CHAPTER 9

Anti-bubbles: How to Profit and Protect the Portfolio via Gold, Volatility, and Correlation

Playing to Make Money, Not to Be Correct

I believe the gold market is at the beginning of a multiyear bull run. A bullish supercycle that offers investors a highly asymmetric risk–reward with “a few hundred dollars of downside and a few thousand dollars of upside.”

Many respected analysts hold the exact opposite view. They believe that gold prices are going through a quasi-permanent bear market and prices will continue to go down “forever.” They have their own perspective and solid arguments to defend their views and investment thesis.

Time will tell who is right and who is wrong but, frankly, it does not matter. Focusing on being correct on our prediction misses the point. What really matters, the real and only true objective of the trading and investment game is to make money, not to be correct about our predictions.

Many respected analysts and strategists consistently lose money because their objective is to be accurate and correct in their predictions. They lose money because they are playing the game by the wrong rules.

Let’s look at a simple example to explain the difference between “playing to be correct” and “playing to make money.” Let’s assume that alternative A has a 90 percent chance of making $1 and alternative B has a 10 percent chance of making $100.

If I play the game to be “correct,” I should bet for alternative A (I would win 90 percent of the time).

If I play the game to “make money” I should bet for alternative B (expected win = $100 * 10% = $10, much higher than the expected win of alternative A = $1 * 90% = $0.9). It is your choice how you want to play the game. My strong suggestion: play to make money.

Bulls, Bears, and Pigs

The current market consensus is as polarized as ever, and that’s why I believe it is going to be a very volatile and bumpy road. The bulls that are hoping for a steady and orderly appreciation of gold may be set for a surprise, and may end up being pigs.

Playing to win removes the ego from investment processes. Recognizing and quickly correcting our mistakes is a key trait of successful investors and traders. Being stubborn and slow is a trait of losers. You choose.

You may have noted the extensive use of the word thesis. An investment thesis is meant to be tested and either validated or rejected. A mindset that aims to remove our ego from the decision process.

Smart Investing in Gold

There are many ways to invest in the gold market, but just like “not all that glitters is gold,” I believe that many gold-related investments will perform poorly and some even have the potential to fail spectacularly.

One of the primary objectives of this book is to educate investors on the alternatives available for gold and volatility investing, and avoid situations of “I was right, but wrong.”

Debunking the Myth of Gold Equities

Many investors are currently implementing their gold views via gold mining stocks, also known as gold miners. Some of those investors are buying gold miners based on the naive belief that owning gold miners are just like owning physical gold. A misconception in my view that I feel compelled to debunk.

This false belief is strengthened by the fact that many investment vehicles, such as the Blackrock Gold Fund, give the wrong impression of investing in gold but in reality are investing in gold mining stocks. I would like to believe that those investing into those funds are doing it with their eyes wide open (knowing they are buying gold miners, and not gold), but I fear it is not always the case. In my view all these funds should be renamed to Blackrock Gold Mining Fund to avoid any confusion and potential mis-selling with investors.

Investors must understand that a scenario of much higher gold prices does not necessarily imply much higher gold equity valuations. There are many reasons why the divergence in pricing (known as “basis risk”) can arise. I will discuss more of the more relevant ones, but there are many more.

Real Options

One of the best university courses I have taken in my life was taught by Professor Graham Davies, at the Colorado School of Mines, where I completed my Masters in Mineral Economics. The course introduced me to the concept of real options and forever changed the way I looked at the world.

I followed my passion for the topic of Real Options theory and completed my thesis on its application to Mineral Asset valuation. Traditional models relied on discounted cash flows and sensitivity analysis, which I found very limited. The Real Option framework viewed and valued the assets as the right, but not the obligation, to extract the reserves on the ground. The mine could be valued using the models used for financial options, such as Black and Scholes, using the forward curve, the volatility of the price, the Strike Price as the Marginal Cost of Production, or the Option Expiry as the time given by the license. A framework that opened enormous possibilities.

Taxation, Expropriation, and Nationalization

Gold mining companies tend to operate in a range of geographical locations and jurisdictions, which I will refer to as “host governments.” The probability that a host government will tax your revenues, expropriate your gold mining assets, or even outright nationalize the company, increases exponentially with the gold price.

Think about what would happen to your gold mining assets in “Emerging Market country X” (I won’t name names, but there are multiple examples across all continents, not just the usual suspects in Africa and Latin America) if a mega bullish gold price scenario. Thank you very much.

