The case for gold

AFR Investor, Sun-Herald/Sunday Age, May 2010

Gold is an asset for troubled times. It’s real, it’s solid, it’s valuable: you know what it looks and feels like. So when all else is chaos – from sub-prime to dodgy Greek finances and even an errant Icelandic volcano – investors tend to flood to the safe haven of gold.

And now, reflecting these uncertain times, gold is within reach of an all time-high. In December it set a new record of US$1225 an ounce. At the time of writing it looks likely it’s going to beat that high – and many analysts think there’s much more to come. Some are even talking of US$2,000 an ounce.

It’s also easier for investors to get exposure to gold than ever before. You can buy the physical stuff, or a certificate that gives you a right to it; you can buy an exchange-traded fund, which behaves like a share but tracks the gold price; you can buy shares in gold miners.

But an investment in gold must be thought through too, because it doesn’t behave like other assets. It has also been less of a good performer in Aussie dollars than US. And buying something at an all-time high isn’t always the smartest thing to do.

What’s been driving the gold price? One reason is that gold is often seen as a hedge against inflation. If the world is in an inflationary environment, owning gold is commonly said to mean that you won’t be left behind. People have been especially nervous about inflation over the last year because of the amount of stimulus that governments from the USA to China – and pretty much everywhere else besides – have pumped into their economies to help them come out of the global financial crisis.

Another reason is that many of the world’s biggest counties are worried about their currencies. The US dollar is weighed down by the country’s deficit and the state of its economy and banking sector; the same is true of the euro, especially since Greece ran into trouble; and you can find similar worries for yen and sterling. It might seem odd viewed from Australia, where the currency has been one of the best performers in the world, but in a lot of places gold is seen as a better bet than holding your own paper money.

This is a particularly big deal if countries’ treasuries decide they don’t want to hold currency. China has over US$2 trillion of foreign exchange reserves, mostly denominated in US dollars. If they were to lose faith in that currency and start putting it into gold instead, the difference in the gold price would be pronounced.

“All the major currencies have got inherent problems,” says Angus Geddes, founder of Fat Prophets, the research and advice group. “Gold is really going to be a recipient of investment flows in the next few years as it gets re-rated as a hard currency.”

This relates to the fact that traditional safe haven assets don’t look as safe as they used to. “The principal tailwind for gold at the moment is the issue of sovereign debt,” says Geddes. “We have a number of countries that have extensive financing issues with their national debt. Greece is the obvious candidate but there’s also Spain, Italy, Portugal and on a larger scale the US and UK. That issue is not going to go away.” So where people once thought of government bonds as bulletproof, they no longer do; gold looks a better alternative, especially when you add the fact that government bonds are still mostly paying very low yields.

There are other long-term reasons too: jewellery consumption in emerging markets (especially India); cost of extraction as miners have to go deeper and into tougher parts of the world; and, most obviously, that gold is finite, just like oil, and the more you pull out of the ground, the less there is to find, by definition. (Unlike oil, though, gold is still around for centuries after you’ve taken it out of the ground and remains in circulation indefinitely.)

That’s the bull case. But there’s another side to it.

One problem with buying gold from an Australian perspective is that gold is valued in US dollars, so if the Aussie dollar rises against the US dollar, it cancels out much of the improvement in the gold price. That said, you can buy a lot more gold with your Aussie dollar now than you used to be able to. Geddes acknowledges the strength of the currency but adds: “Gold in a relative sense is going to do a lot better than the Australian dollar in the next few years.” Funds in Australia vary in their approach to the currency; the Baker Steel Gold fund sold in Australia through Select Asset Management hedges some exposure but not all.

Others think that after the run in the gold price, it’s the wrong time to buy. “Gold is supposed to be a hedge against inflation,” says Tim Farrelly, principal of Farrelly’s, an investment strategy group in Sydney. “Over the last 300 years broadly if CPI has gone up 50-100%, gold has also gone up 50-100%. But in the last 10 years gold in US dollar terms is up 300%, and CPI 22%.” Farrelly’s argument is that if you believe that over the long term gold and inflation track each other, then gold’s due to fall an awful long way to slip back into that pattern. “If you bought it 10 years ago, well done. But I wouldn’t buy it now.”

On the valuation question, some argue that context is important. “While gold has had a great run up over the last decade, it still remains below its inflation-adjusted peak in 1980, when gold was worth US$2306 an ounce in today’s prices,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors. Oliver is positive on gold in the medium term, but thinks it may be better to get exposure in a broader commodities fund for diversification.

