Gold, for all seasons

PORTFOLIO POINT: From explorers to producers to the physical metal, investors can get exposure to gold with varying levels of risk.

As the recovery stokes inflation fears, smart investors are considering hedging strategies to protect real value. And yet, if there is another pullback in equities, assets that hold their value will come into their own. So in the face of inflation or a market fall, all signs are suggesting gold should be a key component of an investor’s portfolio.

Experts the world over recommend some exposure to gold; the tricky part is choosing the investment that matches your risk profile. As we outlined recently, if you have a low tolerance for risk, then buy the real thing – physical gold. If you want to add some spice to your portfolio, buy a producer. If you have an appetite for risk, then buy an explorer (see The bullish billionaire).

Eureka Report provides regular coverage of explorers and producers, so today we are concentrating on the alternatives such as physical gold, ETFs, call warrants and even gold coins (see A fortune in coins). Outlining how to get the exposure you need, while taking on the risk you can afford. But first, the fundamentals.

The recent appreciation in the gold price has mostly been driven by weakness in the US dollar. That creates a problem for Australian investors whose currency appreciates in tandem with the precious metal. So when we view the gold price tracked in Australian dollars, it appears to be tracking sideways.

Investors need to be confident the US dollar won’t continue to fall if they want to benefit from further upside in the gold price. After a period of strength in the second half of 2008, the US dollar has been heavily sold off in the face of its budget deficit blowout, a decision to expand the money supply and an overall return to risk trades.

But that may not last, according to UBS gold analyst Jo Battershill. “The US dollar might soften further but I think it has already softened a great deal quite quickly,” he says. “In the short term I expect it to consolidate as opposed to weaken further.”

A note from AMP chief economist Shane Oliver on May 27 supports this. He says: “It is doubtful that this is the start of the US dollar crash that has been long feared by many.”

So if you believe inflation is a clear and present danger and that the US dollar is stable, notwithstanding some small downside, now is as good a time as ever to consider the benefits of gold.

Low risk: Gold bullion

As the classic inflation hedge, gold has been the go-to commodity in the darkest doomsday scenarios and for many years the Perth Mint has been the place to acquire gold you can touch.

You can buy gold directly from the mint with a purity of 99.99%, from one gram all the way up to a 50-ounce or 1.4 kilo bar (see '¦ buy it by the pocketful).

There is a considerable expense in producing these bars, however, and the one-gram bar contains a 14% markup on the going price of the gold it contains. In fact, that commission only drops below 5% when you make buy 2.5 ounces or more.

Low risk: Gold certificates

Of course buying a physical quantity of gold presents its own problems, namely security. Investors who know the value of a good night’s sleep may be more inclined to look at the Perth Mint’s certificate program, which offers round-the-clock security for gold investments that start at $10,000 (see Investors catch gold fever).

Certificates can be bought on an allocated basis (where your gold is segregated from the rest) or an unallocated basis (where your gold is held in pool). Allocated certificates attract a fee commensurate with the size of the holding and payable every three years, while unallocated certificates attract a once-only $50 registration fee.

Moderate risk: Gold ETFs

Exchange traded funds are a low-cost way for investors to get exposure in international indices and commodities, generally carrying commissions of less than 0.5%. In Australia, ETF Metal Securities operates five funds based around commodities and the most popular by far is physical gold, which trades under the code GOLD (naturally!).

The gold held by GOLD is kept in a London vault and attracts a management fee of 0.39%. There is an adequate amount of liquidity with about 100 trades made each day, or one every three minutes. Research presented to Merrill Lynch’s Global Metals & Mining Conference showed that demand for gold ETFs has doubled over the past 12 months to 40 million ounces. This presents investors with a puzzle: just where is the gold coming from?

Demand for gold has been rising faster than it could be produced, leading some to question the validity of gold ETF holdings, asking whether the funds could disappoint investors in the same way as the Goldlink funds, which invested in derivatives (see Can Goldlink come back?). While gold ETFs claim that to offer direct exposure to gold held in a you cannot convert ETFs into actual gold, unlike for example, the call warrants offered by the Perth Mint.

Moderate risk: Gold warrants

Trading under the code ZAUWBA, the Perth Mint’s warrants give you the right to right to buy the underlying asset from the issuer at a specified price, on or before a particular date. Although some warrants do not expire until 2013, some owners have exercised their rights to the gold and taken delivery according to the Perth Mint’s treasurer Nigel Moffatt.

Each warrant represents a hundredth of a troy ounce of gold and warrants are bought in parcels of 100. The exercise price contains an additional cost of 50¢ per parcel and other fees depending on whether the owner requests a physical or cash settlement. Because the commodity is tracked in Australian dollars, profits can escape when the US dollar falls as quickly as the gold price rises.

Moderate risk: GOLD ETF and the Perth Mint Gold Warrant

In terms of popularity, the warrant hasn’t exactly set the world on fire. Unlike listed stocks, warrants require investors to sign a special disclosure, which has limited its takeup. With only a handful of trades each day and turnover of just $77 million worth of securities in the year to date, this product doesn’t offer the liquidity most investors would desire. But as you can see from the chart, they both track the gold price closely enough to give an approximation of gold if that’s what you’re after.

Moderate risk: Top-tier gold producers

It’s debatable whether the two previous investment products are more or less risky than a one of Australia’s mid-cap gold producers. However, as respected Australian broker remarked when discussing when discussing the risks of a major Australian producer: “It’s a gold producer!”

For quality exposure to gold it’s hard to go past Newcrest or Lihir. Of the two, Newcrest has been favoured by many investors because of its excellent management team, its lack of hedging and its gearing below 3%.

Lihir has been viewed as higher risk and its management is not as highly regarded. It does, however, have a much stronger short-term production profile and considerable US dollar exposure.

Don’t be fooled by the presence of global gold miner Newmont on the ASX. Its listing is the product of a compliance issue and despite its market cap of $22 billion, it is not actively traded on the ASX.

High risk: Second tier gold producers and explorers

Hard on the heels of Newcrest and Lihir is the explorer Centamin Egypt and the producer Sino Gold. These are closely followed by stocks such as Andean, Avoca, St Barbara and Kingsgate and have all been covered here recently (see A golden era beckons).

At the next level we have the micro cap explorers, which multiply the risk factor yet again. While Tim Treadgold recently covered off on a group of companies keen for a shot at the big time (see Serious new kids on the gold block) the more speculative side of gold has been ably covered by David Haselhurst in his Speculator column, in which he has uncovered such gems as Resolute, Citigold and Cortorna Resources.

With its dual function as both a commodity and sometime global currency, gold has long been viewed as the ultimate safe haven during times of economic upheaval. But like oil, it can also be the catalyst for serious wealth. The gold price also tends be driven by a lot of short-term factors such as the same purely speculative investment demand and reactionary moves that saw demand that saw oil peak at $US150 a barrel.

As outlined by Charlie Aitken recently, if you take the gold price highs of 1980 and adjust for inflation the average one month high of $US850 an ounce is $US2250. No one is suggesting this could be a new trading range, but it does present investors with a tantalising opportunity.