Gold has tail risk hedging benefits, unseen by other diversifiers

20 May, 2024

As stated previously, gold has been shown to help portfolios increase expected risk-adjusted returns. In fact, gold can also considerably mitigate the potential for loss in a portfolio during periods of financial stress by acting as a tail risk hedging asset. 

Chart 6 shows the analysis of gold’s performance under left-tail risk events in the global financial market. During periods of heightened market risks, which signify left-tail risk events, gold has demonstrated relatively stable diversification benefits against stock prices, compared with fixed-income assets. 

The robust performance of gold is perhaps not surprising. Listed equities, as well as unlisted asset classes, can move in the same direction and pose significant losses in left-tail risk events, such as when global liquidity dries up. However, since there is demand for gold for reasons other than investment, including gold holdings at central banks and holdings by individuals in various forms, it is highly likely that gold price fluctuations will not necessarily correlate to those of other financial assets. 

 

Chart 6: Gold tends to outperform in left-tail risk events 

Performance of gold, JGBs and Nikkei 225 during pullbacks, in yen*

Gold tends to outperform in left-tail risk events

Gold tends to outperform in left-tail risk events
Performance of gold, JGBs and Nikkei 225 during pullbacks, in yen*
*As of 31 December 2023. Return computations in yen for Nikkei 225 Index, BPI JGBs Index and the LBMA Gold Price PM. Dates used: Dot-com: 3/2000 - 3/2001; September 11: 9/2001; 2002 recession: 3/2002 - 7/2002; global financial crisis (GFC): 10/2007 - 2/2009; Sovereign debt crisis I: 1/2010 - 6/2010; Sovereign debt crisis II: 2/2011-10/2011; Brexit: 23/6/2016 - 27/6/2016; 2018 pullback: 10/2018 - 12/2018; 2020 pullback: 31/1/2020 - 31/3/2020; 2022 pullback: 1/2022 – 12/2022. Source: Bloomberg, ICE Benchmark Administration, World Gold Council

Sources: Bloomberg, ICE Benchmark Administration, World Gold Council; Disclaimer

*As of 31 December 2023. Return computations in yen for Nikkei 225 Index, BPI JGBs Index and the LBMA Gold Price PM. Dates used: Dot-com: 3/2000 - 3/2001; September 11: 9/2001; 2002 recession: 3/2002 - 7/2002; global financial crisis (GFC): 10/2007 - 2/2009; Sovereign debt crisis I: 1/2010 - 6/2010; Sovereign debt crisis II: 2/2011-10/2011; Brexit: 23/6/2016 - 27/6/2016; 2018 pullback: 10/2018 - 12/2018; 2020 pullback: 31/1/2020 - 31/3/2020; 2022 pullback: 1/2022 – 12/2022.

Although gold is known to be liquid, with an average daily trading volume of US$163bn in 2023, some insurers have raised concerns as to whether its high liquidity holds true for institutional investors, especially under financial market turbulence. 

In fact, Chart 7, which shows the over-the-counter (OTC) trading volume of gold in the London Bullion Market compared with the Tokyo Price Index (TOPIX) during times of gold price decline, suggests that even gold bullion, which is considered to be less liquid than gold exchange-traded funds (ETFs), had a similar trading volume to the TOPIX. Although it may come as a surprise to many Japanese insurers, the trading volume of gold far exceeds that of Japanese equities under nominal market conditions, and according to one of the largest ETF managers, its ETFs can be traded up to about US$0.3 billion without impacting the gold market. Please see Appendix II for more details.

As mentioned previously, gold does not provide fixed, regular income. Hence, it is not intended to be used to hedge liabilities for ALM purposes. Instead, it is intended to be allocated for tail risk hedging, where investors can rely on selling highly liquid assets like gold in times of tail risk events. 

“It is highly questionable whether institutional investors can flexibly buy and sell in billion-yen units, especially during market fluctuations, and while we can say that there is ‘liquidity’ for individual investors, we should say that there is ‘lack of liquidity’ for institutional investors.”

General Manager
Investment Planning Department
P&C insurer

 

Chart 7: Gold has higher liquidity than the TOPIX 

Daily trading volume of gold and the TOPIX (monthly average), trillion yen*

Gold has higher liquidity than the TOPIX

Gold has higher liquidity than the TOPIX
Daily trading volume of gold and the TOPIX (monthly average), trillion yen*
*As of December 2021. Source: London Bullion Market Association Clearing Data, World Gold

Sources: Clearing Data, London Bullion Market Association, World Gold Council; Disclaimer

*As of December 2021.


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