Gold may be a good hedge against an investment portfolio’s fiat currency exposures. But, Martin Steward asks, does it matter that some investors may be holding it for very different reasons?

Ask why investors hold gold and you get a range of responses, from the apparently reasonable (“It’s an independent, non-inflatable currency”) to the paranoid-libertarian (“It’s the only asset the government can’t steal from me when I retreat to the backwoods with my shotgun”). Should market participants at different points on this spectrum worry about one another? And if so, should the former (let’s call them ‘strategic buyers’) protect themselves against the latter (‘safe-haven buyers’)?

For safe-haven buyers, gold is the ultimate currency. And while its liquidity cannot compete with the FX market in volume terms, it is indeed fungible and can be exchanged for goods just about anywhere at any time - even as the exchange value of other currencies collapses.

“If you had to flee the Red Army at the end of the Second World War with a couple of gold coins, you could at least convert them immediately into clothes, food or passage,” notes Markus Bachmann, CEO of Craton Capital Management and manager of its Precious Metals Fund. “That’s the essence of this asset.”

Really? For a European pension fund? It is not as crazy as it sounds. Scheme members are unlikely to waste time trying to claim assets before running to the hills, but many of those assets will be denominated in several of the world’s fiat currencies: and while one can short weakening currencies against strengthening ones, that doesn’t help if a general inflation causes weakness in all of them. Even hedging back to one’s base currency is of little use if one’s liabilities are index-linked. “This is where gold comes into its own,” says Sunil Krishnan, financial markets economist in the multi-asset client solutions group at BlackRock. “It’s basically uninflatable, whereas the whole point of fiat money is that it can be inflated.”

Since the University of Michigan started to survey inflation expectations in 1979, many have noted that gold prices shadow them closely. A 1% rise in expected inflation has historically led to a 2% fall in the dollar against other currencies, leading to long-run negative correlation between the dollar and gold. Essentially, central banks try to diversify from the dollar, and have few choices outside gold. But that’s not to say other fiat currencies are immune: from 2000-10 the dollar lost 74% of its value against gold; but the euro is down 64%, sterling down 75%, the yen down 72% and even the Swiss franc down 63%. No wonder central banks have been buying more gold. Pension funds might do so for similar reasons.

The arguments of a future central banker, Alan Greenspan, that gold “stands in the way of this insidious process” of “confiscation through inflation” and “deficit spending” as a “protector of property rights”, show how readily the sober ideas underpinning gold as a fiat-currency hedge can translate into “guns and tinned-food” rhetoric (the essay, Gold and Economic Freedom, appeared in a periodical edited by Ayn Rand). Indeed, hedging against all fiat currencies is arguably tantamount to hedging against a general breakdown of government sovereignty. Still, the objectives of these two holders of gold are very different. For pension funds, gold hedges FX volatility on a balance sheet, so there is usually no incentive to sell. For safe-haven buyers, it is precisely the liquidity of gold that is highly-prized.

This difference is well-articulated by Stephan Müller, responsible for Swiss & Global Asset Management’s JB Precious Metals Funds - which offer exposures hedged back to investors’ base currencies. “People have to decide why they want gold,” he says. “If you want to be safe in one-year terms, I suggest you hedge; if you have deep pockets and don’t anticipate having to liquidate at a very poor moment, then by all means go unhedged.”

Take a look at a Swiss franc-based investor’s experience of gold in December 2008 (see graph). USD/CHF collapsed and gold priced in dollars soared. But liquidating that back to Swiss francs at the end of the year would have incurred a loss close to 15%, compared with liquidating on 1 December. The safe-haven buyer wants to preserve purchasing power in her home currency: she may not need tinned food for her bunker, but she may well face margin calls on FX-exposed investments. At some point during the crisis, she will want to sell her gold. “I spoke to investors who struggled to sell fixed income paper in Q4 2008,” as Bachmann puts it. “You hold gold to have something you can liquidate, 24/7.”

Does this matter for strategic buyers? Potentially. We might assume that, when things are really bad, safe-haven holders sell into rising markets. The slump of July-November 2008 suggests otherwise. And when things look as uncertain as they do today, sentiment-driven buyers dominate price movement, since the financial crisis broke spot volatility has almost doubled.

One could think of the gradual increase of XAU/USD between 2002 and 2007 as the result of hedging against broad money (M3) expansion; and of the more volatile rise since 2007 as the result of hedging against base money (M0) and MB expansion. The trouble is, whereas the former is about one simple story, the latter is about several scary ones. “Dollar depreciation was probably the main driver in the first period,” says Investec Asset Management’s head of commodities and resources, Bradley George. “But now you see a whole host of things going on: potential dollar depreciation, potential inflation, potential sovereign default, potential deflation.”

Investor behaviour has changed quite radically as a result. Jonathan Spall, a director of commodities at Barclays Capital, notes that buyers are now concerned to have allocated gold in their accounts. “That suggests that most are not thinking: ‘I’m buying at $1,250/oz today because I think it’s going to be $1,280/oz tomorrow’,” he says. “People are worried. They don’t know precisely what they’re worried about - they’re just worried. Since 1975, gold underperformed inflation. Markets bought the idea that central banks had the power to control things. Now gold outperforms inflation. People no longer trust those institutions and they go to gold because they don’t know where else to go.”

So far this year, negative correlation with the dollar has decisively broken down as both compete to be the safe haven of choice. For true believers, the dollar must lose this competition - at which point XAU/USD will rocket. “Markets see us heading towards competitive devaluations,” says Pau Morilla-Giner, head of alternatives at London & Capital.

Joe Foster manages Van Eck’s International Investors Gold fund - launched in 1968 in the face of similar fears. “The bull market is happening because gold is the people’s currency of last resort,” he says. “But that’s not to say that those drivers are not based on fundamentals - the monetary and fiscal policies that have been destroying our financial system since 2001.”

Is that really about ‘fundamentals’? Consider how the inflation/deflation driver breaks down when gold buyers are in this kind of mood: with every bit of (deflationary) bad news they anticipate more quantitative easing and buy more gold. That kind of confirmation bias blows up bubbles taht can be popped by a simple combination of mild inflation and decent macroeconomic data points; rising interest rates make an asset with no cash flows look less than glistering - and the exit look less than big.

Is it worth hedging against this risk? Gold has a fundamental price floor at the cost of production, but estimates for that vary as widely as $400/oz-$700/oz, a long way down from $1,270/oz. That may suggest one solution: low cost of production means high downside exposure, but also high free cash flow for mining companies, so a gold equities position should theoretically act as a buffer against falling gold prices - at least over the medium term. George at Investec suggests focusing on mid-tier companies that are growing production and lowering costs.

That clearly carries its own risks. Buying some gold volatility could be another strategy. Realised volatility might seem elevated at 18%, but implied volatility out to 12 months remains fairly subdued at 24%. That is both a puzzle and an opportunity: option strangles are cheap and the heavy skew towards calls - a $1,500/oz strike for Dec 2010 is popular - makes out-of-the-money puts almost free insurance. “Some central banks have been thinking about fairly low-delta puts,” says Spall, “but in general if anyone is buying options its lottery-ticket-type exposures with low-delta calls.”

In five years it may seem crazy that you worried about the downside risk of gold in 2010. But if the reasons for pension funds to hold gold are the same as those for central banks, perhaps they should take a leaf out of their options books as well?