Gold is basically an indestructible material. It is one of the 92 naturally occurring elements found on earth and there is no natural substance that can destroy it.
It can be dissolved by chemical means, but even then it remains as gold, but just in a more widely dispersed state. It also has a high value-to-weight ratio and has various industrial uses due to the fact it does not corrode and is a very efficient conductor of electricity.
Many believe that the economist John Maynard Keynes called gold a “barbarous relic”, but that is not strictly correct. Keynes was discussing the flawed gold exchange standard used between 1922 and 1939, rather than gold itself. He was actually an advocate of gold for much of his career.
For retail investors, gold can be used for both tactical and strategic investment reasons. The tactical case is driven by a positive price outlook associated with strong demand and tight supply of the material.
As it is virtually indestructible, practically all of the gold that has ever been mined still exists, much of it in near-market form.
This attribute means the supply curve works in a different way to other assets. Supply can, at least theoretically, be readily mobilised from central bank reserves or by recycling gold from the jewellery sector or, to a much lesser extent, the industrial sector.
The ability to mobilise scrap fairly quickly and easily is a reason why the gold price tends to be less volatile than other commodities, such as oil or platinum, which can be far more vulnerable to supply shocks. Coupled with supply is liquidity.
When there is a discussion of the portfolio diversification benefits of “alternative” investments such as gold, it should be remembered that buying them is one thing; selling them when one needs the cash can be quite another.
Gold can be traded around the clock in large amounts, at narrower spreads, and more rapidly than many competing alternative investments.
The strategic case for investing in gold is driven by the investment diversification benefits of holding gold within a portfolio. Gold’s historic correlation to traditional asset classes, such as equities and bonds, is low. It is also far less tied to the movements of the broader commodity indices than is often expected.
Gold is, in addition, distinguishable from many other financial assets through its absence of counterparty risk as, like all physical commodities, it bears no default risk and has no liability. Fiat money systems invariably end or mutate, while gold remains gold.
It has retained its value while various civilisations going back to Rome and before have come and gone. It also provides a valuable means of hedging against the vagaries of inflation, a function it has successfully performed for centuries.
There are distinct fears that the only way various countries can currently repair their balance sheets and reduce the debt burden will be to devalue their currencies. When there is that possibility, some investors turn to gold.
Finally, gold itself does not provide an income, but an income may be obtained by investing in gold mining stocks, but that involves added volatility/risk.
How to invest in gold?
There are several ways to invest in gold, each with its own level of potential volatility/risk. The main ones are:
1. Physical gold
The advantage of physical gold over some alternatives is there is no guarantee the value of gold securities and equities will survive a major financial meltdown as everyone rushes for the door.
Various countries, particularly India and China, have a deep cultural affinity for gold, and this is why their citizens are the biggest buyers of physical gold, either as jewellery and/or gold coins/bars.
Unlike other ‘alternative’ assets, such as art or wine, gold is relatively easy to store and will not degrade, while having an enduring and liquid market.
Physical gold can be purchased from various sources, and recently the Royal Mint introduced a new trading platform allowing self-invested personal pension investors to purchase physical gold. This move followed a decision by the Financial Conduct Authority in 2014 to add physical gold bullion with a minimum 99.5 per cent purity to its list of standard assets.
Standard assets are defined as being “capable of being accurately and fairly valued on an ongoing basis, readily realised whenever required up to a maximum of 30 days, and for an amount that can be reconciled with the previous valuation”. Non-standard investments include all other assets, according to the regulator.
The main considerations when it comes to physical gold will be storage and insurance costs, and you should also consider ease of access and the reputation of the vault operator or custodian if purchasing physical gold and using a storage facility rather than simply cost.
2. Paper gold
When considering Exchange traded products, there are two basic choices, physically backed or synthetics. Synthetics use gold futures contracts that track the future price of gold. Using synthetics should mean lower costs, but there are then counterparty and other market risks to consider.
3. Gold equities
For some, the volatility of the gold price on its own is the limit of the risk they wish to take, but for added risk/return there are gold mining stocks/equities to consider. Gold miners are, in essence, a leveraged bet on the gold price, and in addition can potentially pay a dividend, subject of course to profitability.
This is why many gold mining stocks have outperformed the increase in the physical gold price this year. There is also, for UK-based investors, the benefits of a weaker pound on the exchange of overseas earnings into sterling.
When choosing to invest in gold mining stocks you can choose to invest using a collective such as, for example, Blackrock Gold & General or you can, if you wish, select individual gold mining stocks such as, perhaps, Randgold Resources or Pan African Resources. For the very speculative there are, in addition, gold exploration and mining/development companies such as Hummingbird Resources and Shanta Gold.
Performance
At the height of its popularity, in the midst of the global recession in September 2011, gold peaked at more than $1,800 an ounce. Its value almost halved in the subsequent years, but it has seen a significant recovery since the beginning of this year.
Gold has been one of the best-performing asset classes this year due to an increase in demand driven by a number of concerns and events.
Brexit has seen an increase in the demand for, and hence the price of, gold, while potential non-Brexit shocks include negative economic signals from China or the US, on-going concerns regarding Greece, the levels of debt in southern European countries generally coupled with the strength of their banking systems, and the US presidential election at the end of the year.
Gold has also benefited from the fact that some hold the view that Brexit itself is less important than the possibility, heightened by Brexit, that the euro cannot survive.
Another demand driver for gold has been the now widespread introduction of unconventional monetary policy by central banks around the world. Various central banks now have a negative interest rate policy (NIRP) either to prevent steep currency rises or to encourage lending and inflation. Even the US Federal Reserve could be argued to have a NIRP, as it is allowing inflation to rise faster than headline interest rates.
With more than $10trn (£7.7trn) worth of various government debt around the world now providing negative yields to redemption, various investors are looking for ways to avoid this new ‘cost’.
Physical gold does not provide a yield, but at least the costs of keeping it in storage are relatively low, and in a negative interest rate environment, investors are looking at gold as a near-zero coupon bond with no counterparty risk.
Arguments against gold
The most often made argument against gold is that it has no ‘intrinsic value. The argument is that the price of gold is not determined by inputs or factors of production. A small amount of gold is used in almost every sophisticated electronic device. So why does gold have any value? For me, the short and simple answer is that gold has a value because ultimately it is the purest form of money.
Conclusion
Today’s cocktail of geopolitical and economic tensions can only be supportive of gold prices. When unexpected things happen, and in particular when governments and political alliances rise and fall along with their currencies, gold is a means of payment and store of wealth that everyone has always been prepared to accept. Unlike cash, equities or bonds, gold is not dependant on the goodwill of other countries.
Basic investment theory dictates that one should create an appropriately diversified portfolio and hold on to it through periods of even extreme uncertainty, rather than try to ‘time’ the markets – time in the market rather than market timing, as the adage goes.
In addition, as certain fund managers rightly point out, the best way to make money is not to lose it in the first place, and as an uncorrelated asset class, gold does, in my opinion, potentially have a place in a diversified portfolio. - ftadviser
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