Gold has been considered a source of wealth and value for thousands of years. With continuing concerns over the modern financial system and with gold hitting record highs, much of the public is looking to buy gold as a “safe haven”. There are many ways for individuals to gain exposure to gold, each with its own characteristics.
Coins – To stop the rush to turn bank deposits into currency or gold, President Franklin Roosevelt issued an executive order in 1933 banning the private “hoarding” of gold worth more than $100 and requiring the surrender of gold to Federal Reserve member banks. The order exempted “gold coins having a recognized special value to collectors”, and coins became the preferred vehicle for investing in gold.
There is now readily available information on specific coins and current prices. While coins typically trade at prices very near their gold content, current high demand can create some market abnormalities. Coins with collectible value in addition to their gold value are “graded” as to their physical condition. It is important to find a reputable dealer who does not charge excessive commissions or “mark-ups”, which can significantly eat into any price appreciation. And once coins are bought, they have to be securely stored either directly by the owner (say, in a safe deposit box or home safe) or in a gold storage facility. Stories abound of gold coins being lost, misplaced or overlooked by uninformed family members.
Bullion – In 1971 the United States went off the gold standard and ceased converting its currency to gold on demand. In 1974 private ownership of gold was legalized and in 1977 Congress removed the president’s authority to regulate gold transactions other than during war. As a result, direct ownership of gold has become more popular, despite some lingering fear that the government could again ban private gold ownership.
Taking physical possession of gold bullion, even in small quantities, has the same issues of transaction cost, dealer integrity and storage as coins. For those who fear hyperinflation and are looking to gold as a medium of exchange if the financial system fails, there is an additional challenge of how to conduct small transactions with, say, a one ounce bar of gold.
Some dealers and banks offer gold certificates that are backed by gold held in a secure vault. It is critical that an account of this type be “allocated”, or segregated from the other assets and obligations of the institution, so that it is protected if the institution were to fail.
Exchange-traded Funds (ETF) and Notes (ETN) – These investment vehicles trade like a stock and can offer direct exposure to gold and other precious metals, although this exposure is a step removed from owning coins or bullion. They have the same trading tools as stocks, including standing orders, limit orders and in some cases options. There is a transaction cost to buying and selling these exchange-traded products and an ongoing expense ratio which is similar to the storage and other costs of physical metal. The largest of these is now the sixth largest holder of gold in the world, owning more than even China.
There are tax issues with ETF’s and ETN’s. Any gains from those that directly own gold are taxed at the 28% rate for collectibles, the same as coins or bullion. They may also have gains from trading gold within the fund which creates taxable income for investors even though the income is not distributed. ETF’s that gain exposure to gold through futures and options are often structured as partnerships; investors have a direct claim on the assets of the fund but receive complicated partnership tax reporting. ETN’s, on the other hand, promise the return of a market index but are an obligation of the issuer; investors have no claims on the assets, so there is some risk that the issuer could default. As a result, tax reporting is more straightforward.
Mining stocks – Like most stocks, mining stocks can be bought either individually or through funds. The economic logic of mining stocks is simple – a company typically has a fixed cost of extracting its gold, and increases in the price of gold fall right to the bottom line as increased earnings. In practice, mining companies often have additional costs for exploration, and the market may consider unproven reserves of undeveloped gold that may not pan out. (Several years ago a Canadian mining company reported a major new gold discovery in the jungles of southeast Asia and its share price soared from $1 to over $100. The company imploded when the independent expert hired to verify the find “fell out” of a helicopter returning from the mine.)
The general appetite for stocks, or for mining stocks in particular, can magnify the change in share prices compared to the price of gold itself. When gold is popular, demand for gold mining stocks pushes stock prices up faster than the price of gold; when gold fever subsides, or when investors are dumping stocks in general, the effect is reversed.
Gold may seem like a sure bet, increasing over 370% in the last ten years and seemingly the answer to many financial woes. Gold is used sparingly in jewelry, dentistry and some limited industrial areas, so unlike most other commodities, its value is not supported by uses other than as a default currency. Indeed, gold fell more than 71% over the course of 19 years from its previous inflation-fueled spike in 1980. And there have been a number of dramatic ups and downs along the way of the long-term trends, the latest being a nearly 30% decline in 2008.
The best approach to buying gold is to first identify the reasons for your interest – short-term trading of an appreciating asset, long-term portfolio diversification, method of exchange, collectible or protection against possible hyper-inflation. Then, after making sure that you are not merely reacting to current hype, choose the investment method that fits your goals.
December, 2009