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Investing in Gold

by Charles Rotblut, CFA

Investing In Gold Splash image

Investors who are interested in allocating a portion of their portfolio to gold have several choices. Direct investments can be made by purchasing physical gold or gold certificates. Exchange-traded funds and futures provide semi-direct exposure. Mining companies provide indirect exposure.

Physical Gold

The most direct way to invest in gold is to buy the physical metal itself. Registered dealers sell bullion coins and gold bars. Deciding between the two is dependant on the amount of money being invested. The most common weights for bullion coins are 1/20, 1/10, 1/4, 1/2 and 1 troy ounce. “Good delivery” bars in the United States weigh either 100 ounces or 1,000 grams. (However, bars do come in many other weights.)

Gold jewelry can also be purchased but its value may differ from the price of gold depending on the design. As a result, bullion coins and bars are better options for investing directly in physical gold.

The inherent problem with physical gold—or any other commodity—is storage. Space must be allocated to house the metal. In addition, and more importantly, the space must be in a secure location to deter theft. Small amounts of gold can be stored in safe deposit boxes. A safe can be used, but it should be immobilized.

An alternative is to use a custodial service. These are services that hold the metal in their vaults for a fee. Depending on the service, gold coins and bars from several different investors may be stored together (“commingled”). Therefore, it is important to ask about a service’s storage policy. If a service does commingle gold, keep a record of any serial numbers.

Another downside to custodial services is the risk of the custodian running out of physical space. This happened last November to small investors who housed their gold at an HSBC vault in New York. According to the Wall Street Journal, increased demand for gold storage from large, institutional clients caused the vault to run out of capacity. As a result, the bank asked smaller clients to move their gold elsewhere.

Gold Certificates

Gold certificates provide ownership of gold, but do not require physical delivery. Rather, an investor receives a certificate listing the amount of the gold purchased, while a bank or other organization obtains and holds onto the metal on behalf of the certificate owner. Banks in certain countries, such as Germany and Switzerland, sell gold certificates. In the United States, the Australian-based Perth Mint sells certificates through various third-party dealers.

A minimum investment may be required to purchase a gold certificate, and a commission may be levied on top of the cost of the certificate. The Perth Mint requires a minimum of $10,000 to open an account and a minimum of $5,000 for all subsequent purchases.

Counter-party risk should be considered. This is the possibility that the issuer of the certificate defaults on the contractual terms (e.g., fails to buy the gold, fails to pay the full amount due at the time the certificate is sold, etc.). This risk is particularly heightened when the third party is located in a foreign country. However, it should be noted that the Perth Mint does operate under a guarantee by the government of Western Australia.

Gold ETFs

SPDR Gold Shares (GLD) and iShares COMEX Gold Trust (IAU) both are trusts that invest directly in gold bullion. Each share of these exchange-traded funds (ETFs) is the equivalent of having an interest in slightly less than 1/10th of an ounce of gold. (The reason why each share does not exactly match 10% of the current price of gold is because of the cash transactions necessary for fund operations. As a result, the trusts hold both gold and cash.)

Exchange-traded funds offer low transaction costs, are easy to trade and do not require the investor to take physical delivery. The downside is that the investor does not own actual gold, but a minority stake in a trust that has gold as its predominant asset. As a result, investors have little control as to if or when the fund chooses to liquidate its holdings. This is potentially problematic because any liquidation would cause tax issues for the shareholders.

Futures Contracts

Gold futures contracts enable investors to obtain exposure to gold without directly buying the metal or investing in a trust that holds gold. Rather, a futures contract is an agreement to buy or sell the metal at a specified price on a predetermined date (e.g., the third week of June). Futures contracts are volatile and can result in a substantial loss of capital.

Gold futures require physical settlement. Physical settlement means that the commodity must be delivered to the purchaser once the contract expires. As a result, an investor who maintains a long position until expiration must be prepared to accept delivery of the precious metal. (Alternatively, an investor holding a short position must be prepared to deliver gold bars.) However, this can be avoided if the position in the futures contract is closed at any point prior to expiration.

(Futures contracts in general can use either physical settlement or cash settlement. Physical settlement requires delivery of the underlying asset, most often a commodity such as gold or oil. Cash settlement allows the payment of cash in lieu of the underlying asset. Cash settlement is most often used for financial products such as S&P 500 futures.)

Mining Companies

Gold mining companies are an option for investors who want exposure to gold, but wish to avoid the storage and potential tax consequences associated with the precious metal. Both profits and stock prices of gold mining companies are influenced by changes in the commodity’s price.

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However, it is important to understand that investing in a gold mining company is not the same as investing in gold. Many gold companies have exposure to other metals such as copper or nickel. Production costs, labor unrest, political instability and other issues can negatively impact profit margins. The competency of management and the financial strength of the company are also factors. Finally, gold stocks can be influenced by the direction of the stock market. As a result, share prices of gold stocks may not always reflect price changes of the precious metal itself.

As is the case with many other industries, investors can purchase gold mining stocks directly through a broker.

Gold Mining Funds

Various mutual funds and exchange-traded funds invest in gold mining companies. The returns realized by these funds will be dependant on the performance of the securities they invest in, rather than being directly tied to the price of gold.