Host governments are also driven by populist measures. “Foreign multinationals are coming and taking our precious assets.” Rings the bell.

It is therefore not inconceivable that at record high gold prices the equity valuation of those gold assets would be a big fat zero.

Up and Out Calls

For those versed in exotic derivatives, I would describe gold equities as an “up and out call” on gold, which describes a “knock-out” feature if gold prices reach a certain price substantially above the current market.

Jurisdiction

The dynamics described previously are very much a function of the jurisdictional risk of the assets, more than the listing of the company, which also matters. In that sense, we may gain a false sense of security from investing in a Canadian-listed miner, but if the assets are all in some dubious sub-Saharan Africa, the valuation should reflect those risks.

Marginal Cost of Production

Let’s now think about the exact opposite scenario. Prices have collapsed to new historical lows, a price that is very significantly below the average marginal cost of production in the industry. Under this extreme price scenario, the higher marginal cost producers would be burning cash and would eventually be forced to shut down, effectively reducing the supply.

For all commodities that are produced and consumed, such as oil or corn, the supply destruction would eat into inventories, which, once depleted, would incentivise substitution and destroy demand via high prices. The price elasticity of demand would determine how high prices need to go in order to destroy the necessary demand. In turn, higher prices provide an incentive for producers to return to the market and increase supply. These dynamics, driven by Adam Smith’s invisible hand, provide a strong floor at the marginal cost of production for these commodities.

But gold is not a normal commodity. In fact, some respected research houses don’t even consider gold as a commodity at all. The rationale is that all the gold ever-mined is currently sitting somewhere in the form of “above ground stocks.” In the oil market, the “above ground stocks” are measured in days of consumption. In the gold market, it would be decades.

The key implication is that the marginal cost of production is not a solid floor for gold prices. That is, gold prices could, in principle, trade substantially below the marginal cost of production for substantially long periods of time. Bad news for producers and their equity valuations.

Down and Out Calls

The mirror image of the “up and out call” described previously, whereby for those versed in exotic derivatives, I would add to my description of gold equities the “down and out feature,” which describes a “knock-out” feature if gold prices sustain a certain price below the current market.

Hedging

In order to protect their cash flows and equity valuations, many gold producers have historically engaged in hedging, whereby they lock-in a minimum selling price for a portion of their future production.

Hedging programs are meant to be risk-reducing, but that’s not always the case. It is important for investors in gold mining stocks to understand the hedging policy in full detail. I will describe some of the common mistakes and hidden risks so investors can make more informed decisions.

The simplest and most conservative hedging strategy is to price gold price insurance via vanilla put options. The producer pays a premium to protect itself against lower prices while retaining full participation to higher prices, as the investor is effectively long a synthetic call option. The worst-case scenario is the loss of premium, which would only happen if prices are higher. A happy scenario for the gold producer. This is my preferred hedging strategy by far.

Other producers are reluctant to pay an upfront premium. Instead, they engage in “zero premium” strategies such as forward sales or zero-premium option strategies that provide some degree of downside protection but commit some degree of upside participation.

It is critical to understand the credit terms of these hedging facilities. Those hedging programs supported by open lines of credit are fine. But those programs subject to margin calls create a very dangerous, often fatal, dynamic. Let me explain.

Let’s say a gold miner has 10 million ounces of proven reserves, which he hopes to extract over 10 years at a regular pace of 1 million ounces per year. Let’s assume that he has limited cash and decides to hedge 50 percent of the production (500,000 oz per year) at the then prevailing forward prices. If the gold price sells-off, the mark-to-market value of his hedging program is positive. On the other hand, if the price rallies, the mark-to-market of his hedging program will be negative. Let’s assume that the gold price is rallied by $100/oz from the initial hedging price. In that case, the mark-to-market loss of the program will be $100/oz multiplied by 50,000 oz/year over 10 years equals $5m mark-to-market loss. In principle, these losses are offset against gains of the gold underground. Hedge accounting forces the companies to represent these gains or losses in their balance sheet. So far, so good. The problem emerges if the hedging program was subject to margin calls. In that instance, the bank will require the producer to post the full mark-to-market ($5m in this example) in cash. Very often, the producer does not have that cash at hand or needs it to run its operations. In order to pay for the margin, the company is forced to borrow money, which in some instances may be both challenging and expensive. As an old colleague would say, “excess liquidity has never made anyone insolvent.” The opposite unfortunately often holds true, and lack of liquidity can lead to the bankruptcy of perfectly solvent businesses.

