Why gold is good for you, in small amounts

Volatility is high, but so are the diversification benefits.

Ben Johnson, CFA 30 August, 2016 | 5:00PM
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Gold is traditionally sought after as a store of value in times of severe economic dislocation, an insurance policy against financial Armageddon. Its historically low to negative correlations with most broad asset classes indicate that gold might be a worthwhile investment for a small portion of an investor's portfolio.

While gold has exhibited a low level of volatility relative to equities over the past quarter century, the massive price swings experienced from the early 1970s through the mid-1980s -- as well as its sharp sell-off in 2013 -- demonstrate the effects of fickle investor sentiment.

This type of volatility also underscores why an allocation to gold should probably occupy only a small portion of a well-diversified portfolio. As for an investment in physical gold through an exchange-traded product (ETP), gold ETPs are the least costly, most broadly accessible, and most liquid vehicles for acting upon one's gilded aspirations.

Gold has no intrinsic value. It does not produce cash flows that it can share with investors, like equities. Nor does it throw off coupon payments, as a bond does. Financial theory states that a security's intrinsic worth is equal to the present value of the future cash flows it will generate. With no cash flows to project and discount back to today, gold is a purely speculative instrument: It is only worth what someone else is willing to pay for it.

Unlike most commodities, gold has little practical use. According to the World Gold Council's Gold Demand Trends report for the first quarter of 2016, just 6.3% of gold demand was tied to practical uses -- such as dentistry and electronics.

The largest source of gold demand (accounting for 37.3% of gold usage in the first quarter of 2016) is typically the jewelry industry. But demand from investors took pole position in the first three months of 2016. During that span, 47.9% of the global appetite for gold could be attributed to investors. The remainder (approximately 8.5%) came in the form of official purchases.

The world's central banks have been playing an increasingly important role in the gold market in recent years. In the second half of 2015, the world's central banks bought more gold than in any other six-month period in history. Also, investment demand for gold has surged as concerns over paper currencies have flared, interest rates have in some cases gone negative, and the precious metal has been made more accessible to the masses via ETPs.

However, until recently, ETP investors had been running for the hills. Holders of gold-backed exchange-traded products had been net sellers for three years. This trend reversed in the first quarter of 2016, when ETPs accounted for a combined 363.7 metric tons of gold purchases.

While demand for gold in practical applications and for jewelry has historically exhibited normal cyclical behavior, investment demand for gold appears to be in a secular uptrend. Gold is now more accessible than ever, and its safe-haven appeal seems to have staying power, which could signal that prices -- while far from their peak -- have trended too high.

On the other hand, bloated sovereign balance sheets and massive bouts of monetary stimulus and negative interest rates have many convinced that gold is the world's one true currency, and perhaps it will only climb higher.

While gold notched record high price levels in nominal terms in September 2011, the nearby peak was well below its inflation-adjusted record price of US$2,358 per troy ounce, which was reached in January 1981. Whether the price of gold will tumble or spiral higher is impossible to tell. Though the gold price has demonstrated limited volatility over the past decade, past experience has been marked by episodes of massive price declines, as we've recently been reminded.

Nearly two years after the real price of gold hit an all-time record in 1981, its value had fallen by two thirds. What can be said for certain is that gold-backed ETPs are an excellent way to gain exposure for investors and speculators alike.

The largest exchange-traded product for investing in gold bullion is the US$40.9-billion  SPDR Gold Shares (GLD). It's a "pass-through" vehicle for physical gold ownership, with each share worth about a tenth of an ounce of gold.

The fund -- technically, a trust -- is sponsored by World Gold Trust Services and is marketed by State Street Global Markets, but the day-to-day management is conducted by the trustee, BNY Mellon Asset Servicing. The trustee calculates the trust's net asset value, using the London p.m. fix price for an ounce of gold as its benchmark. The gold itself is held in the London vaults of HSBC Bank USA, though at times some of the gold will be held by other banks, or "sub-custodians."

The gold is insured by the custodian, but the prospectus makes clear that the custodian doesn't have to maintain insurance to cover the full amount of gold held, and sub-custodians aren't required to be insured. If you're hoping for total insurance, you're out of luck. The custodian is only "liable for losses that are the direct result of its own negligence, fraud, or willful default in the performance of its duties."

This fund sells off a little bit of gold over time to offset its 0.40% expense ratio. The trust's sponsor (World Gold Trust Services, which is wholly owned by the World Gold Council) claims an annual fee of 0.15%, while another 0.15% goes to marketing agent State Street Global Markets.

GLD's chief competitor, the US$9.6-billion iShares Gold Trust (IAU), also owns gold bullion but has a lower expense ratio of 0.25%. Because of its cost advantage, IAU shines a little more brightly than its much larger rival.

Fees are higher for gold exchange-traded funds listed on the Toronto Stock Exchange. However, one advantage for Canadian investors is that these ETFs are denominated in Canadian dollars.

The TSX-listed iShares Gold Bullion is available either in Canadian-dollar hedged CGL or unhedged CGL.C units, and the expense ratio is 0.56% for both classes of units. Sponsored by the Horizons family of ETFs is Horizons COMEX Gold (HUG), which employs futures contracts to obtain its passive exposure to gold bullion. This ETF also hedges its foreign-currency exposure back to the Canadian dollar. Its expense ratio, at 0.74%, is higher than its iShares counterpart.

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Ben Johnson, CFA

Ben Johnson, CFA  Ben Johnson, CFA, is director of global ETF research for Morningstar and editor of Morningstar ETFInvestor, a monthly newsletter.

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