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A beginner's guide to investing in Gold

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From the Archives : Originally published September 14th, 2008
3172 words - Reading time : 7 - 12 minutes
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Category : Gold University





For centuries gold has been coveted for its unique blend of near indestructibility, beauty, rarity and because of its status as a universal currency. Empires and nations have sought to possess gold as a medium of international exchange, as a store of wealth and in order to increase and preserve power. Individuals have used gold as a store of wealth and as insurance against the fluctuations and depreciation of paper money and other macroeconomic and geopolitical risks. Perhaps no other market in the world has the universal appeal of the gold market.


Successful investing is about the diversification and management of risk. In layman's terms this means not having all your eggs in one basket. We know from history that markets can and do crash and if you are not diversified your entire nest egg can be wiped out.  


So a healthy portfolio includes a wide range of assets including a variety of equities with exposures to different market sectors and regions; a variety of different countries’ bonds; a diversified property portfolio; a cash component and a 5-15% allocation to gold-related investments and gold bullion. The key is to determine what amount of each asset class to have. In a globalised and increasingly integrated global economy, a portfolio should be compiled based upon current global macroeconomic fundamentals.


 


Some exposure to gold should be included in all diversified portfolios. A good rule of thumb would be a minimum allocation of around 10% to gold and related gold-investments.


One’s motivation for buying gold is fundamental to deciding in which form you should buy it. Are you a speculator, investor or saver? Do you wish to take a short term speculative position in gold? Are you investing for the short, medium or long term? Or are you diversifying, saving or using gold as a form of financial insurance?


Investing in physical gold


Physical gold should form a part of every properly diversified portfolio. It is a universal finite currency, held by every central bank of note in the world . In the same way that the family home should not be regarded as an investment, gold is not an investment per se, rather a form of ‘saving for a rainy day’ or of financial insurance. It is to be taken possession of or stored with a secure third party and should not be traded. One does not trade an insurance policy and thus as a form of financial insurance, physical gold should not be traded.


Gold bullion is the ultimate safe haven asset and a great way, if not the best way, of ensuring wealth preservation and for passing wealth from one generation to the next. Once the solid base or core holding of gold bullion is achieved in a portfolio then other investments in gold such as mining stocks and mutual funds and other more speculative gold investments can be considered.


Modern bullion coins and bars


Modern bullion coins allow investors to own investment grade gold (between 0.90 and 0.9999 fineness) legal tender coins at a small premium to the spot price of gold as quoted on the markets. The value of bullion coins and bars is solely determined by the price of gold and thus follows the bullion price. Larger bars are not generally taken delivery of due to the cost of insured delivery and the security implications of having very large amounts of bullion outside the chain of integrity (say in a private residence). A London Good Delivery Bar of 400 troy ounces costs some $240,000 and is prohibitive in terms of cost and thus big bars are normally the preserve of large companies, institutions and central banks.


Gold, silver, and platinum are all available in the form of bullion coins, minted in the US, in Canada, South Africa, Austria, Australia, China and other countries. Most bullion coins are minted in 1/10oz, 1/4oz, 1/2oz & 1oz form (and some can be bought in 2oz, 10oz & 1 kilo). However, one ounce gold bullion coins such as Krugerrands are by far the most popular for both small investors and high net worth individuals who like the divisibility afforded by them.


Buying investment grade gold bullion for investment is stamp duty free and now tax free (VAT exempt) in the UK and EU due to the EU Gold Directive of 2000.


Semi-Numismatic and Numismatic Gold Coins


Numismatic or older and rare coins are bought not solely for their precious metal content but also for their rarity and their historical, aesthetic appeal. They are leveraged to the gold price which means that the price of these coins will generally surpass and increase faster than the gold price in a bull market (due to their historical and aesthetic value and to their rarity) and will decrease by more when gold is in a bear market.


