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Satyajit Das: Return of the Age of Gold


In economic chaos, war, or collapse, gold reappears, reasserting it grip on humanity.

Means to a Golden End

For investors, investing in gold is not without problems. Shares in gold mining companies may not provide the sought after exposure to gold prices.

The value of mining companies behaves more like shares than the gold price. This reflects the company's operation which may include exploration. The mining company may have investments in other commodity operations which dilutes the exposure to gold. Decisions to hedge the gold price may affect the sensitivity of the company's earnings to the gold price. There are problems of mergers and acquisitions, purchase and sale of operations, borrowing and sundry issues like mismanagement and fraud.

Most investors prefer direct investment in the precious, yellow metal. This takes the form of trading in instruments like gold futures contract or direct purchases of gold.

Gold futures and similar contracts require knowledge of derivatives trading. Physical gold is expensive and also difficult to store and insure. Popular forms of physical gold investment like coins reflect a premium to the actual gold content, adding to the cost.

To overcome the problems of physical investment in gold, some banks offer gold 'passbook' accounts especially for smaller investors. Operating like a normal bank account, the facility allows investors to buy and sell modest amounts of gold. The bank pools investors' money and buys and sells gold to match the amounts owed to investors.

Increasingly, investors use gold ETFs, which are an extension of the gold account. The ETF is structured as a mutual fund or unit trust which is listed and tradeable on a stock exchange. Investor purchase fractional shares in the ETF which then invest the money raised in gold. Some ETFs invest in the metal itself [such as the world's oldest gold ETF, SPDR Gold Trust (NYSEARCA:GLD)]. Others synthesize the exposure to gold using instruments linked to the gold price via gold futures and derivatives [such as ProShares Ultra Gold (NYSEARCA:UGL)]. Some ETFs allow leverage, borrowing funds to augment the investor's contribution to increase sensitivity to fluctuations in the gold price. [A popular short 2x leverage fund is PowerShares DB Gold Double Short ETN (NYSEARCA:DZZ); a popular long 3x leverage fund is VelocityShares 3X Long Gold ETN (NYSEARCA:UGLD).]

Gold ETFs create new risks. Where the ETF uses derivatives and other financial instruments to obtain exposure to the gold, it is exposed to the risk of default by the financial institutions with which it contracts. Even where the funds are invested in physical gold, the metal is held via custodians, often financial institutions, exposing them to the failure of these entities.

This is ironic given the fact that the investment in gold is specifically motivated by fear of the failure of the financial system. In 2011, President Hugo Chavez ordered the Venezuelan central bank to repatriate 211 tons of its 365 tons of gold reserves (worth around $11 billion) from US, European, Canadian, and Swiss banks, including the Bank of England. Part of the reason was concern about the developed economies and their banking systems. More recently, the Bundesbank, Germany's central bank has requested an audit of its gold holdings.

Investors also worry about the risk of confiscation of gold holding. In reality, a government can confiscate anything -- gold, savings, property -- they want to in times of economic emergency.

In 1933 President Roosevelt issued Executive Order 6102, prohibiting the private holding of gold and requiring US citizens to turn over their gold bullion or face a $10,000 fine (equivalent around $170,000 today) or 10 years imprisonment. In response, opportunistic coin dealers encourage investors to buy expensive "numismatic" or "collectible" coins, taking advantage of an exemption in the 1933 order which protected these assets from government seizure.

Seeking to reassure investors, some ETFs have installed fiber optic cable linked cameras in their gold vaults. Investors can monitor their holdings via the Internet. Of course, this clever marketing gimmick does not protect the investor from the failure of a custodian or financial counterparty as well as confiscation risk.

Golden Brown Bottoms

The investment case for gold is mixed. Gold's tactical value over specific periods is significant.

The period from 1999 to 2001 is referred to the "Brown Bottom" of a 20-year bear market during which gold prices declined. The reference is to the ill-fated decision by Gordon Brown, then UK Chancellor of the Exchequer and subsequent Prime Minister, to sell half of the UK's gold reserves via auction over 1999 and 2002. At the time, the UK's gold reserves were worth US$6.5 billion, constituting around half of the UK's foreign currency reserves.
No positions in stocks mentioned.

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