Feature Stories | Sep 27 2006
By Greg Peel
Why buy gold?
It doesn’t provide an income stream. You can’t eat it. Three quarters of the gold mined in the world is turned into jewellery, so really its value lies only in its intangible quality of beauty. No different to a piece of art really. Art may prove to be a good investment, but art enjoys only a peripheral place in the world of financial markets. Gold, on the other hand, is very central to financial markets. Why so?
Gold is the most malleable of metals, yet it is extremely dense. Hence it can be easily fashioned into jewellery which is impressively heavy, providing some indefinable pretence of quality. It has a colour and lustre like no other metal, and it is not abundant. Ancient civilisations first mined gold thousands of years ago.
When civilisation began to trade, money was soon invented. Gold (and its cousin silver) were obvious candidates for the purpose of defining the value of money. The first gold coins were literally “worth their weight in gold”. The rarity of the metal ensured gold could not be devalued by inflation. Its purity meant it could not be counterfeited.
As trade and population increased, paper money was introduced for convenience. It represented an amount of existing gold – a “gold-backed” currency. Yet still this posed problems in a world where booming trade provided wealth that was not easy to cover with an amount of gold. Hence the “fiat” currency became popular – money backed by a government promise of its value.
After the Great Depression the leaders of the world’s largest economies (of which America’s had become by far the largest) realised a return to a currency system backed by gold would remove catastrophic volatility from the global system. This came about after World War II in the form of the Bretton Woods agreement.
Bretton Woods was abandoned after the Vietnam War after it became apparent the US had actually printed more money than existed as gold in the government vaults. As the benchmark currency, the US dollar had enjoyed inequitable value above that of the rising economies of Japan and Germany. Currencies were thereafter officially measured against the US dollar and allowed to “float”. A purely fiat system had returned.
When gold reached its peak value of US$850/oz in 1980, it was due to oil price shocks impacting on the value of the US dollar. Only a decade earlier, gold was worth US$35/oz. The oil shocks showed that the mighty US economy was indeed vulnerable, and that at the end of the day a paper promise is a paper promise.
Gold, on the other hand, is gold. It is not consumed. The late seventies saw the return of gold as the so-called “safe haven”. While gold provided no income, its value could not be destroyed.
When the oil shocks ended and the US economy proceeded to boom once more, gold’s appeal withered. The US dollar became a safe haven of choice, given that investment in US Treasury securities provided an income stream and a sufficiently robust level of security. The value of such securities could be undermined by inflation, but global inflation began a long slow return to comfortably low levels over the next twenty years. As a safe haven, gold became less appealing.
Gold remains extremely rare. The entire global stock of mined gold is only 155,000 tonnes – enough to fill just over three Olympic swimming pools. The rate of new gold production barely grows each year. After World War II, the world’s central banks held 68% of the world’s gold in their vaults. Today that figure is only 10%. (www.goldprice.org/james-turk)
The reason central banks have sold gold is to maintain the value of their currencies, or more specifically the US dollar, against which everything else is measured. By selling gold governments can then print money, without causing inflation shocks, and thus finance consumption, and an affluent “western” lifestyle. What this has meant, however, is that the “real” value of the US dollar has fallen – that which is measured as purchasing power.
By comparing the cost of the most significant commodity in the world – oil – this fall in value is apparent.
It is thus no surprise that it is only recently that the price of gold has attempted to test previous highs once more based on the significant rise in the oil price. In the last decade central banks have been forced to sell gold to maintain the value of the US dollar. It is speculated that the fall in the price of gold from its highs in 2006 was due to such activity, which can be conducted without official account by the International Monetary Fund. (See “The How And Why Of Gold Price Manipulation”, 30/08/06)
There are further means for central banks to indirectly “sell” gold, through leasing arrangements and derivative instruments. Such transactions are again difficult to account for, rendering IMF conclusions as to the amount of gold currently held as potentially inaccurate.
Gold is thus a valuable part of any investment portfolio. It is the asset which acts as insurance against what is otherwise a paper-based financial system. In a less stable world, gold is immutable.
How then does an Australian invest in gold?
Physical Gold
The most straightforward way to buy gold is to buy gold. Gold bars are available from sources such as the Royal Australian Mint, the Perth Mint and other official dealers in any capital city.
Gold can also be purchased from the same sources in the form of gold coins. Coins offer an intrinsic value – their weight in gold – as well as an extrinsic value – their value as a collectable, related to their rarity in terms of the number of coins issued.
And obviously any form of gold jewellery is an investment in gold, with a less tangible concept of extrinsic value that is “in the eye of the beholder”.
If an investor is interested in purchasing physical gold for fundamentally intrinsic reasons, the problem arises that such a valuable asset needs to be stored and secured. If it’s gone, it’s gone. There are two ways to overcome this problem.