Many investors opt for high-quality pre-1933 gold coins graded MS-65 or better by either the Professional Coin Grading Service or the Numismatic Guaranty Corporation. They are bought by both collectors and investors and most investors opt to take possession of these older coins unless they have invested in significant quantities.


Insured delivery of bullion and numismatics is usually some 1%-2% of the total value.  Insured storage of bullion and numismatic coins in an allocated account will cost some 1.5% per annum. Some investors store gold in safety deposit boxes of conservative secure banks or in specialist depositories or storage facilities. Investors should choose their storage provider carefully, making sure of a high credit rating and high net worth. This leads some to prefer an offshore bank or specialist depository.


Gold Certificates


The Perth Mint Certificate Programme is the only government backed precious metal certificate programme in the world. It allows investors to own bullion in unallocated or allocated accounts. The Perth Mint is rated AAA by S&P credit rating agency and is one of the safest and securest ways to own investment grade gold bullion. There are no initial or ongoing shipping, insurance, holding or custodial fees and thus it is one of the most cost effective ways for investors to own bullion. Most investors opt to own their bullion in unallocated accounts as there are no insurance or holding fees on them and there is the flexibility of being able to transfer to an allocated account simply by paying small fabrication fees should the investor deem it necessary. Bullion can be shipped internationally from an allocated account or from an unallocated account once it has been converted to allocated.


Digital Gold Currency or E-Gold


Digital Gold Currency, goldgrammes or e-gold are also increasingly popular. There are no specific financial regulations governing DGC providers, so they operate under self-regulation. DGC providers are not banks and therefore do not need to comply with bank regulations and there are concerns that there are unscrupulous operators operating in this emerging sector.
However, two of the more respected providers who have rightly garnered trust are Goldmoney.com and Bullionvault.com. They offer allocated accounts where gold can be instantly bought or sold just like any foreign currency. Digital gold is primarily used by clients to buy gold for saving or as an investment and/ or as electronic money amongst users. As every bar is audited and accounted for it is considered a safe way to own bullion.


Providers: Gold Money, Bullion Vault


Allocated Accounts


Allocated gold accounts allow an investor to buy gold coins and bars from a bullion brokerage which will transfer or ship the bullion to an individual’s account in a depository or bank. Allocated accounts involve ownership of specific gold and the owner has title to the individual coins or bars. Due diligence should be done on allocated gold account providers and the history, security, credit rating and net worth of the provider is of vital importance.


Providers: Major Bullion Banks and Specialist Depositories


Gold Bullion in SIPPs


UK citizens can as of April 2006 invest in gold bullion through their Self-Invested Personal Pensions (Sipps). US citizens could already do so in their Individual Retirement Accounts (IRA’s). Sipps are new types of personal pension scheme that hold investments until you retire and start to draw a pension income. They are designed for people who want to manage their own fund by investing in asset classes of their choice. Investments made in gold bullion are topped up in the form of tax relief, meaning individuals can claim up to 40% back depending on the income tax band they fall in to.


Gold bullion is allowed in a Sipp providing it is investment grade gold which is gold of a purity not less than 995 thousandths or 99.5% pure and which is in the form of a bar, or of a wafer, of a weight accepted by the bullion markets. The bullion must be immoveable and stored with a secure third party. It cannot be taken possession of and used as a “pride in possession” article. Thus ETFs, some digital gold providers, allocated gold accounts and gold certificates are all allowed in the new SIPP.




Investing in Paper Gold


Mineral exploration, mining and the processes used to mine and produce metals are highly technical. Therefore investors in gold production and exploration company stocks should equip themselves with a basic understanding of the industry, in order to identify possible pitfalls and the risk-reward relationships of entering this investment sector. Investors should generally not buy just one or two stocks, but rather a basket of unhedged stocks or a mutual fund.


