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Gold: currency of last resort?

It has been years since the world abandoned the gold standard, but now, for many institutional investors, allocating to gold has become about currency and inflation hedging, writes Maha Khan Phillips

In Ancient Rome, one gold coin weighing one ounce could buy its owner the finest quality toga in the market, along with some sturdy sandals and a belt. Over two thousand years later, here is what an ounce of gold can buy: a good quality suit, some fine leather shoes, and a belt.

It is a story that fans of gold love to tell. "Gold has a steady value. It should not be seen as an investment, but as an insurance against things happening in the monetary system," explains Dennis Van Ek, European partner with Mercer in Amsterdam.

It seems that institutional investors agree. At the end of the first quarter of 2009, the gold price ended at $916.50/oz on the London PM fix, according to figures from the World Gold Council - a 4% rise, compared with a 12% drop in US stock prices during the same period. Inflows into gold exchange traded funds (ETFs) continued to grow through the quarter, with investors buying a record 469 tonnes, far superseding the previous quarterly record of 145 tonnes set in Q3 2008. This took the total amount of gold in ETFs to 1,658 tonnes, worth $48.6bn.

"Central banks are worrying about deflation, but investors and analysts are looking beyond that and asking what's going to happen down the line," explains Rozanna Wozniak, investment research manager at the World Gold Council. "With low interest rates, quantitative easing, and governments pumping money into the economy, at some stage we could end up with an inflation problem. Gold has proven in the long run to be a good hedge against inflation."

Monetisation of gold
Analysts point out that gold is a positive bet not only in times of inflation but also in times of deflation. If quantitative easing works, and the world stabilises and inflation returns, then gold will rise as well, argues Investec Asset Management. In its February 2009 market report, the firm points out that the inflationary period of the 1970s cemented the link between rising inflation and gold prices. "Gold behaves like a currency. It can be traded globally at the same price and has adequate stocks to back it up, yet it cannot be printed. It must be mined at a cost. It is hence a real asset which generally holds its value in inflationary conditions."
 
If quantitative easing does not work, and the world enters into a deep recession or depression, then gold still makes sense, because, argues Investec, past periods of rising deflationary risks have been associated with hoarding cash and cash equivalents, which also includes gold and other precious metals.
 
"The most attractive feature of gold at the moment is the fact that it's a currency whose production is going down, not up," says Daniel Sacks, Global Gold Fund manager at Investec.
 

Volatility
Investec predicts that gold prices will remain steady, roughly at 2008 levels. Analysts do not expect prices to recover beyond their 2008 peak of just over $1,000/oz, unless there is another panic sell-off in equities, partly because jewellery demand remains low. Prices did spike up 5% in one day however, after the Federal Reserve announced plans for quantitative easing. It is something investors need to get to grips with: gold is not without volatility. During the first quarter, average gold price volatility was 29.2% on a 22 day rolling basis. During Q4 2008, it was 44.8%.
 
"There is volatility in the gold market just like there is volatility in every market," concedes William Rhind, head of sales in the UK & Ireland for ETF Securities, the exchange traded commodities (ETC) player which listed the world's first gold ETC in 2003. "But gold doesn't go bankrupt like a company can go bankrupt, and in the last ten years, gold has been the best performing asset class in the market."
 
The firm has seen an influx of $6bn into its gold products, $2bn in the last few months. "There's a lot of talk about the gold standard coming back," says Rhind. "For our investors, gold is a safe haven. It has no counterparty risk and no credit risk," he adds, pointing out that ETFs are backed by physical allocated gold.

Exposures
Consultants see it differently. Mercer points out that an ETF investment is operated through the exchange by banks, and the investment is in a fund of a bank. The investment fund guarantees the investment, backed by physical gold, but this of course hinges on the security of the bank.
 
"ETFs do not equal gold, because they do not give you the ownership of the gold," claims Van Ek. "If you have no ownership of the gold, and you want to get your gold out in an emergency, you can't. Because you have no ownership of the gold, ETFs can be perceived as promises to pay the price of gold."
 
Investors can also make an investment through an account at a bank, although, here too, the guarantee is only a partial guarantee, as the gold is not "allocated" - physically in your account. They can also invest through the Perth Mint in Australia, according to Mercer. The federal state of West Australia carries its own currency, a gold coin, which is legal tender in the whole of Australia, and has the only government guaranteed gold program in the world.
 
Investors can also invest in futures, but this has become less common as pension funds move lower down the risk spectrum. "A lot of pension funds have picked up the ETF product because they aren't mandated to run futures, but generally there's little economic difference between the two," says Steve Ellis, portfolio manager at RAB Capital. "Rolling gold futures is probably cheaper, because ETFs charge a management fee of 40 basis points. Also gold futures reward investors for gold interest rates whereas the ETF does not, so if gold moves into backwardation (gold interest rates higher than LIBOR) then rolling gold futures would be a superior strategy." Ellis believes that investors are thinking with their feet: "There's a lot of distrust of governments and central banks that are combining efforts by trying to print their way out of a recession."
 
For investors who want to take the direct route, physical gold can be purchased unprocessed or through coins. Van Ek believes institutional investors should consider making physical allocations because it is the purist form of allocation, and investors do not have to worry about counterparty risk: "Gold is the cash of last resort. It cannot default."

ETF Securities' Rhind points out that buying physical gold ends up being costly, because of storage requirements. "It's expensive and impractical. That's why people tend to shy away from it, and that's why ETFS are so popular, because they give you the benefits of ownership without all the extra costs."

Investment
Whatever route investors choose to take, industry experts are clear on one thing: gold may be a great hedge against monetary disorder, but it also has a compelling investment argument. "Gold is not just an inflation hedge," says Adrian Ash, head of research at BullionVault, the private investor service for gold bullion investment and ownership. "Gold has gone up fourfold and held its value last year when everything else was deflating quickly."

Gold has returned 13.3% over the 10 years ending in 2008, compared to US equities, which underperformed at -0.1% (see table). In fact, because of its diversification benefits and long term performance, the World Gold Council recommends average allocations of 5%-10% of the total portfolio to the asset class.

"Institutions have learnt not to invest in what they don't understand," says Wozniak. "Gold is a simple concept, and it's a real asset. It has thousands of years of history behind it." If the analysts are right, that history will continue - and in centuries to come, an ounce of gold should still buy you a very good suit.

 

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