It is very important to read the prospectus before investing in a gold mining mutual fund or ETF. Some may invest only in mining companies, whereas others, such as Tocqueville Gold (TGLDX), may also maintain an allocation to gold. (If gold is held, consider the potential tax implications.)

Factors to Consider

Though the price of gold rose significantly last year, there are no guarantees that the precious metal will continue to appreciate in the future. Like any commodity, gold trades in reaction to actual and forecast demand. Perceived changes in central bank policies, both monetary and those involving the buying or selling of the precious metal, can influence prices. The strength or weakness of the dollar relative to other currencies influences how gold trades. The economy is another factor. If long-term interest rates or inflation differ from expectations, gold prices could potentially be helped or hurt. Geopolitics, though unpredictable, play a role as well.

The most important factors to consider, however, are wealth, time horizon, portfolio diversification, the type of account the metal will be held in and the willingness to deal with potential storage and tax issues. Gold can play a role in a diversified portfolio, but, like any asset, it may not be suitable for every investor.

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


Discussion

Kenneth from OR posted over 3 years ago:

What would some of the issues be if an ETF liquidated their product (i.e. gold or silver holdings?


Robert from MN posted over 3 years ago:

Primarily tax implications if there was a capital gain.


Carl from AZ posted over 2 years ago:

What situation would prompt the liquidation of an ETF like GLD? Would there be any warning to shareholders?


Gary from WA posted over 2 years ago:

After much study, in my mind the only acceptable way to own gold is to own the physical gold itself
Even the largest Gold ETF (GLD) is surrounded with unknown consequences for the investor
Anything other than physical GOLD is not a GOLD investment, it is a stock or ETF/Mutual fund investment
One of the better articles I have read on this subject is located at the “Seeking Alpha” site and is written by Jack Holland and posted Dec 7, 2011
<5 Questions GLD Investors Need To Ask>
Also it is a mistake to not read the Prospectus available at the various websites for any GOLD ETF you are even thinking of getting into

http://seekingalpha.com/article/312311-5-questions-gld-investors-need-to-ask


Peter from CA posted over 2 years ago:

If one were to buy gold coins, say the one ounce American Eagle from a reputable dealer, what "markup" is reasonable? Right now, for example, gold is selling for $1,733 per ounce. How much would I expect to pay for a single American eagle or say I wanted to purchase 10 of them, or even 50. Are quantity discounts customary? Conversly, if I wanted to sell the coins today to a reputable dealer, what might I actually expect as the redemption value? Is this also variable based on the quantity involved in the transaction? Anybody have experience with this?


Gil from VA posted over 2 years ago:

The investment analysis on Gold was quite good. The flawed public and investment discussions by analysts, are usually clear out of the ball park.

SOME good info is available from web sites but take ALL of it with a grain of salt.

The best resource I know is the Northern Miner which covers mining world wide.

Gold stocks are HIGH risk for all the reasons stated and many more as are ALL mining stocks. That said, MOST PRODUCTS USED IN MANUFACTURING AND OUR DAILY LIFE IS THE RESULT OF COMMODITIES THAT COME FROM MOTHER EARTH. Therefore, it is difficult to talk about gold stocks without including other commodities like silver, zinc, molybdenum, copper and a host of other elements, many of which may be a side product of gold and silver mining, which reduces the cost of producing gold or silver.

Pick 3 or 4 mines and google their home page and look at the number of mines the own, often in several countries with several products.

The Mines Handbook might be worth buying to become better educated before investing in mining stocks. THERE ARE SEVERAL NEW GOLD/MINING LOCATIONS WITH HUGE NEW RESOURCES . IT TAKES 2 TO 10 YEARS OR LONGER AND 500K TO 7 BIL. to bring a mine on line.

Become knowledgeable or find someone who is, before investing in mining stocks...Canada/USA/Mexico are places I like. Oil, coal, diamonds, rare earths, cooper and many other commodities look good for the future although some are looking for a gold downturn in 2013 and some are looking for $5,000. gold in 5 years.......


G from VA posted over 2 years ago:

On holding physical gold or coins. You MUST HAVE THEM assayed before you can sell and be sure you have a safe place to store them!


Paul from PA posted over 2 years ago:

Gold is real money & Silver. All the Pro's say take possession of your metal. Personally i keep mine in a Del. Repository. Don't overlook Pre 1965 coins called Junk silver, sold in priced right sizes,..from 50:00 up to 1K. There are computer sites to help you determine it's daily market value,...a dime should buy a loaf of bread ..a quarter possibly a sm size Tyenol. My Greek Dentist is willing to take metals for any of my tooth related repairs! Does anyone keep their metals in any other commercial buildings [Repositories]? Regards .Paul


Thomas Grzymala Cfp from VA posted 6 months ago:

With today's global security uncertainty, investment volatility and its present relative position market-wise, how wise is it to keep 1-2% of one's retirement portfolio in a gold mutual fund?

Thank you,
Thomas Grzymala

tom@blueserenity.us


Charles Rotblut from IL posted 6 months ago:

Gold will give you different return characteristics than bonds or stocks. Keep in mind, however, that if you invest in a fund that holds gold mining stocks, you will not get as much diversification as you would by owning a fund that purely holds gold.


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