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03.17.10, 11:20 AM ET
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.
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 dependent 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 U.S. 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.
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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 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 U.S. 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 (i.e. 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.
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.
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. 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.
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. 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.
Various mutual funds and exchange-traded funds invest in gold mining companies. The returns realized by these funds will be dependent 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.)
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 is editor of the AAII Journal. Click here to visit the Web site of the American Association of Individual Investors.
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