A Safer Way to Play Gold
Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The global macroeconomic situation is setting up to send gold on a new run to never before seen levels, but some investors still find the volatility and position sizes of the commodities markets too much to handle. Even with the use of exchange-traded-funds (ETFs) like the SPDR Gold Shares (NYSEMKT: GLD), the potential for significant daily swings can leave potential investors on the sidelines. Fortunately, there is another alternative that can lower the risk and volatility of obtaining gold exposure: a carefully executed pairs trade. The basic concept behind a pairs trade (and yes, there are books on the subject, including one I wrote) is that when a historically stable price relationship becomes unbalanced, one can easily build a trade that will profit from the return to “normalcy” of the price relationship.
Why Gold Looks Attractive
Prior to this week, the combination of a global economic slowdown, the ongoing European debt crisis and the general level of uncertainty meant that safe haven investments, like those in precious metals, looked attractive. With the release of the recent FOMC minutes that included strong statements about the likely need for more quantitative easing, gold looks even more appealing. The news caused the U.S. dollar to weaken, further sending shock waves through the overall economy. Many commodity experts, including those that have been hesitant to endorse gold investments, have pointed to a weakening dollar as the most likely cause of a new run higher for gold.
Considering the Instruments
Over the past month, the price of gold, using GLD as a proxy has lagged the prices of the mining companies. Where GLD is up about 5%, the gold mining stock ETF, Market Vectors Gold Miners (NYSEMKT: GDX) is up about 16% and the junior miners, Market Vectors Junior Gold Miners (NYSEMKT: GDXJ) is about 22%. In that same time, Barrick Gold (NYSE: ABX), arguably the most attractive of the majors, is up 15% (see chart below). Over a three-month period (see chart), GLD and GDX are each up about 6%, while GDXJ is up 12.5% and Barrick is down roughly 4%.
There are two primary explanations for these performance differentials, each which can be used to build a different pairs trade, depending on which argument one finds to be the most compelling. The first argument for this divergence is the fact that over the past year, the miners have dramatically underperformed gold as a commodity. As this process continues to reverse itself, betting on the miners continuing to catch up is one way to play the situation.
The other explanation is more specific to the past month or so in the stock market. As glimmers of hope at the global macro level have caused commodity prices to fizzle, stocks have continued to be strong. This has led to the outperformance of the mining ETFs over the last month. If one believes that the music may finally stop, or slow, when the Fed announces the nearly inevitable commencement of QE3, then commodities are likely to take back over, and this performance differential may reverse. In fact, if gold prices are able to reach new nominal highs, the outperformance by GLD may be even more dramatic.
While selecting which pairs trade one prefers is dependent on one’s views on the above discussion, one’s levels of risk tolerance and the overall risk positions in one’s portfolio, building either trade is very straightforward. Under the first scenario, the miners will continue to close the performance gap over the next several weeks and months. In this case, one would buy GDX and GDXJ, while simultaneously selling an equal amount of GLD. The purpose of this trade is not to profit from the absolute direction of gold prices, but on the relative performance of gold as a commodity versus gold mining companies. The success of this trade may ultimately be tied to the direction that gold prices move, as this may impact the relative performance, but it is not the main motivation.
Likewise, if one prefers the second scenario above, one would buy GLD while simultaneously selling GDX and GDXJ. Short-term traders will prefer GDXJ because the divergence between GDXJ and GLD is more extreme. Over the last year, these two ETFs have a performance correlation of nearly 80%. This means that there is a strong relationship between the two, despite the recent divergence. If this relationship normalizes in the near-term, GLD should significantly outperform GDXJ. Owning GLD against a short position in GDXJ would serve to capture this expected relative performance.
While pairs trading involves multiple positions, in normal cases it reduces risk. This is particularly true when trading commodity-related stocks; the relationships here tend to remain strong indefinitely. Either of the trades above, therefore, should perform independently of the overall price direction of gold. This may allow investors who are hesitant to invest in anything gold-related to participate with a mitigated risk level.
Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.