When I last wrote about gold one year ago, I said that gold was sufficiently risky that an investor’s best strategy would be to purchase at-the-money call options on GLD (the gold ETF) rather than to buy GLD directly. 

At-the-money GLD options have appreciated by 69% since.

I did not go as far as to advocate a pure-option strategy – that would have been a massive, bullish bet on gold; instead, my recommendation for exposure to gold was a combination of a bond ETF and GLD call options.

As I will discuss, that strategy has performed well on an absolute and risk-adjusted basis.

Underlying gold prices have risen 24% since my previous article was written, leading to several important questions — including whether my advice of a year ago still holds today.  I will look closely at how a direct investment in GLD performed as compared to the bond-plus-call-option strategy, and which conditions favor each strategy.  Going forward, I will demonstrate that the gold-call-plus-bond strategy looks even more attractive today versus a direct investment in GLD.

The Case for Gold

A year ago, gold had already enjoyed a huge run-up in price, and it has appreciated even further since.  In my previous article, I examined the strategic case for gold in a long-term asset allocation, and I concluded that some allocation to gold makes sense in a diversified portfolio.  From a tactical perspective, though, gold already looked high-priced then, and today it appears even more so. 

Gold is, of course, a favorite ‘fear’ asset class, and the deep and abiding uncertainty since the onset of the financial crisis in almost every risk asset class has fueled gold’s run-up.  Performance chasing has also played a role; investors are flocking to gold because it has delivered high returns in recent years.  The three-year trailing average annual return for GLD was more than 22% per year. 

Even last year, making the argument for gold as an inflation hedge was difficult – the huge gains in gold were far larger than gains in other assets that tend to rise with inflation (such as commodities).  Today, this argument for gold as a tactical inflation hedge remains problematic for the same reason. 

My thinking on gold is also shaped by the argument, made by both Warren Buffett and Jeremy Grantham, that gold is inherently difficult to value.  The price of gold is far more behaviorally driven than are prices of other asset classes. 

Jeff Gundlach recently suggested that here is potential for additional upside in gold to the extent that investors become convinced that gold is an asset class that every portfolio should have at least some allocation to, although he is also concerned that gold has become too ‘faddish.’

In my previous article, I said that the risk level associated with GLD was sufficiently high that the best strategy would be to purchase at-the-money call options on GLD rather than to buy GLD directly.  By combining call options with bonds, it was possible to have exposure to the upside from a possible continued rally in gold while creating an absolute floor on loss in the event that gold declined.