Finally, other producers prefer to collect upfront premium. They engage in strategies such as call granting strategies or exotic strategies with complex conditions, which are difficult to price and manage. In some cases, ill-designed hedging programs have created dynamics where the producer was net short the underlying. Over my two decade career, I have seen many of these programs blow up spectacularly due to a combination of leverage, currency, and exotic risks. The Australian miners or Ashanti Goldfields spring to mind.

Even well-designed hedging programs can create conflicts. By construction, a positive outcome of the hedging program is not in the best interest of the company. And vice versa, a negative outcome of the hedging program, which should be in the best interest of the company, is not necessarily always in the best of the finance department in charge of it. Badly run companies are not clear in their objectives and often play the blame game after the fact. The typical 20/20 hindsight, “I told you not to hedge. We have lost/wasted X million $.” A dynamic I refer to as “which team are you rooting for? Do you want prices to go up, or go down?” A dynamic that, believe it or not, is more often the rule than the exception.

The gold market has historically been divided into two philosophical camps: the hedgers and the nonhedgers. During bear markets the hedgers tend to do better and vice versa, the nonhedgers do better during bull markets.

A well-designed hedging policy can significantly reduce the “down and out” risk, but both hedgers and nonhedgers are subject to the “up and out” knockout feature, and that’s why the jurisdiction is such an important consideration when investing in gold equities.

Exploration, Juniors, Majors

The stage of development and the strength of the balance sheet are major considerations when investing in gold miners. The framework of Real Option can be very helpful to understand the risk and behavior of the underlying. The detail of the discussion are beyond the purpose of this book, but the key point I want to stress is that the more “non-gold” risks that we add to the equation, the greater the risk for a “I was right, but wrong” type of outcome.

Management

Another important source of optionality and basis risk is the quality of the management of the mining company. They are the ones who take the strategic and tactical decisions in terms of organic expansion versus M&A, hedging, and many other important considerations that can result in the success or failure of companies.

Gold Equities Are Not Gold

In summary, I am not saying that gold equities are better or worse investments than gold. What I am saying is that they are different. Those investors who are investing in gold based on the macro topics discussed in this book should be very aware of the large basis risk they may be incurring by investing in gold equities.

At this point in time, many gold equities are behaving as highly leveraged positively correlated assets to gold prices, but those relationships can and will change over time. Leverage can be achieved via many other ways.

Correlations can break for many reasons, and why I recommend that gold equities are viewed primarily as equity investments, and not as gold investments. You need to know what you are buying: the quality of the reserves, the jurisdiction, the management, the leverage, the financing, the taxation, and many other important factors that drive the price in addition to gold prices.

Most investors understand that oil futures are different from BP or Shell. I hope the brief and simple discussion earlier will open the eyes of gold investors too.

Gold Services

There are many other creative ways in which investors can implement their views. A good friend of mine has bought gold drilling equipment in Africa. The view is that gold drilling rates are positively correlated to gold prices. They are real options (the right but not the obligation to drill). Investing in the gold services industry worked very well for someone named Levi Strauss during the gold rush of the 1800s.

Lessons from the Oil Market

Investors in gold miners should pay close attention to the lessons learnt from the recent bull market in energy markets where many investors were correct in their bullish outlook but gold prices but lost money due to the wrong implementation.

Production sharing agreements reached taxation levels of 99 percent in some cases, which effectively converted equity investments, theoretically call options, into put options with limited upside and full unlimited downside. Not what many investors thought they were buying into. Another case of the dreadful “I was right, but wrong” we are trying to avoid here.

The “Widow-Maker”

Another important lesson to be learnt from the oil market is the dangers in Relative Value trading (“RV”) between oil and oil equities.

The run-up in oil prices from 2005 to the peak of 2008 was characterized by a major divergence between the oil futures curve (which was updated live) and the assumptions used by oil equity analysts (which were very stale, and significantly lagging the rapid moves in the oil futures curve).

Many investors were monitoring the divergence in implied valuations between oil equities (which implied $40/bbl oil) and oil futures (which implied $60/bbl). A 50 percent premium that enticed investors to buy oil equities and sell oil futures.

Such convergence plays can be implemented in many ways. One is on a “dollar neutral basis,” whereby you buy $100 of oil equities and sell $100 of oil to hedge it. A dollar neutral implementation assumes that oil equities have an oil beta (sensitivity) of 100 percent, which is pretty much never the case. It also assumes that the volatility of both assets is the same, which is not necessarily true either. As a result, convergence plays tend to be implemented on a “beta neutral” or “volatility neutral” basis.