Derivatives, such as ETFs, gold forwards, futures, options and spread betting are normally short term speculations on the future price of gold and other markets such as commodities, shares or bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) or an index of weather conditions). They are financial instruments which derive their value from or whose price is dependent on the underlying equity, indices, commodity or currency. One does not directly own the underlying asset and one does not have a right to take possession of the underlying tangible asset. Leverage or borrowing substantially may increase investment gains but also increases risk as if the price goes against the purchaser they may be subject to a margin call. There is significant leverage involved with derivatives and they are thus considered risky for non professionals as the potential positive or negative outcome is greatly magnified.


Gold Exchange Traded Funds (ETFs)


The recently launched ETFs are derivatives that track the price of gold and silver. Two of the more popular are the Streettracks Gold Shares (NYSE:GLD) and in London the Lyxor Gold Bullion Securities (LSE:GBS). They can be bought through stockbrokers.


Stamp duty is applicable and there is an annual administration fee of between 0.4% and 0.5% per annum. Thus every year the amount of gold or silver backing an ETF share shrinks by that amount. This makes them unattractive as a medium or long term way to invest in gold. They are derivative contracts and one does not own or have title to the underlying asset. Thus they are primarily used by day traders, hedge funds and institutional players going long and short and speculating on short term movements in the gold price.


Providers: Stock Brokers, Online Brokers


Gold Stocks


Gold stocks are not gold - rather they are shares in gold mining companies. If the gold price rises, profits of a gold mining company should rise and as a result the share price should rise. There are many factors to take into account and it is not always the case that a share price will rise when the gold price increases. It is important to consider the performance and abilities of the management, auditors and geologists; the conduct of trade unions; a company’s gold hedging position; whether it is producing or exploring; its cost basis; how much reserves it has in the ground and whether it is subject to political, economic, nationalisation or environmental risk.


Individual gold shares would be regarded as more volatile and risky. There is a higher risk-reward scenario and thus gold shares are regarded as more speculative. However, the added risk can be compensated for by the leverage which can result in higher returns. Such higher returns would be expected from mid and large-capitalisation un-hedged senior gold mining companies with proven reserves and strong earnings which have strong balance sheets and growth in resources and production and effective company management.


Providers: Stock Brokers, Online Brokers


Gold Stock Options


Stock options are a contract between two parties that expires at an agreed-upon time in the future. The contract purchaser is buying the right, but not the obligation, to buy a gold mining stock (a 'call' option) or sell (a 'put' option) a gold mining stock (the 'underlying') at a specific price, on or before the agreed-upon date, the date of expiration.


Stock options allow for a lot of leverage as a trader can control a large stock position with only a small outlay. However due to the very short term of the option contracts, they can expire worthless with the entire outlay being lost. Stock options allow speculators to make bets on market movement without having to pick an up or down direction. Because of this, stock options traders are often said to be trading volatility rather than price.


Providers: Online option brokers such as Options Express and E-Trade and certain stockbrokers


Precious Metal Unit Trusts or Mutual Funds


Instead of personally selecting individual shares, some investors spread their risk by investing in collective investment vehicles specialising in investing in the shares of gold mining companies. These include mutual funds, open-ended investment companies (OEICs), closed-end funds, unit trusts. Two of these funds are the UK-based Gold & General Fund by Merrill Lynch or the Canadian Sprott Gold & Precious Minerals Fund by Sprott Asset Management. There are many precious metal funds in the US but investors assume US dollar currency risk when buying them.


Collective investment vehicles are a good way to invest in the precious metal mining sector as an investor’s risk is greatly reduced; mutual funds are not dependent on the performance and profits of one individual gold mining company and specialists in the field choose a diversified portfolio of gold mining companies.


Providers: Merrill Lynch, Sprott Asset Management, US Global Investors, Tocqueville Fund


Gold Futures


Gold futures are traded on exchanges in London, Tokyo, Sydney, Singapore, at the New York Mercantile Comex Exchange (COMEX), the New York Mercantile Exchange (NYMEX) and at the precious metals department of the Chicago Board of Trade (CBOT).


