Gold as a Refuge in the Face of Recession

In times of economic uncertainty, like the one we are experiencing, investors tend to lose their appetite for risk and one of the favorite refuge positions ​​is often investing in precious metals. Gold, in particular, has appreciated almost 20% so far this year, and is expected to continue appreciating if fears of a global recession are confirmed.

While this financial market strategy is common in turbulent times, how effective is it in the long term? And how much can this investment strategy work in emerging markets such as those of Latin America?

Although it is advisable to create diversified investment portfolios, a thorough knowledge of the different investment instruments is required to reduce risk and improve returns.

During the last decade, diverse financial innovations have allowed commodities, be they agricultural products, metals or energy, to become part of investment portfolios, along with other traditional financial assets, such as stocks and bonds. Commodities are seen today as a way to diversify risk and hedge against inflation.

Several studies have shown that a portfolio that includes commodities has a lower risk because it is more diversified and also provides higher returns than a portfolio that does not include them. In addition, investing in precious metals, such as gold, silver and platinum, protects against the volatility of stock prices.

The financial theory of portfolios establishes the basic concept of hedging. A hedge is the most commonly used strategy to eliminate or mitigate possible losses on financial assets. An effective hedge is one for which changes in the price of a financial asset compensate for changes in the value of the financial asset to be covered. In other words, this strategy reduces risk for a specific position in the market.

In my most recent research, entitled: Estimación de niveles óptimos de cobertura para portafolios de inversión estáticos, dinámicos y con varianza condicional. Evidencia en países emergentes (Estimation of optimal levels of coverage for static, dynamic and conditional variance investment portfolios. Evidence in emerging countries), I analyzed the behavior of different methodologies for determining an efficient coverage ratio. To ratify the above, I used data on gold futures as a hedging tool for investment portfolios in emerging countries.

Gold is an investment instrument that has a low correlation to the general market, making it an attractive instrument during periods of poor economic management or financial crisis, a significant feature of emerging markets. In other words, I sought to try different methodologies in order to determine an efficient coverage ratio that compensates for the effects of volatility in emerging markets through a very safe instrument: gold.

The methodologies used were as follows:

In the first model, a least squares regression analysis was carried out to construct a static portfolio. Such investors would be those who invest their funds, are unaware of changes in the market and do not make adjustments to optimize their investment.

The second model represented a dynamic portfolio characterized by the use of mobile windows with six-month timeframes for rebalancing funds. This means that every six months regressions were prepared considering these time windows with monthly dynamics. This model exemplifies the profile of investors who are more aware of market movements and continuously monitor their portfolios by making adjustments and optimizing them.

The third model was the construction of a portfolio with conditional variance using the GARCH model (1,1). A main feature of financial time series is the presence of volatility over time. This volatility is not constant; there are periods with high volatility and periods with low volatility, which indicates the presence of heteroscedasticity. That means that the variance is not homogeneous (homoscedastic), but fluctuates over time. Hence, the importance of establishing a model that takes these changes into consideration and enables the establishing of a better coverage ratio. This is the approach of GARCH models that try to capture and model the movements of the variance over time.

The results of the study contributed to broadening our knowledge of the subject, allowing us to draw three conclusions:

1. Gold is a very noble instrument and represents a good hedging strategy for emerging countries with high volatility.
2. The three models described confirm the financial theory that having any level of coverage is better than having none, since it reduces volatility by 96.17% compared to a static strategy.
3. Although the GARCH model efficiently models conditional variance movements, a least squares model with mobile windows proves to be an accessible and easy-to-implement tool in the determination of optimal coverage levels.

Emerging countries represent investment opportunities because they provide attractive returns and have high volatility, but it is necessary to implement mechanisms that allow optimal levels of portfolio coverage in order to minimize risk exposure.