To the pain and surprise of many, the valuation spread continued to wide rapidly as oil prices rallied, creating large mark-to-market losses in the oil futures, which required additional margin, while the oil equities were lagging behind unable and unwilling to catch up.

The divergence reached such extremes that the trade was commonly known as a “widow maker.”

In some cases, the perception of low risk due to the high positive correlations led investors to implement their bets in large notional sizes. A very common and potentially fatal mistake, in relative value trading, which I have seen many times over the years, such as Brent versus West Texas Intermediate (“WTI”), or Gold versus Silver, assets that tend to show positive correlation but occasionally show negative correlation, leaving investors with wild swings and often large losses.

A risk I call “correlation breakout,” a very real possibility for gold and gold equities, especially at very high gold prices, due to the risk of taxation, expropriation, and nationalization.

Debunking the Myth of Physical Gold

Many investors are currently implementing their gold views via physical gold only. I totally agree with the merits of physical gold (its physical and chemical properties are what makes gold unique), but I think it is worth reviewing some of the common and potentially dangerous misconceptions associated with physical and paper.

The Rationale for Physical Gold

There are many instances when physical gold may well be the most effective and appropriate way to implement a gold investment. There are many others when it may not.

Many investors buy physical gold to take it “off the system.” They have gold in private storage facilities, outside of the radar of banks and governments. Gold has played a key role as money since inception, but has experienced a progressive detachment, starting with seigniorage (gold coins issued by the government), paper money (fiat currency), the digitalization of money (credit cards), the virtualization of money (bitcoin), and more recently negative interest rates (“tax on cash”), which are in my view planting the seeds of a monetary supercycle that may bring gold back to the monetary scene. More on this later.

Many investors also buy physical gold because of its convenience yield. History is full of examples of families forced to flee their homes and leave behind their land and possessions, but were able to take their gold (ingots, coins, jewelry, etc.), giving them a clear head-start to rebuild their lives somewhere else.

All these benefits come at a cost in the form of storage cost, insurance cost, lower liquidity, which need to be balanced with the benefits and the ultimate goal of holding gold, which leads me to the discussion about the end game.

Paying with Gold Coins in the Supermarket?

Let’s assume for a second that gold has regained its status in the monetary scene. Does it mean that we will be paying in the supermarket with gold coins? No, we won’t. Does that mean that the USD or the EUR or the JPY will disappear? No, they won’t. In my view fiat currencies will continue to be used after a monetary supercycle.

What will be different is the value of those fiat currencies relative to gold. Instead of buying a Fiat 1 with your gold, you may be able to buy a Ferrari, who knows.

The ultimate goal of owning gold is to preserve value and exchange it for something else at a future day. A holiday, a meal, a house, whatever that is, in my view it will be cheaper in gold terms in the future. As a result, the objective is to find ways within the system that preserve the value of our savings.

Mind the Basis

I have come across some passionate gold bugs who believe paper-gold is worthless. They proposed a strategy that would buy physical gold and simultaneously sell gold futures (paper-gold). The rationale, they argued, was that paper-gold was not backed by sufficient physical gold, and as a result, in their view, physical gold should be worth more than paper gold: a very basic and possibly lethal mistake. Let me explain via an example.

Let’s assume that there are 1 million ounces of gold and open interest of 100 million ounces of gold futures. What would happen if the people holding the 100 million ounces of longs decided to take physical delivery with a fairly short notice? Clearly, the amount of physical gold is not sufficient to deliver into the obligations, which forces the short positions to cover their position and potentially pay a significant premium above the then prevailing physical gold price. In the commodity lingo, gold would turn into a steep backwardation, which reflects the premium for immediate availability. As a result, those holding the short futures and long physical would incur very sizeable losses. A dynamic that bears some similarities with the Sumitomo scandal, when in 1995, the chief copper trader at Sumitomo, Yasuo Hamanaka, tried to corner the market but ended up costing Sumitomo over $1.8b in trading losses and a suspension of 10 years.

Gold ETF

The gold ETF (Exchange Traded Fund) was a game changer for the gold market. For the first time ever, retail and institutional investors alike, would be able to buy physical gold as easily as they could buy shares of Microsoft.

The concept was very simple. Create a company whose assets are only gold, say 100 oz, and its liabilities is only equity, say 100 shares. By construction, the share price of that company would equate the price of gold on a one-by-one basis. The ETF would carry a management fee (not negligible 0.50 percent p.a.) to pay for the cost of storage, insurance, and operations.