Gold futures contracts are firm commitments to make or take delivery of a specified quantity and quality of gold on a prescribed date at an agreed price. Investors may take or make delivery of the gold underlying the contract on its maturity although, in practice, that is unusual. The major benefit is that such contracts are traded on margin, so that only a fraction of the value of the contract has to be paid up front. As a result an investment in a futures contract, whether from the long or the short side, tends to be highly geared to the price of bullion and consequently more volatile.


They are normally the preserve of institutions and hedge funds. The leverage makes them a high risk/high reward investment. Participants are attempting to predict whether the value of gold will rise or fall in the short term. Gold futures contracts are also valuable trading tools for commercial producers and users of the metal to hedge their price risk.


Doing well with them depends on what happens to the value of gold during the contract term. Traders in these markets without protective stop-losses can quickly find themselves on the wrong side of a fast moving trade, losing large sums of money. Part of the risk is due to the leverage involved which can result in a speculator losing more than their initial capital outlay. Therefore, futures markets are not for amateurs or novice investors.


Providers: Commodity Brokerages, Online Brokerages such as Internaxx


Gold Futures Options


All the bullion banks trade in gold options and a list of bullion banks is available from the London Bullion Market Association (LBMA). Another way of trading options is through the COMEX Division of the New York Mercantile Exchange. The third route would be to contact a futures broker. They are often used to contain risk in the trading of futures.


Providers: Commodity Brokerages, Online Brokerages


Spread-Betting


An alternative is to use spread betting to gain leveraged exposure to precious metals. Firms such as Cantor Index, IG Index and Delta Index, in the UK and Ireland, offer the ability to take a bet on the price of gold through what is known as a spread bet. Say the price of January gold was quoted at $675.10 to $676.10 per troy ounce. An investor who thought the price would go down would 'sell' at $675.10. The minimum bet is $2 per point, (i.e. equivalent to 200 ounces). If the price of gold finished at $680.10 when the seller closed their bet, the loss would be 500 points multiplied by the bet of $2 making a loss of $1000 in total.


No commissions or taxes are levied in the UK and Ireland on spread betting. The advantages are that any gains are CGT free and one can also take a view on movements in either direction. The downside is that in a spread bet the spread can be high, your exposure is geared up and short term bets are risky as it is difficult to forecast any markets short term movement. One can lose more than the initial capital thus they are for speculators with very short term horizons rather than investors.


Providers: Cantor Index, IG Index, Delta Index, City Index


The World Gold Council is an excellent resource for investors wishing to further assess and study the various ways to buy gold.


Investing in gold: conclusion


As we have seen, there are major differences in the various motivations for buying gold and ways to buy gold – from trading and speculating to investing and saving.


Holding precious metals in a portfolio can provide distinct benefits in the form of speculative gains, investment gains, hedging against macroeconomic and geopolitical risk and / or wealth preservation. Traditional asset allocation theory, as represented by the investment pyramid, advocates higher risk speculations at the top, with lower risk assets at the bottom. Commodity futures contracts, options and exploration junior mining companies should be placed at the top of the pyramid, while cash equivalents and fully allocated or taken delivery of physical bullion should form the foundation or base.


Experienced and knowledgeable investors have long known that gold and gold related investments can be solid investment choices. Gold is stable in times of global geopolitical instability and when there is economic uncertainty, recessions and depressions. It is important that investors look at their portfolios holistically. Used correctly, gold and gold related investments can be highly effective components of a properly diversified investment portfolio.



Mark O’Byrne



 


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Mark O'Byrne is executive and research director of www.GoldCore.com which he founded in 2003. GoldCore have become one of the leading gold brokers in the world and have over 4,000 clients in over 40 countries and with over $200 million in assets under management and storage.We offer mass affluent, HNW, UHNW and institutional investors including family offices, gold, silver, platinum and palladium bullion in London, Zurich, Singapore, Hong Kong, Dubai and Perth.
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