Using Gold Futures to Hedge Equity Portfolios

Hedging is a risk management strategy used to offset potential losses in one investment by taking an opposing position in a related asset. By using financial instruments such as options, futures, or derivatives, investors can protect their portfolios from adverse price movements. The primary goal of hedging is not to maximize profits but to minimize potential losses and provide stability.

Reference [1] explores hedging basic materials portfolios using gold futures. The authors pointed out,

Seven different portfolio construction methods were selected for the study, which used historical data from 01/03/2018 to 01/03/2022. Excluding gold futures, five portfolios (equal weight, two Monte Carlo, and two mean-variance portfolios) from 01/03/2022 to 01/03/2023 and from 01/03/2023 to 01/11/2023 were loss-making, and only two SLSP portfolios showed a positive return. The practical application of the basis trading strategy revealed that the inclusion of short gold futures in portfolios did not change the direction of the result but mitigated both profits and losses. Thus, the basis trading strategy acted as a hedge during the two testing periods…

Practically, portfolio hedging using futures contracts can stabilize an investment portfolio, but stability comes at a price. The proposed investment strategy using gold futures could be applied by risk-averse investors who would like to invest in the commodities market but are not prepared to take high risks. Furthermore, the elaborated strategy can be used by investment managers who seek to satisfy different groups of clients by offering them well-informed hedging strategies and various levels of risk management.

Basically, the authors concluded that hedging with gold futures can reduce the PnL volatility of base metal equity portfolios.

While we find the research objective commendable, i.e., hedging to reduce a portfolio's PnL volatility, we have several reservations:

• The studies appear to be performed with in-sample data, with no out-of-sample results presented.
• A mining company can perform hedging on its own, making further hedging a case of double hedging.
• From our experience executing pair trades of gold stocks versus gold futures, constructing and managing such a pair is not trivial, leading us to question the viability and feasibility of the proposed approach.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Stasytytė, V., Maknickienė, N., & Martinkutė-Kaulienė, R. (2024), Hedging basic materials equity portfolios using gold futures, Journal of International Studies, 17(2), 132-145.

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