Taking a shine to gold
A liquid asset with low correlation with equities and fixed income and negative correlation with the dollar should be relatively easy to sell. Yet funds have shown an almost complete aversion to gold. A raft of new investment products and a sustained educational campaign by the World Gold Council (WGC), the body backed by gold mining companies, may just change their attitude.
The WGC promotes gold not as a means to make a quick buck but as a way of introducing diversification and stability into a portfolio. One of gold’s prime investment attributes is a lack of correlation with other assets. Richard Davis, manager of Merrill Lynch’s Gold & General Fund says it has a correlation of almost zero with equities and bonds in the long run.
In addition, correlation veers towards the negative during times of financial turmoil, as investors seek what is perceived as a safe haven. “In other words,” says Robert Weinberg, managing director of institutional investment at the WGC, “just when you most need an efficient diversifier, gold really comes into its own.”
So why is it proving so difficult to get institutions to invest in this apparently attractive asset? Access is limited and, when available, expensive and cumbersome. But recent products that have securitised gold have made it more accessible that ever before.
The most straightforward way to invest in gold is to buy bullion, most commonly traded in 400-ounce bars. There is then a choice for the investor – whether to hold it in an allocated or unallocated account. An allocated account involves taking delivery of the gold and arranging its storage and insurance – a relatively cumbersome approach. The institution also has to set up dealing agreements and complete the associated paperwork. “For something that’s never going to form a major part of the portfolio, you have to ask yourself whether it is worth all the trouble,” says Weinberg.
Alternatively institutions can hold their gold in an unallocated account, a concept similar to foreign exchange accounts. Using this approach, investors avoid storage and insurance charges. The only risk is that investors rarely have bars ascribed to them and so are exposed to the creditworthiness of the bank or dealer. “In practice, it’s still quite a lot of hassle to set up the account,” says Tony Baird, managing director of the London-based bullion merchants Baird & Co.
An alternative and easier way is to invest directly in mining companies but this approach requires very careful due diligence and research. On top of market risk, to which every equity is subject, each company has additional risks associated with mining – the cost of exploration and extraction as well as potential geological and metallurgical problems. Political instability also comes into the equation as many gold mines are in politically volatile regions.
As a rule of thumb, gold shares consequently have a gearing of three to four to the price of gold. “If the price of gold goes up 10%, you’d expect gold shares to go up three or four times that,” says Weinberg. The converse is also true, so small fluctuations in the gold price are normally accompanied by wilder volatility in mining share prices.
Institutions deterred by this can opt for a specialist fund investing in mining shares. These are scarce commodities themselves; Merrill Lynch’s Gold & General Fund is the best known and JP Morgan Fleming runs a Resources Fund. A couple of small alternatives – Resources Investment Trust and Baker Steel Capital, run by Trevor Steel, formerly of Merrill Lynch – have entered the market. “With these funds at least you know you’ve got somebody who spends their every waking moment concentrating on this market alone,” says Weinberg.
Merrill’s $400m (e348m) fund is up 2.1% this year but managed 82.1% in 2002, against a 39.4% rise in the FTSE Gold Mines Index. Despite having a relatively flat year, the fund has seen a rise in the number of institutions asking for information. “We get the impression that there has been a change in attitude and that more institutions are interested in investing in gold,” says Davis.
He says the fund offers institutions an advantage in that its analysts cover nothing but mining companies. “Analysing a mining company is similar to analysing other companies but it helps if you have practical experience and technical training in the field.”
Other means of investing in gold are available to pension funds. Most large investment banks produce a variety of structured notes and gold-linked convertible bonds that offer a securitised investment in gold. These notes vary according to issuer but are typically a hybrid, part receipt for debt and part pure gold.
These convertible bonds are traditional fixed income instruments and enable investors to buy gold with an income. They can either be offered at a premium to provide a higher level of income or they can be priced at a discount to create a zero coupon bond.
Gold options and futures are seen basically as a leveraged play on the price of gold. The benefit is that contracts are traded on margin, so only a fraction of the contract’s value has to be paid up front. As with other futures contracts, an option position can give the investor great leverage while risking only the premium if the option is not exercised.
Goldman Sachs recently launched a series of covered warrants on gold. Mark Valentine, executive director at Goldman Sachs, says volatility in the price of gold in the run-up to war in Iraq precipitated the launch. Investors buying the warrants are able to buy (using a call) or sell (using a put) gold at a set price within a defined time frame. “They provide investors with a means of gaining long or short exposure to gold,” he says.
The warrants are traded on the London Stock Exchange and the maximum exposure is the initial amount paid up front. An added benefit is that trading and exercising these warrants is exempt from stamp duty as investors receive cash, as opposed to the physical asset, on settlement.
These products increase access to gold but the WGC has taken it a step further. In March a joint venture with the Australian company Gold Bullion saw the launch of the world’s first listed gold bullion security. This is simply an exercise in securitising gold – each share is the equivalent to 1/10th of a Troy ounce held in trust. Investors in the securities, which are listed on the Australian Stock Exchange, own a specific portion of a gold bar (similar to an allocated account) which is held in vaults in London and insured by HSBC.
To date the shares have attracted a relatively modest AS$50m (e29m) but the WGC has submitted documents to the Securities and Exchange Commission in the US, where it intends to launch a similar product. Davis agrees the move is positive as it gives investors the opportunity to buy bullion. “If you speak to institutions in the UK many probably don’t know how to invest in gold. There could well be quite a lot of pent-up demand for this product.”
Weinberg says the best way of making the market more accessible is by creating investment products that are distributed through conventional channels. Now that this is the case, it’s for the pension funds to choose. It’s difficult to imagine making investing in gold any easier.