The liquidity has grown significantly over the years and has already surpassed the liquidity of the Over the Counter (“OTC”) market, where all the gold trading used to happen.

Many people are critical of the second-order and third-order risks incurred when buying an ETF, such as the force majeure clause, which may lead to cash settlement (at the then prevailing prices), which in my personal view is a minor risk. Personally, I am more worried about the risks involved in gold equities or the wrong type of physical trading than the risks of ETFs.

Gold Futures

Moving on to leveraged investments (so far gold equities, physical gold, and gold ETF tend to be “fully funded” investments), gold futures allow investors to express bullish and bearish views with significant leverage.

The initial margin is the amount we must deposit with the exchange to cover for potential losses. The margin varies with the underlying and can also change over time based on the liquidity and volatility of the market.

Assuming an initial margin of 10 percent, investors are able to take risk on much larger positions (in principle up to 10 times larger in this case), which is why speculators favor futures versus fully funded vehicles.

Gold Structured Products

Many investors implement gold via structured products sold via private banks and financial advisors. These strategies tend to be optically very attractive but carry several layers of structuring and distribution fees that dramatically reduce the attractiveness and risk–reward of these products.

My father has a saying that goes something like “meat in a sock, for whoever stocked it,” which tries to explain that when you have a steak you can see the type of meat you are eating, but when you eat a sausage as you don’t know what meat is inside.

Let’s start with the Principal Protected or Capital Guaranteed products. These products are composed from two parts: the zero-coupon bond and the option.

The zero coupon bond is the portion of the capital that we need to invest day one in order to receive $100 at maturity. Oversimplifying, if the issuer is willing to pay 5 percent for one year, we would only need to invest approximately $95.23 for one year, and receive 95.23 * 1.05 = 100 at maturity. The higher the interest rate, the less we need to invest day one. The longer the maturity, the less we need to invest day one.

The option is generally some kind of insurance product, whereby we invest the balance between the amount paid by the investor ($100) in this case, minus the commissions (can be several percent points, let’s assume 1 percent for the structurer and 1 percent for the distributor), which would leave us with just 2.76% (= 100% − 95.23% − 1% − 1%) to buy something.

In order to make the structured products optically attractive, the banks often add a few bells and whistles such as knockouts and other exotic features that add leverage and reduce the probability of success. Not a very effective way to express a view.

The main problem with structured products is that the return of the capital is guaranteed by the issuer of the note. If your issuer goes bankrupt, the note will be worthless, irrespective of what happened to the gold option. Not an acceptable risk for most gold investors, who are trying to protect themselves from systemic risks.

As a result, I would not recommend gold structured products in general unless we have a very clear understanding of what it is inside, the risks, and the pricing, in which they can be effective packages. Otherwise, I can think of many more effective ways to implement your gold views.

Mind the Leverage

Financial leverage is possibly the number one reason most investors suffer from “I was right, but wrong” type of mistakes.

Physical investments tend to be the most “sticky,” and often last for many years. Gold ETF investments are reasonably sticky, as investors can hold to their views without having to worry about margin calls. Gold futures, on the other hand, tend to see wild swings in open interest and positions.

Trend Following Strategies

I often come across investors who tell me, “yes, I own gold via CTAs,” which in my view has some merits but has the potential to fall in the “I was right, but wrong” category. Many reasons why, but first and foremost because Commodity Trade Advisors (“CTA”) try to catch trends in both directions and therefore buy and sell gold, which often puts them in the opposite direction to where you expect them to be.

There are certain scenarios where trend following strategies work very well (clear trend with low volatility) and other scenarios when trend following strategies fail spectacularly (no clear trend and high volatility). My big picture view of higher volatility and dislocations does not favor CTAs.

Discretionary Macro Strategies

I often come across investors who tell me that they are long gold via discretionary macro strategies. Similar to CTAs, however, global macro managers can play gold from the long and short side. Currently, the investment community is highly polarized. Some managers are very bullish, and some managers may be very bearish. That’s in principle a good thing as we know where they stand, but macro managers are also known for changing their views and positions quite quickly.

Even dedicated commodity hedge funds, which many investors expect to have a long bias, have been caught many times short the commodity. A very painful experience for the investor, and yet another case of “I was right, but wrong” in the gold market.

Silver, Platinum, and Palladium

Silver has played a key monetary role throughout history. In Spanish, “plata,” is used today to refer to money in countries such as Argentina. Some Central Banks, such as Russia, still hold silver as part of their FX reserves, but they are the exception rather than the rule.

