Going for gold has its pitfalls

Published on Saturday 14 November 2009 12:09

GOLD hit a record high last week of more than $1,117 (£694) a troy ounce as investors rushed to hedge against the falling dollar, and central banks in China, Russia and especially India, which had been sellers for years, reversed the trend and started to buy.

Since the early 1970s, gold has no longer formed the formal backbone of the international monetary system. Prior to this, gold was held by central banks to underpin their national currencies. It was also used in trade and as a store of personal wealth, and held by rich collectors. Today its price is no longer fixed and is subject to market forces.

After peaking in the early 1980s, the gold price entered a protracted slump, reaching a floor of $256 per troy ounce in July 1999. Since then there has been a rally and gold has never been so expensive, with the price in September having breached $1,000 per troy ounce. The effect is seen everywhere gold is traded, from savvy investors pouring into the metal in the belief its price has not yet peaked, to British viewers being urged in TV adverts to cash in the contents of their jewellery boxes.

Yet what drives the gold price?

It is important to remember gold is not just a commodity, subject to the usual laws of supply and demand. It is also a financial asset that can attract or deter investors. In this respect gold has some unusual properties. Just as in ancient times, gold today has little or no tangible purpose. The smallest component of annual demand for gold is from industry (12 per cent), generally for use in electronic components and dentistry. However, there is the prospect that industrial demand for gold may increase as a result of it being contained in, for example, catalysts for fuel cells.

The use of gold in jewellery, primarily in Asia and the Middle East, dominates annual demand (69 per cent) while investment, although growing, represents only 19 per cent. Demand also consistently outstrips supply, which peaked nearly a decade ago.

Gold is unusual in that it is virtually impossible to destroy and can usually be recovered. Therefore, the supply of gold scrap has a significant part to play in meeting annual demand in addition to what is mined.

It is worth remembering gold does not, like other assets, provide an annual yield or income. Indeed, an investor with any sizeable amount of gold bullion or coins will need to pay a bank or security firm to keep the stuff under lock and key.

For investors, much of the attraction of gold is as an asset of last resort that, when everything else fails, will still have an underlying value. There is also a widespread belief that gold is good to hold during periods of either inflation or deflation.

The truth is that the gold price can be altered by a wide range of factors; from political uncertainty in the Middle East or soaring investment demand. Demand can also be seasonal as a result of the "wedding season" in India and, in the West, Christmas. Knowing what the dominant factor is in determining its price can at times be difficult.

And yet at times the behaviour of the price of gold is an enigma. The price stood at circa $750 per troy ounce in October last year when the world's financial system was said to be hours away from total meltdown, but it is more than $1,100 today when the financial system is showing signs of recovery.

My belief is that there are two main forces driving the gold price. The first is that the price is rising and investors believe they will make money by having exposure to gold; ie there is "momentum buying".

However, more profoundly, investors are also anticipating a period of uncertainty in foreign exchange markets as often debt-laden central banks try to ensure their economies remain competitive on the world stage by allowing their currency to weaken. Gold is being viewed as a store of value that should retain its purchasing power as a relatively liquid asset. In effect, investors are becoming wary of paper currencies.

Nevertheless, the glitter produced by this metal should not blind us to the fact that the gold market is very small.

Technically, there should be no upper limit to the value of the stock market, but the amount of gold mined is probably no more than 160,000 tonnes, and known reserves are said to be no more than 45,000 tonnes, so there will always be a physical restriction to world stocks.

The most obvious way to buy into the metal is to instruct one of the many companies that offer to buy gold in bars or bullion coins.

Alternatively, investors can purchase an exchange traded commodity fund in which they own exposure to movements in the gold price through a derivative but do not necessarily physically hold the metal. This arrangement can be enhanced by including instructions to buy and/or sell should the price rise or fall to a certain level.

However, there has been speculation that the use of derivatives to replicate a movement in the gold price may fail at times of stress in the financial system. Another option is not to invest in gold per se but in one of the companies which mine it. However, their share price may move independently of the gold price; for instance, due to political instability in the country being mined.

For most investors in, as opposed to collectors of, gold, the most common route is a managed fund and one of the most impressive of these has been BlackRock Gold and General Fund, a unit trust concentrated not just on the metal itself but the entire gold industry.

But before choosing a conduit, investors must ask themselves if the current price of $1,100 per troy ounce is a ceiling or the floor of another, higher storey.

My hunch is that there is some way up for the price yet. But gold's relatively short history as a freely traded commodity/asset is punctuated by bouts of severe slides in value and, therefore, should be viewed as just one part of a diverse portfolio.

Charles Robertson is senior investment manager with Murray Asset Management in Edinburgh