Firstly, institutions such as the Perth Mint will store your gold for you. However, more conveniently, the Perth Mint offers depository certificates which allow you to buy physical gold without ever having to deal with it. The certificates are guaranteed by Gold Corporation, fully owned by the Western Australian government, and your gold never leaves the vault.
Gold Stocks
Possibly the simplest and most popular way to invest in gold is via the stock market. This has been, to date, the way your superannuation fund would invest in gold. But an investment in a listed gold mining company does not guarantee a pure investment in gold. Consider the following:
(a) Most gold mining companies also mine something else. For example, Australia’s largest gold miner, Newcrest (NCM), also mines copper. Thus the price of shares in Newcrest will reflect both the price of gold and the price of copper. There are, however, “pure-play” mining stocks such as Lihir Gold (LHG).
(b) Gold mining is a risky business, and different gold mines operate at different levels of cost. While the gold that comes out will ultimately be the same as any other gold, the gold miner’s profit can vary. Furthermore, gold mines are often subject to shut-down for various reasons. A landslide closed Lihir’s operations for some time last year.
(c) The amount of gold reserves attributed to a mining company is only an estimate. Hence the value of a mining stock will fall, even as the price of gold rises, if production falls short of expectations.
(d) Gold stock prices are far more volatile than the price of gold. As is the case with any equity instrument, prices are driven by market perceptions of value, rather than by known value. When the gold price rallied hard in early 2006, the value of the ASX gold index rallied harder. This was a bubble at work. It is thus no surprise that the index also fell harder in the correction.
(e) Gold miners often hedge their production. They do so by selling gold forward and delivering mined gold at a prescribed later date. This protects mining companies against a fall in the price of gold, but it also means prices can be locked in at levels significantly lower than the spot price if gold is rallying. This was the case with Newcrest this year, as investors charged into the stock without appreciating the amount of pre-sold gold on the company’s books.
(f) Gold miners can go broke. This usually is the case when the price of gold falls short of the cost of recovery, but can also occur if miners over-speculate. While gold hedging can stifle the profits achieved from mining, it can also enhance the profit achieved by careful use of forward sales and derivative instruments. Rampant speculation brought down Sons of Gwalia (SGW) – once the world’s third largest gold company. Overhedging (where gold recovered is less than is obliged to be delivered) brought Croesus Mining (CRS) to its knees.
The end result is that investment in a listed gold miner is in no way a pure replication of an investment in gold. It is important to note, however, that some gold stocks offer dividends, providing an income stream from a commodity which otherwise does not provide an income stream.
Futures Contracts
The most popular form of global gold speculation is via futures contracts, of which the New York Commodities Exchange (Comex) contract is the most heavily traded. So heavily, in fact, that annual turnover far exceeds 155,000 tonnes.
Futures contracts offer a form of leverage trading, as only a deposit need be placed in order to participate. However, the investor is constantly subject to margin calls (account top-ups) if positions are moving towards the red, and contracts expire within short time frames. Futures trading is a highly risky business, suited to experienced speculators and not to John Citizen. A futures contract is effectively a cash IOU, and exchanges have been known to step in (as occurred this year) to control prices if major defaults look possible. This could prove adverse to long position holders.
For Australians the situation is made more difficult in that there is no local contract (there has been, on and off, over the years, but not presently) and as such investors would need to trade offshore and thus become exposed to adverse currency fluctuations.
Gold Warrants
A warrant is a form of call option. There are a multitude of warrants listed on the ASX, the vast majority of which are individual stock warrants. A warrant holder has the right, but not the obligation, to purchase the underlying instrument at a time in the future. The warrant would be “exercised” if the underlying price exceeds the exercise price.
Warrants attract only the payment of a premium, rather than face value. Thus they can be used as a cheaper alternative investment, or can be leveraged. At exercise an investor can choose to sell the warrant rather than pay out the contract, while still making an equivalent profit. Only the initial premium can be lost (unlike futures contracts which have essentially unlimited downside).
There is one gold warrant listed on the ASX, again by the Perth Mint (via Gold Corporation). ASX code: ZAUWBA, The contract can be settled in gold or cash. 100 warrants is the minimum parcel size, representing one ounce of gold.
The gold warrant is not particularly liquid, however under ASX rules warrant sponsors are obliged to “make a market” over a minimum bid-offer spread for a minimum number of contracts. In other words, you can’t be caught without a buyer.
Contracts for Difference (CFDs)
One of the fastest growing financial products, in Australia in particular, are so-called Contracts for Difference, commonly known as CFDs. They allow investors to do exactly as the name suggests: enter a contract with a financial entity to exchange the difference between the opening value and the closing value of a financial asset (in other words: you are trading the difference between the two).
Some of the specialised financial service providers have significantly expanded the range of assets for which CFDs can apply, including listed stocks, a bond, a future, an option or a currency and even certain indices.
