If you look at most investors' portfolios, you'll typically see the bulk of their assets in stocks and stock-related mutual funds and ETFs. That makes sense, given how easy it is to invest in stocks and how important they are in producing growth for your portfolio. Although bonds and cash play vital roles in having a balanced portfolio, the current low-rate environment has pushed many investors to increase the amount of stocks they own.

Yet with unprecedented stock market volatility recently, many investors are looking for ways to protect themselves from a possible repeat performance of the coronavirus bear market in February and early March. Historically, gold has often acted as a safe haven investment during times of trouble. That has plenty of people asking whether they should invest in a gold ETF to try to help protect their stock portfolios from the full brunt of future losses. Below, we'll look at various types of gold ETFs and whether it makes sense to invest in them as a possible hedge.

Three rows of shiny pure gold bars

Image source: Getty Images.

The 2 kinds of gold ETFs

Not all gold ETFs are the same. They generally fall into two categories:

  • One set of gold ETFs focuses on investing in physical gold bullion. SPDR Gold Trust (NYSEMKT:GLD) is the largest of these ETFs, with each share representing roughly a tenth of an ounce of gold.
  • Another group of gold ETFs owns shares of stock in gold mining companies and other related businesses. For instance, gold mining ETF VanEck Vectors Gold Miners (NYSEMKT:GDX) concentrates on the largest miners in the world. Other ETFs include exposure to smaller companies that are earlier in their respective development phases.

It might seem counterproductive to use a gold mining ETF to hedge against stock market exposure, given that gold stock ETFs own stocks. However, the argument in favor of gold mining ETFs is that the fundamental financial performance of miners relies more on the price of gold than on the conditions that govern most other stocks. Therefore, the returns of gold stocks and other stocks aren't always highly correlated -- and in some cases, gold stocks go up when the rest of the market is falling.

The argument for gold as a hedge

There's a debate about whether gold makes for a good hedge against stock market declines. In the past, gold has performed well during times of inflationary pressure, rising in line with soaring prices. Some market forecasters see a danger of inflation from all the money the federal government is spending on stimulus measures in an attempt to bolster the economy, and that sort of uncertainty in monetary policy management makes hard assets such as gold look more attractive.

Moreover, other potential hedges against stocks have largely run their course in terms of effectiveness. Bond yields have dropped to historically low levels, and that's reduced the effectiveness of bonds to respond positively to further economic pressure. Low interest rates tend to support gold prices by making it less expensive to get financing to speculate in hard assets, and the current low-rate environment seems likely to persist for a long time to come.

Why gold might not be the right answer right now

That said, gold's track record isn't perfect, and there are situations where it hasn't done much to protect stock market investors. One reason the government has had to be so free with fiscal and monetary policy is that economic activity levels are in free-fall. That's making deflation a real threat, even with efforts from policymakers to avoid it, and deflation can hurt gold's value.

More broadly, gold ETFs of both types face risks. Gold bullion doesn't produce any income, and that leaves bullion-owning gold ETFs with deteriorating asset bases because they have to pay for fund expenses from their core gold holdings. Meanwhile, gold mining ETFs can benefit from the income that gold miners produce, but those mining operations are also vulnerable to financial and company-specific risks that are independent of the price of gold. For instance, if a gold miner has large amounts of debt that it can't refinance, it might have to declare bankruptcy and leave shareholders with nothing -- even if gold prices are faring well.

The better hedge

Gold looks like an attractive alternative to stocks when the stock market is under pressure, but it often fails to deliver strong returns when times are good. Over the long run, the better course is to use asset allocation techniques to tailor the size of your stock portfolio to your overall risk tolerance.

Embracing the possibility of stock market downturns is important in order to leave yourself best-positioned to benefit from bull markets. Although some see gold as an insurance policy against a cataclysmic market meltdown, relying on gold to protect you from a future bear market carries too great a risk of failure.