an unhelpful environment for gold and silver investing, we can take the physical allocation all the way to 50 percent if we want to.”

The remaining portfolio is allocated to about 40 individual mining companies. “Gold and silver miners are a form of open-ended call options,” says Naylor-Leyland. Although gold and silver miners can offer upside potential in times of monetary distress, each one carries material operating risk. “If there were perfect call options, obviously everybody would use them. So individually, gold miners are call options, but they have a hundred percent idiosyncratic downside risk,” points out the fund manager. “When using index and passive funds to get exposure to miners, you are saying that you want to participate on the upside, but you are equally happy to potentially lose all the money.”

“By taking yourself away from complex jurisdictions, where you have problems with logistics and labor and regulation, you are managing your call option better.”

Naylor-Leyland and his team focus on a more concentrated portfolio of gold and silver miners to mitigate operating risk. “I want to keep the maximum upside on the call option, but I also want to mitigate the downside risk. By taking yourself away from complex jurisdictions, where you have problems with logistics and labor and regulation, you are managing your call option better,” explains Naylor-Leyland. “Gold miners work in very rare circumstances, but we are talking about structural hedging here. When the bond market realizes that one U.S. dollar will buy you 80 cents not 99 cents of goods and services, then you will find the call option will work very, very well,” he continues. “Gold and silver miners represent a sleeper form of diversification.”

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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