Where to get your gold

Most investment strategists concede that having some gold exposure is probably a good idea for a client’s portfolio. Where there is a more pronounced debate is where and how to get that exposure.

For clients, the first issue to address is the reason for adding gold. Does a client want it to preserve value of his or her savings, using the precious metal as an inflation hedge? Is it a speculative investment, with the client hoping for short-term returns? Or does the client see it simply as a non-correlated asset class?

All of these different strategies will likely require an allocation to different types of gold investments.

For example, investing in gold mining equities presents arguably the greatest upside potential for investment return. These are publicly-listed businesses and they trade on varying price-to-earnings multiples.

If investors are looking to get a substantial amount of their gold exposure from stock investments, they must realize that while the valuations of the stocks are connected to the price of physical gold, there are other elements at play, says Sadiq Adatia, chief investment officer for Russell Investments Canada.

“Although we don’t necessarily have a dedicated allocation to gold, we do look at its valuations comparable to whatever stocks are valuable. We determine what we hold based on that. You should not be absent gold in a portfolio,” he says. “Where we do have a hesitation is that gold stocks to us are not as compelling in terms of their valuations and we still believe there are some better opportunities in other sectors.”

The managers of Russell’s Canadian Equity Pool remain bullish on gold prices, which seem poised to benefit from either a persistent deflationary environment or an inflationary environment erupting from a devaluation of currencies, which many feel is already underway. They remain cautious about the actual companies that operate in the sector.

A recent report from Russell outlines that visibility of earnings is “extremely difficult” in gold stocks, and there are added political risks as well as earnings pressure that the companies can come under.

“With the pullback we’ve seen in the equity markets, there are lots of great companies out there trading at discounts to the market. Gold has definitely run up. You still have the underlying gold bullion prices that are high, but you have to expect then that companies that are extracting are going to be efficient. We are not as highly confident on that,” he says. “With all these mines, there is political risk as well as well as the fact many mines may not be able to extract as much gold from the ground as they say (they can).”

The bottom line on gold equities is that you’re likely going to want to have a good stock picker with experience and knowledge of the industry and the producers.

Pure hedge Sprott Asset Management’s Jamie Horvat is an award-winning precious metals fund manager. He says gold equities are where you’re looking to get leverage on your return, but if investors are looking for a pure-currency hedge to preserve the value of their holdings, bullion serves as a good investment.

Bullion is cyclical and can be volatile, but Horvat says over long periods of time it tends to have a return that keeps pace with inflation.

Traditionally the difficulty with bullion investing, which is a pure gold play, is the difficulty in getting access. Sprott recently enhanced investor choice in the marketplace by launching its own fund, the Sprott Gold Bullion Fund.

“This fund is for investors who cannot go out and buy a couple of ounces of gold or 10 ounces or 100 ounces. It gives them an opportunity to own physical unencumbered bullion that is going to be stored in a vault,” Horvat says.

The fund is more expensive than using an ETF, such as the popular U.S.-based SPDR Gold Trust, which directly tracks bullion. However, investors have the guarantee that the fund is actually holding the bullion, rather than a derivative.

“Our bullion fund has a lot less sub-custodial counterparty risk and third party risk that people have been questioning with the StreetTracks Gold Fund in the U.S.,” he says. “They deal with 30 plus sub-custodians. If they asked for this gold back, would they ever receive it? Everybody should have a portion of their investments in hard assets. Gold [bullion] is the ultimate store of value amongst hard assets.”

A hurdle gold investors face with bullion is currency fluctuations. Most bullion is bought in U.S. dollars, so the currency hedge benefits are substantially reduced if you have to translate that cost back into Canadian dollars.

“As a Canadian investing in U.S. gold, you have to be very careful in how you make that investment. If part of your investment thesis for investing in gold is you think the U.S. dollar will depreciate, you could forego a lot of your gains in bullion when you translate your investment back to Canadian dollars,” says Adam Felesky, CEO of BetaPro Management. “For the month of March, a person who bought [the SPDR fund], and brought the U.S. dollar proceeds back to Canada is seeing a compounding difference of 2% over the month so far. Consider what would happen if the loonie increased from 80 cents to a dollar? You could lose 20% of your investment’s value.”

Horizons BetaPro offers a currency-hedged ETF that tracks the bullion index at a leveraged 200% exposure. Since the fund’s inception, he says investors have preferred the bull version over the inverse-return-generating bear version by a factor of about 10:1.

But buy-and-hold investors need to be aware that the product rebalances daily, so the tracking error can start to build up if it’s held for long periods of time.

“[Reducing tracking error] is all about volatility. You just want to rebalance more frequently,” he says. “You want to make sure the investment in our fund is half of what you had in a traditional fund. If the ETF is moving in your favour, you want to take those profits off the table or else we’re going to leverage your profits as well.”

Dan Hallett, president of Dan Hallett and Associates, points out in a report released Tuesday that to statistically maximize your odds of having gold work as an inflation hedge, you need to hold it for a really long time. He points out that gold has outpaced inflation on a 137-year track record — but over shorter periods it can lag.

“Few investors have an investment horizon that remotely approaches triple digits. Over this time period, gold has produced a compound annualized return of 0.62% annually on top of inflation,” Hallett says. “We have never been big gold bugs. Based on historical data, however, a decent case can be made for its inclusion in a portfolio. Long holding periods are usually required to enjoy gold’s benefits, though holding even for as long as 20 years still risked disappointment.”

Hallett does point out that gold has been a consistent producer of non-correlated returns, particularly during stock market downturns.

“The second major reason investors want gold in their portfolios is to preserve capital in times of stock market weakness. During its period of fixed prices, gold indeed held its value. But even during its four decades of free-floating prices, gold has generally delivered during times of turmoil. Then again, we must be careful not to draw firm conclusions from only a handful of past instances,” he says.

Read: Managers see little downside to gold

(03/25/09)