There are several reasons why silver will play a less critical role than gold in a Gold Perfect Storm and Monetary Supercycle scenario. To start, silver’s chemical properties are not as noble as gold, as silver easily oxidizes and produces a blackish coat we must regularly polish. Silver is also more reactive and can be attacked by acids that gold is resistant to. Lastly, the relative scarcity and price makes silver a less efficient store of value. Based on current ratios, we would need 70 times more volume of silver than gold to store a given amount of USD.

Platinum and palladium are precious metals with extensive investment and industrial use. Historically they have played a minor role as monetary assets, but their properties and scarcity make them solid candidates as a store of value, to the point that platinum prices have historically traded at a premium to gold. The concentration of mining supply (platinum is mainly produced in South Africa, and palladium in Russia) has important implications as currency fluctuations in the South African Rand (“ZAR”) and the Russian Ruble (“RUB”) are a key driver of these metals.

Overall, the relationship across the main four precious metals offers attractive relative value opportunities, and I have historically actively traded the main ratios gold/silver, platinum/gold, and platinum/ palladium.

Smart Gold

The Gold Perfect Storm investment thesis is not just about gold. It is a thesis about bubbles and anti-bubbles, where gold, volatility, and correlation will all play a very relevant role.

Based on the Gold Perfect Storm investment thesis and the experience I have gained trading and managing risk over the past two decades, I have perfected a strategy that I call Smart Gold.

The strategy has four building blocks, each one addressing a set of opportunities and risks.

Building Block #1: Long Gold

Smart Gold invests in gold only, not in gold equities, and is designed to provide investors with an effective vehicle for Strategic Allocations to Gold, which is supported by both traditional asset allocation models (such as Markowitz) and modern approaches based on risk-factors.

As a risk-factor, gold is a unique asset class that combines three distinct characteristics, namely (i) gold as a commodity, (ii) gold as a currency/monetary asset, (iii) gold as a credit/safe haven asset that make it an unique diversifier and insurance against many of the key risks ahead, namely inflation, duration, credit, equity, inflation, geopolitics, currency, among other direct implications of the Lehman Squared and the Gold Perfect Storm investment theses.

In addition to its strategic nature, the tactical case for gold is also very supportive (in my view gold offers a few hundred dollars of downside and a few thousand dollars of upside), and possibly even more asymmetric in most non-USD currencies, and believe that the current global market conditions are setting the beginning of a multiyear bull cycle as we Central Banks, Governments, and market participants are (1) testing the limits of monetary policy, (2) testing the limits of credit and equity markets, which will eventually lead to (3) testing the limits of fiat currencies.

Another common objection that comes up is “gold has no yield.” Indeed, in a yield-seeking environment, the negative carry of physical gold (storage and insurance costs) has contributed to gold’s anti-bubble dynamics. The yield-seeking bubble inflating fixed income, credit, equity, high yield, Emerging Markets (“EM”), and so on, has a mirror image in gold and volatility. A dynamic that I believe will eventually reverse leaving investors focused on the return of their capital, instead of return on their capital.

In this context, gold has become a real alternative to negative yielding cash and bonds, which make gold a “positive carry” versus trillions of cash and bonds in Euros (“EUR”) and Japanese Yen (“JPY”). Time will tell how much damage has been created during the “yield seeking bubble” created, but the downside risks in my view are highly asymmetric.

Building Block #2: Long Gold Volatility

Smart Gold buys gold price insurance based on both quantitative and qualitative factors.

I believe that implied volatility is deflated due to the combination of the Central Bank Put and the Complacent Desperate search for yield. From a quantitative perspective, I seek to capture relative value from the divergence in implied versus realized volatility. From a qualitative perspective, I seek to capture relative value from the divergence in implied versus expected volatility. On a historical basis, Smart Gold has been a consistent buyer of short-dated gold volatility, where the most attractive risk–reward has been, but it is also able to buy longer dated volatility to take advantage of cheap vega and to benefit from the trend in volatility.

The gold insurance overlay addresses one important consideration often raised by investors: “gold’s volatility is too high for me.” Smart Gold long insurance profile is designed to reduce the “bad volatility” (to the downside) via long gold puts, and maintain “good volatility” (to the upside), effectively resulting in realized volatility that—by construction—will notably be lower than gold.

Smart Gold is designed to provide “blue sky” exposure to gold prices, which is achieved through its long-bias approach to insurance. In my opinion, yield-seeking strategies such as covered calls are negating the benefits of holding gold on the first place.

