Inflating a golden balloon??

Hi,

A topic LINKS has seen in the press on and off in recent months has been the issue of whether Gold makes a good hedge against inflation. This issue clearly isn't the only one turning the grey matter of investors who have inflation issues.

Where are interest rates going? Can markets absorb the large supply and what will happen to inflation outright? Will governments use inflation to reduce the real impact of the huge wave of public expenditure of the last few months? At this stage it's unclear what will happen and it is this uncertainty that continues to drive markets.

It is unlikely that we will see inflation rear its head for some time while there is spare capacity in the global economy. However, those with a longer -term view or those looking at the tail risk should now be considering suitable hedges.

The obvious hedge for inflation is gold. Or is it? It's a position that has reached almost mythical status but supporting evidence is thin on the ground. In fact, the seminal work by Roy W. Jastram (1977) presented in "The Golden Constant" suggests something very different. He analyses the purchasing power of gold in England and the US from 1560 to 1976. The key conclusions are that:

- Gold is an ineffective hedge against inflation
- Gold appreciates in operational wealth in major deflations
- Gold is an ineffective hedge against yearly commodity price increases
- Gold maintains its purchasing power over long periods of time. This is not because gold eventually moves towards commodity prices but because commodity prices move towards gold.

The use of gold as an inflation hedge seems to have its roots in the collapse of the Bretton Woods agreement in 1971. Since gold was no longer regarded as money it would act like any other commodity. However, during Jastram's period of study gold flips between being "money" and a "commodity" on numerous occasions: it isn't this distinction that drives the relationship. Gold may not be money but it certainly acts like it. Gold is produced for accumulation, whereas all other commodities are produced for consumption.

The other reason for the strength of the hedgers' convictions is simply poor inductive reasoning. Because gold has preserved its value in periods of big upheaval does not mean that it is useful as a strategy against cyclical behaviour. It is a crisis hedge rather than an inflation hedge.

Those wishing to hedge inflation will need to be a little more creative, particularly given uncertainty over what will cause it and the point of its emergence. Something we will return to in a later blog.

Regards,

Dr Mark Tomsett

Rolex quantitative strategies - beware of expensive imitations

Hi,

http://www.battleofthequants.com/agenda.html

I've just returned from the Battle of the Quants having survived a close scrape with a cyborg hedge fund investor sent from the future to melt the markets. Think Gordon Gekko crossed with the Terminator - not a pleasant experience. Now, in all seriousness, some of the claims from the quant strategists to be able to read the future didn't seem much more far fetched than my fictional market cyborg, yet they were adamant at the value they could guarantee to add.

Autoregressive models do have some merit, particularly some of the smarter times series analysis out there, but you're only ever as good as your data, and keeping these models current is tough in chaotic illiquid markets, especially when the markets have just gone through what a chaos mathematician would call a 'phase' change.

Despite this, I don't want to put investors off. If you do your homework and if your quant strategist is willing to pull the curtain back on their methodology, savvy investors will find some good returns in the quant strategy field. However, in this environment you must keep one eye on your exit. When quant strategies get too crowded, exiting with your returns intact can be a precarious business - the Goldman funds debacle of Aug 2007 is well documented and could easily happen again. Furthermore, whenever a strategy meets some degree of success, beware of what the biologists would call 'mimicry'.

For every sound quant strategy out there, you'll also find a manager or two with a poor idea yet the marketing machine to raise capital. This manager effectively gains an advantage by mimicking the successful credible quant players, despite having weak models and a poor idea. With 'black box' strategies still doing the rounds, and with complex lingo coming thick and fast in a world with cash rich investors chasing credible hedge fund managers, dud horses will inevitably be backed.

I can't stress enough for investors to ensure they have some explanation of the strategy employed, in what markets the manager believes it will work (there's no magic bullet for quant strategies, despite what the most bullish of quants may say), and, should returns prove negative, a rapid exit strategy.

You'd never buy a Rolex out of a suitcase on Times Sq, why do the same with your hedge fund investments?

Happy hunting,
Andy