Fund managers try to insist on a long-term view. “People often get obsessed with what the gold price has done in the last few months, or 12 months,” says Dominic McCormick of Select Asset Management, which distributes Baker Steel’s gold fund in Australia. “Our view is we have been in a bull market in gold in US dollar terms since 2000, 2001. Every year since then the US dollar gold price has closed higher.” His view is that all the drivers that have sustained this bull run are still here, particularly the monetary and fiscal situation globally. “We are in a low nominal and real interest rate environment, particularly in the key economy of the US. There probably will be a bit of a sell-off when the Fed starts raising short term rates, but we don’t think that necessarily marks the end of the longer term bull market.”

Even so, over the much longer term, McCormick thinks there are dangers. “Our view is that this gold market will probably end up as a bubble, because that’s the nature of gold. That’s how we think the game’s going to end but we’re not seeing evidence of it yet.”

There’s also the behaviour of gold as an asset to consider. While Oliver is still positive on gold, he does point out there are dangers. “Investors should realise that gold is highly speculative,” he says. “It’s not grounded by an income stream like most shares, property, bonds and cash. As such there is no general agreement as to how it should be valued.” All the gold ever produced is still out there, he says, and come back on to the market; all sorts of odd factors can influence price. “This can make for a volatile ride over time and suggests that gold should not be dominant in an investment portfolio.”

Investing in gold miners is a whole separate subject since there are so many other variables involved. “Gold mines by their nature are going to give you indirect exposure to gold,” says McCormick. “The problem is, it’s still in the ground. And often it’s hard to get it out of the ground.” While they are not as pure a play on the gold price as an ETF, they can have merit. “They come with a few other risks like management and geopolitical risk, but we still think they make sense as one way for the more aggressive investor in particular to get exposure.”

Analysts are quite positive. “Gold equities have underperformed the gold price here in Australia and overseas,” says Geddes. “Gold price is near an all time high, but gold shares are well below their all-time highs which were prior to the global financial crisis. I see a lot of catch-up happening.” One thing that will impact gold equities is M&A activity. “The amount of corporate activity in precious metals is likely to increase,” he says. This has been most obvious in a bid by Australia’s biggest gold miner, Newcrest Mining, for the second-biggest, Lihir Gold, but Geddes thinks this trend will filter down to small and mid caps and will drive performance accordingly.

In general, nobody thinks gold should be the be-all and end-all of an Australia’s portfolio, but many feel there is benefit in an allocation to it – perhaps 5% of a portfolio – as a diversifier, a hedge (whether against inflation or another financial crisis) and as a likely medium-term performer. And – as the box alongside explains – there’s never been a greater variety of ways to try it out.

SIDEBAR How to buy

There are several ways to invest in gold.

• Buying physical gold. The Perth Mint allows you to buy bars of bullion (a 50-ounce bar will make you feel like you’re in Goldfinger but will set you back A$62,513.77), gold coin (from one twentieth of an ounce to a kilo), or certificates confirming your ownership of gold stored within the Mint’s vaults. It’s all government guaranteed, just in case sometimes tries to be Goldfinger for real. Bullion and coin clearly gives you a genuine exposure to gold – there’s no risk of holding something synthetic that’s meant to track gold but turns out not too – but comes with storage costs.
• Exchange-traded funds. An ETF is bought and sold like any other share, but represents something else – often a stock market index, for an example. You can buy Australian-listed ETFs that track the gold price. One is ETFS Physical Gold, previously known as Gold Bullion Securities; unlike some gold ETFs around the world, this one is backed by physical allocated metal held by a custodian, HSBC Bank USA. It’s cheap: the management fee is 0.4% per year.
• Gold equities. This involves buying the shares of a gold mining company, such as the two biggest in Australia, Newcrest Mining and Lihir Gold. (The former is in the midst of a takeover bid for the latter.) Miners are exposed to the gold price, but share price movements will depend on plenty of other things – chiefly their ability to find it and mine it efficiently. Some mining stocks will perform better than gold over a period of time, others will do much worse.
• Gold funds. There are managed funds that invest in gold equities (often with exposure to other precious metals too). An example is the Baker Steel Gold Fund, managed by the Anglo-Australian investment group Baker Steel Capital, but offered in Australia through Select Asset Management. This fund invests mainly in small to mid cap equities globally, but can put up to half its money in gold/precious metal ETFs, futures and commodities. It charges 1.89% management fee and a performance fee of 10.25% for outperformance of its benchmark, the FTSE Gold Mines Index.
• Gold futures. These are derivatives which can use leverage to gain exposure to movements in the gold price. Investors need to be sophisticated and experienced before using futures to invest, especially with heavy leverage.