CFDs are in essence a geared risk instrument. Their fast growing popularity is due to the fact that they’re not complicated to understand (unlike their risks) and the fact that they allow retail investors to leverage their positions up to twenty times (meaning they can win twenty times the amount of a profitable trade, minus costs). These are instruments for short term risk traders.
Some CFD providers offer the opportunity to trade the spot gold price via CFDs. FN Arena is currently preparing a feature story about CFDs which will be published in a not too distant future.
Exchange Traded Funds
Exchange traded funds (ETF) are the new buzzword in financial markets. Since the first gold funds appeared on the New York Stock Exchange, their popularity has soared to such an extent that the rally up to US$775/oz was attributed to a great extent to the emergence of such funds.
Nevertheless, the world’s first ever gold ETF was introduced in Australia in 2003. The fund is controlled by Gold Bullion Limited and is described by the ASX as such:
“The development of Gold Bullion Securities (ASX code: GOLD) has been a joint initiative between Gold Bullion Limited and the World Gold Council. A GOLD security consists of a gold bullion share of nominal value and a beneficial interest in approximately 1/10th of one fine troy ounce of gold bullion held on trust for the holder of the security.
“The gold is held in London vaults by a custodian. A trust deed establishes a separate trust for each holder of GOLD so that the holder is absolutely entitled to the gold bullion held in the vaults. Each time a holder transfers GOLD to a new holder, the beneficial interest in the gold bullion automatically transfers to the new holder.
“Investors can buy GOLD securities on ASX or, if they have a minimum of $500,000 to invest, they can apply for new GOLD securities from Gold Bullion Limited. Likewise holders of GOLD securities can sell them on market, or (subject to certain conditions and fees applying) they may redeem them at any time for cash or in exchange for London Good Delivery bars.”
The GOLD contract has enjoyed reasonable liquidity over the latest gold rush. As the fund manager buys and sells gold to offset the purchases and sales of the instrument, it is about as close to buying physical gold as a listed instrument as can be achieved without actually buying physical gold.
Managed Funds
Another way to invest in gold is to get someone else to manage that investment for you. There are a handful of managed gold funds available in Australia. Two prominent examples are the Merrill Lynch International Gold Fund and the Select Asset Management Select Gold Fund.
The MLI Gold Fund “aims to provide investors with strong capital growth over the long-term through an actively managed portfolio of select international gold mining shares. History shows that exposure to gold equities can provide useful diversification as well as the potential for high capital growth.”
The fund is managed by an experienced team out of London, and while it is a return to gold investment via mining stocks the investor needs to be confident in the capacity of Merrill Lynch to enhance value and provide a cash flow stream (which physical gold does not). Minimum investment is $5000.The fund is not solely a gold investment fund, however:
“The Fund primarily invests in gold mining stocks from around the world including North America, South Africa, Australasia, Latin America, Africa, Russia and China. It also may invest in precious metal, base metal and other mining related stocks from any part of the world. Pure exploration companies will usually comprise only a small part of the portfolio.”
By contrast, the Select Gold Fund invests in more than just equities. It is a “long only” precious metal fund managed by London-Sydney based Baker Steel Capital Managers.
“The aim is to provide exposure to an area that adds value and typically does not move in line with mainstream assets”, which the fund does by “investing principally in equities of gold and precious metal companies globally, but with an ability to have up to 50% of net asset value invested in gold and precious metal bullion and futures.”
Although “long only”, the Select fund is more akin to a hedge fund given its potential use of derivative instruments. This is for the more risk-friendly investor, and the minimum investment is $25,000.
Hedge Funds
GoldLink Capital provides two ASX-listed hedge funds that aim to provide an absolute return through trading gold derivative instruments from either long or short positions. This is the speculative end of the market, and is not for the faint-hearted. GoldLink’s products are not as much an investment in gold as an investment in the exploitation of gold market opportunities.
There is a growth fund (ASX code: GLC) and an income fund (ASX code: GLI).
The investment strategy of both funds “comprises long-term investments to capture arbitrage opportunities from yield curves in interest rate and commodity markets.”
Both obtain margin-backed credit facilities from major financial institutions, and use the cash subscribed by investors as collateral to underpin the investment exposures. The investment strategy is designed to perform during rising and falling markets, and is not wholly dependent on market movements to earn income or returns.
“The GrowthPlus Investment Strategy aims to deliver capital growth over the medium to long term. The primary focus of its Investment Strategy will be to seek to grow the value of the Investment Portfolio and, accordingly, the value of the Company over time.
“The GoldLink IncomePlus strategy generates strong cash flows, and pays regular dividends. All dividends have been fully franked to date.”
Despite this being the high-tech end of the investment market, both funds are listed, which means investors can trade the minimum parcel available (equating presently to about a $500 investment).
Of all the investment instruments listed here above, which is the best? That is up to the individual, and FN Arena strongly advises first talking to a broker or investment advisor.