Another major benefit of Smart Gold is that it is focused on the long-run, and removes concerns about entry and exit, which are extremely difficult to time. By embracing volatility (instead of resist or fight it) Smart Gold aims to act as a “gold accumulation” program, reinvesting the proceeds from insurance to buy more gold without any incremental cash outlay, thus benefiting from both rallies and selloffs.

This is important as many investors are disillusioned with gold, having suffered significant capital losses and dilution over the past few years. From the highs of 2012 to the lows of December 2015, gold collapsed by almost 50 percent and the gold miners by almost 80 percent, leaving a sour taste to investors. Many of them sold along the way down, locking-in losses. Smart Gold is designed to enhance capital preservation via the purchase of gold price insurance.

By adding a long insurance profile, Smart Gold enjoys the benefits of a long-only strategy (known behavior as risk factor for asset allocation) but also the benefits of absolute return (capital preservation and higher risk-adjusted returns).

Building Block #3: Rotation Across Precious Metals

Smart Gold rotates a portion of its gold exposure into other precious metals, namely silver, platinum, and palladium.

The rationale is to capture “mean reverting” relative value opportunities that complement the “breakout” profile of the long insurance.

Building Block #4: Long Tail Risk

Smart Gold deploys a small portion of its capital to buy tail risk insurance in option format.

The idea is to take advantage of the low implied volatility and high implied correlations. Historically, the strategy has bought options that believe gold will go higher and Euro would go lower, a scenario that the market believes as unlikely due to the recent high realized correlation between the non-USD currencies, including gold.

At the time of writing, the market holds the view that gold and the Japanese Yen are “the same thing,” and are trading at similar level of implied volatility and with high realized correlation. This dynamic offers an attractive contrarian opportunity to buy options that would make money if gold trades higher and the yen simultaneously trades lower. These transactions can offer extremely high risk–reward (20 to 1 or higher).

At the time of writing, gold remains a contrarian view versus the complacency of global markets who believe we can “print and borrow our way out of a problem.” Smart Gold is positioned to participate in the long-term appreciation of gold, while embracing and taking advantage of the short-term volatility, short-term dislocations, correlation breakouts, and tail-risk events.

Contrarian Bias

Smart Gold has a contrarian bias, which means it favors views that go against the consensus and speculative position of the market. The main benefit of contrarian ideas is that they have superior risk–reward than consensus “me too” ideas. The main consideration is that contrarian ideas tend to go against the prevailing trend and, as Keynes famously said, “the market can remain irrational for longer than I can remain solvent.”

The consensus and positioning can be monitored via public information such as the Commodity Futures Trading Commission (“CFTC”) reports. In addition, I also pay close attention to expressions such as “it’s a no brainer” or “it should be higher.” In my experience can be a red flag for market imbalances.

I favor contrarian trades but also invest in ideas that are neutral or in-line with the market consensus when other sources of asymmetry offer sufficiently attractive risk–reward.

I rarely invest in ideas that are crowded, and when I do invest, it is because it is a long-term theme I want to stay invested in, as it has been the case in gold, and I look for ways to protect my position and take advantage of short-term dislocations, often via relative value and insurance. I call this Smart Beta. More on this later.

Investment Horizon

The investment horizon of my Gold Perfect Storm thesis is three to five years. I have a reasonably high degree of conviction that gold will be much higher than today against most currencies, including the U.S. dollar.

The investment horizon for a normalization of volatility is shorter. Realized volatility has notably picked up since Brexit and the U.S. elections and in my view may have already bottomed.

In terms of implementation, it is important to ensure that the instruments and leverage are adequate for our investment horizon. As a rule, the higher the leverage the more likely to be taken out of our position by corrections and noise. A dynamic that could result in the unfortunate “I was right, but wrong,” because at the end of the day, being early is another way of being wrong.

Timing

It is impossible to time the market perfectly all the time. Sometimes we are too early. Sometimes we are too late. Sometimes we are just on time. Just like catching the bus.

Most amateur investors focus only on the entry and totally the exit. As the market saying goes “you make and lose money when you exit, not when you enter.”

I recently read a book titled The Art of Execution by Lee Freeman-Schorr, which puts forward a simple and clear framework for best and worst practices for entries and exits. The book analyzes behavior when we are losing money and when we are making money, and creates personality traits for each behavior. Lee identifies the “rabbit” (lets losses run), the “hunter” (adds to losing positions), the “assassin” (cuts losses quickly), the “raider” (takes quick profits), and the “connoisseur” (lets profits run). I have adapted that framework slightly, and prefer to analyze behavior as a function of entries and exits, which opens up a new hidden personality trait, I have called “the collector” (adds to winning positions).

