Portfolio protection that glistens

By Ross Hunter

Gold has been one of the strongest performing assets in the last ten years. It delivered an average annual return of 15.19%*, while the S&P 500 was losing an average of 0.08%* each year.

Gold is one of the most interesting and multi-dimensional investments you can make. The market in this special metal offers investors a combination of structural growth, protection from inflation and a built-in ‘wealth protection’ insurance policy that provides true diversification from traditional asset classes. Let’s look at these features in a bit more detail.

The inflation shield

Gold’s primary function as an investment is to protect against the devaluation of money due to inflation. Over the long term, everyday items like food, tuition and clothes continue to become more and more expensive. That £10 note in your pocket buys you less than it did last year. When devaluation occurs, the price of real assets rises; in this scenario, real assets protect the value of your portfolio.

The structural growth provider

The supply and demand characteristics of gold are absolutely compelling.

On the supply side, while there is plenty of gold in the world, the remaining unmined deposits are so deep in the ground that it is becoming increasingly expensive to dig it out. As chart 1 shows, gold production costs swelled over 150% in the five years between 2003 and 2008. Due to recent increases in energy and labor prices in the second half of 2009, global gold production costs reached $478 an ounce in 2009. The World Gold Council has recently estimated that production costs are moving closer to $760 an ounce. Largely because of this trend, South Africa is no longer the world’s largest producer – it’s China.

Chart 1: Global gold production costs

Source: GFMS Gold Survey 2005-2009

Staying on the supply theme, there have been no new major discoveries in the past ten years. The world is still producing a little more each year (growth is 1% a year) but at a decreasing rate (the growth rate for gold production used to be nearer 4%). Add that to the rise in production costs and you have an extremely supportive supply side.

Demand too is positive for gold. At a fundamental level, the world population is growing; estimates show the current six billion people on Earth swelling to around nine billion by 2050. More significantly, the growing wealth of emerging markets such as China and India, who account for around 2.4 billion of the world’s population, means there will be growing spending on discretionary items like gold jewellery.

The insurance policy

Consider your portfolio of assets – your home, your car, your investment portfolio. You take out insurance for your home and your car, so why not for your investment portfolio? That’s what gold offers.

In moments of financial turmoil, gold protects your portfolio. It proved its worth in 2008 by turning in a 4.38%** return when financial assets lost 37% of their value. The same thing happened in May 2010, as gold maintained a steady return while equities were extremely volatile.

But why insure your portfolio now? In the first place, no one knows when shock events are going to occur. There are always tensions in the world, but it’s hard to predict if, or when, one of them is going to erupt into something more serious.

Recently, we have faced growing tension across various parts of the world such as in the Middle East (Iran, Israel), Afghanistan/Pakistan and North Korea. Furthermore the financial world is more closely tied together than ever before, while Western world debts are not going to disappear anytime soon. All it takes is one major event to shake confidence in the markets and send financial assets plunging.

Who’s buying gold?

A good indicator of the demand for a product is to look at what the experts are doing. Central banks are buying gold. Indeed, Russia and China have been very significant net buyers of gold for many years. Russia’s central bank bought 143 tonnes of gold in 2009, raising its holdings of the metal by 29%. India bought 200 tonnes from the IMF in October 2009. And China bought more than 450 tonnes between 2003 and 2009. These emerging markets (especially China) have seen their investment portfolios become overweight in US government bonds and are now looking to gold for the characteristics we’ve described above.

How do you buy gold?

There are various ways to make money from gold. You can buy some shares in gold mining stocks. However, these do not give you the insurance policy attributes of gold or even a close link to the gold price; gold shares are linked to the stock market and rise and fall broadly in line with markets.

A spread bet on the price of gold has no physical value. Although it gives some financial protection from volatility in other markets, there is no intrinsic value stored away for the future. For example, in a doomsday scenario, all that matters might be the ability to exchange a bag of potatoes for some gold coins. Your gold spread bet isn’t much use in that event.

So let’s buy some gold dubloons. Head off to Frankfurt Airport or a glitzy Dubai hotel and insert your euros into the gold vending machines that have started appearing. This is a growing trend; buying and storing gold as a long term insurance policy for your family. Be warned though: there is a big risk to doing this, do you have a good safe or vault in your home? Probably not. This is important as the security of your asset matters. It is also expensive to buy gold yourself, you’re often charged 5% up front and another 5% on exit.

An alternative answer is an investment vehicle that is backed by gold. ETFs are often backed by physical gold to the tune of 50-75%, and the rest by derivatives. Castlestone Management’s Aliquot Gold Bullion Fund is backed 100% by the physical asset, giving ultimate wealth insurance.

Currency matters

One flaw with many gold ETFs is that they are priced in dollars, and not in the investor’s base currency. Investors choosing gold are usually doing so to protect their wealth. They are not buying gold to take a punt on the currency markets.

Look at what currency markets have done in the past year. Sterling has lost around 12% of its value, most of it since the start of 2010. That’s a good thing if your investments are priced in dollars, but of course the reverse is true if sterling rallies. Here, you could lose recent gains – even if gold prices continue upwards as your dollars could translate into less sterling.
The magnitude of these movements means the purchase of a dollar-based gold ETF is as much a bet on the dollar as the price of gold.

Chart 2: Performance of sterling over the last 12 months

Conclusions

Historically, real assets have outperformed financial assets during times of economic turmoil. This is likely to be the case for years to come. There is no gold bubble occurring, as a few people have suggested. Even if gold hits the $1,400 level, we’d still be nearly $1,000 from the inflation-adjusted ‘real’ high of $2,300 in the 1980s.
As predicted by some, gold could have the potential to deliver returns of around 8% a year over the next decade. Not bad for an insurance policy.

Information in part supplied by Castlestone Management

* Source: London Bullion Market Association and Financial Times – Gold Bullion: London PM Fix.
**Source: Bloomberg and Castlestone Management.
***Source: Bloomberg & Castlestone Management - Financial Assets: S&P 500. Gold Bullion: London PM Fix. Data from January 2008 – December 2008.

For more information or advice on gold, please contact one of our experienced financial consultants now on investorinsight@devere-group.com