There are multiple combinations for entry and exit. The worst possible combination is a rabbit when we are losing and a raider when we are winning. Failure guaranteed.

Luck versus Skill

In the short term, luck is king. The component of “noise” in the price dominates. The probability of heads in one fair coin toss is 50 percent.

In the long term, skill is king. The component of “noise” evens out and becomes negligible. The probability of having 10 consecutive heads is 0.1 percent.

As a corollary, there is little point in fundamental investing with the expectation of making money in the short term. In the short term, pretty much anything can happen; bad players can win and good players can lose.

Path Dependency

Over the years I have learnt to embrace—rather than resist—the irrationality of the market. Eventually being right can make you feel good, but it is not the objective of the investment game, as we discussed. The only true objective is to make money. Full stop. With that in mind, our analysis and implementation must incorporate nonfundamental considerations such as speculative positioning, which can be a dangerous source of volatility and risk.

First Mover Advantage

I finished cowriting my first book, The Energy World is Flat: Opportunities from the end of Peak Oil in March 2014, when crude oil was comfortable trading above $100/bbl and the belief in the Peak Oil theory was very much accepted.

Our investment thesis, “Flattening of the Energy World,” presented a transformational framework that challenged many of the fundamental beliefs then prevailing in the energy market, that would invariably lead to the collapse of crude oil prices, the natural gas glut, the collapse in LNG prices, the emergence of the “energy broadband” (a global network of land and “floating pipelines” in the form of LNG infrastructure), and the end of crude oil’s monopoly in transportation demand, among other concepts and contrarian conclusions.

The chapter titled “the Btu that broke OPEC’s back” (adaptation of “the straw that broke the camel’s back”) challenged the belief that the “Central Bank of Oil” was in full control. A dynamic that has important similarities with the current belief (in my view misconception) that Central Banks are infallible. More on this later.

The timing was impossible to predict with certainty, but in our view “the collapse of crude oil prices was a matter of when, and not a matter of if.” The unavoidable consequence of severe imbalances. A situation that is repeating itself today in other parts of the economy and global markets.

As a first mover challenging the status quo, our ideas and investment thesis were received with great skepticism, almost like science fiction. Not anymore.

To our credit, the investment thesis of the Flattening of the Energy World has not only been validated, but actually strengthened, with the phenomenal stress tests it has had to endure over the past almost three years. The Flattening of the Energy World is today very much alive and kicking, and has been a useful tool to anticipate and rationale the behavior from OPEC (as per my interview in Real Vision TV published in January 2017). But “that will be another story that will be told another time”, as Michael Ende’s Never-ending Story used to finish each chapter.

The investment theses that I present in this book, “Lehman Squared” and “Gold’s Perfect Storm” reached global distribution with the article published on the front page of the Financial Times on August 8, 2016, but the ideas were first presented on a large public scale in October 2015 during the annual LBMA Gold Conference in Vienna, where I was part of an investor panel moderated by John Authers, the columnist from the Financial Times.

Winning by Not Losing

Capital preservation should be the primary objective of any strategy, and that’s why even the long-only strategies I run tend to have a long-only insurance overlay, whereby I buy protection against lower prices at the expense of paying a premium.

Known Unknowns and Unknown Unknowns

There are many known risks, such as geopolitics, and many unknown risks, such as a global pandemic, that could dramatically change global markets overnight.

Smart Gold long insurance bias (it only buys options, never sells them) is an important risk management tool against any known and unknown unknowns as the worst-case scenario is the loss of initial premium, which is controlled by our risk limits. In the current environment, more than ever, I suggest extreme caution and ensure that, by construction, our portfolio will be able to withstand any shocks, no matter how large or unexpected.

False Diversification

During normal market conditions many asset prices move independently, uncorrelated from each other. During time of stress, however, correlations tend to converge to either +1 or −1.

During the Lehman crisis most asset classes collapsed at the same time, eroding any expected diversification and correlation benefits one might expect, a phenomenon we could describe as false diversification.

Mind the Gap

Another major consideration is liquidity. The accumulation of large overvalued positions should be a major consideration to anyone involved in those markets. The perception of liquidity during normal market conditions could dry up during times of stress. A problem compounded by the increase in volatility and correlation, which would force investors to liquidate greater and greater sizes at a time of thinner and thinner liquidity.