THE INVESTMENT CASE FOR GOLD


	THE INVESTMENT CASE FOR GOLD
	www.gold.org The Investment Case for Gold 1 Why Invest in Gold? Gold is a unique asset. It has been both a global currency and an investment for thousands of years. What sets it apart from other commodities is that it is virtually indestructible, fungible and also highly liquid: there are large above-ground stocks which can be mobilised easily and quickly. Importantly, gold is an effective portfolio diversifier. Publicly available research shows that returns on gold do not correlate with major economic variables, whereas returns on mainstream financial assets and most other commodities tend to. The factors influencing the gold price are different from those affecting other asset classes. This brochure outlines the strengths of gold as an investment and looks at the factors that may determine how much gold investors choose to hold in their portfolio. The case for investing in gold focuses on three key characteristics: • Preserver of wealth • Good portfolio diversifier • Superior alternative asset 1. Preserver of Wealth Insurance value Gold bullion can provide ‘insurance’ against extreme movements in traditional asset values – insurance which comes at little cost to portfolio return. Many investors also turn to gold as a ‘safe haven’: it is useful to have in a portfolio during periods of market turbulence. Gold provides this ‘insurance’ because its correlation with traditional asset classes – the extent to which it follows their performance – is low. In addition there is statistical evidence to show that these low correlation characteristics are maintained – and indeed that the correlation can diminish further or become negative – in times of market stress so that the diversification benefits of gold continue when they are most needed. This is not always the case with other assets sometimes used as diversifers. Allocated gold is no-one else’s liability Gold is not a paper asset – it is an indestructible asset which is no-one else’s liability. Gold does not depend on someone’s ability to pay; both equities and bonds do – their value is dependent on the issuer’s ability to pay in the future and in certain circumstances these obligations can become worthless. Even Treasury bills (and cash) depend on a government’s ability to pay in the future. Although a government can simply print more money, this may cause its currency to weaken, thereby reducing the value of its Treasury bills to international investors and their real value to domestic investors. Gold has maintained its value Over the centuries, gold has maintained its purchasing power, in particular during periods of upheaval. Analysis of five countries (USA, Britain, Germany, France and Japan) has shown that its real value may fluctuate in the short term but consistently returns to its historic purchasing power parity with respect to other goods. Over time, therefore, gold has proved to be an effective preserver of wealth. In periods of economic and political instability, when the value of many other assets has been all but wiped out, gold has been a safe haven. 2. Good Portfolio Diversifier Statistical analysis shows that price movements in gold bullion tend to be unrelated to those in traditional asset classes such as equities, property and bonds. Including gold in a portfolio can lower risk without necessarily decreasing returns. It can reduce the possibility of a very negative return in any period, in particular when markets are volatile or ‘stressed’. This is extremely beneficial because it can: • increase portfolio returns for the same level of portfolio risk, and/or • reduce portfolio risk for the same level of returns. Historically, gold has shown low-to-negative correlation with equities: Gold also appears to be one of the few assets that generally has low-to-negative correlation with other major asset classes. Outperforms in stress periods Although the point of diversification is to hold assets that perform differently from each other under various conditions, equity markets tend to become more closely correlated during periods of market turbulence. However, it has been shown that commodities tend to become negatively or less correlated with mainstream asset classes during such periods1. Research by Mercer Investment Consulting, reviewing the strategic case for gold in UK pension funds, showed that the presence of gold reduced the impact of extreme market events (defined as substantial falls in equity markets). It showed that gold’s low correlation characteristics were maintained during such periods and there was even slight evidence that the correlations fell. Therefore, this means the benefit of holding gold in a portfolio is maintained and may increase during turbulent times. As it is often hard to forecast when such times may occur, it is prudent to hold assets which can withstand all markets. 3. Superior Alternative Asset Class Portfolio investors searching for alternative asset classes to stabilise and enhance portfolio performance will find gold bullion offers superior characteristics. When compared to other alternative asset classes, gold bullion offers very high diversification benefit, is low risk, highly liquid and inexpensive to hold and manage. Where to find more information A number of independent research papers are currently available on the World Gold Council website (www.gold.org). These include: • Harmston, Stephen (1998) “Gold as a Store of Value” • Smith, Graham (2001) “The price of gold and stock price indices for the United States” • Smith, Graham (2002) “London Gold Prices and Stock Price Indices in Europe and Japan” • PricewaterhouseCoopers (2002) “A review and analysis of the role that gold bullion could play in the investment policy of Australian superannuation funds” • Lawrence, Colin (2003), “Why is gold different from other assets? An empirical investigation.” • Mercer Investment Consulting (2003) – a report on the strategic case for gold in UK pension funds is expected to be available in December 2003. • Capie (Forrest), Mills (Terence) and Wood (Geoffrey) (2003) – a report on gold as a hedge against the US dollar. This report is expected to be available in early 2004. Alternative Potential Liquidity Diversification Risk Holding/ asset returns benefit management costs Private equity venture capital v.high low moderate v.high high Private equity buy ins/outs high low moderate high high Hedge funds various low various various high Gold low high v.high low low Commodities volatile high high high low Timber/forestry medium low high moderate high Art and collectibles medium v.low high high high How much to Invest in Gold Ultimately, it is up to investors to decide whether gold is an appropriate investment and to determine the amount needed to achieve individual investment objectives. Investors should take a number of criteria into consideration, including risk tolerance, tax impact and time horizon. Strategic Allocation Although investments in gold mining companies have been a traditional – albeit indirect – way of gaining access to gold, the market capitalisation of the sector is only some US$85bn (as at 24 November 2003). This limits the exposure institutional investors can gain to gold through this channel. However, given that the “market capitalisation” of gold – the value of aboveground stocks – is around US$1.9 trillion, direct exposure to gold increases the potential size of the investment. Diversification for all situations Assets move in and out of favour. It is also difficult to predict when gold will outperform equities and when portfolio returns will be extremely volatile. Therefore, there appears to be a case for gold bullion to form a long-term, strategic component of certain portfolios. A review of current financial market and gold market fundamentals would suggest that gold could perform well relative to equities over the next few years. This is because: • global equity market fundamentals are uncertain • gold market fundamentals appear generally positive. Current financial market fundamentals Based on the following observations, the current financial market fundamentals appear to be positive for gold: • the Dow-Gold ratio has fallen, indicating that investor confidence in equities (relative to hard assets) is falling • Tobin’s Q is close to one, indicating that financial assets are well valued compared to their book value or replacement cost, but has also been on a downward trend • the US dollar continues to depreciate – the dollar gold price has tended to show an inverse relationship with the value of the US dollar. The Dow-Gold Ratio and Tobin’s Q The chart below compares the Dow-Gold ratio, which is often referred to as a value comparison of financial assets (equities) versus real assets (gold), to Tobin’s Q. The latter is a widely quoted measure of the market value of equity assets versus their replacement or book value. Value of the US dollar Gold is often thought of as a dollar hedge with the dollar gold price tending to move inversely to the value of the dollar. Statistical research2 has confirmed that this is so and that this relationship has proved generally robust since the gold price was freed in 1971. In its 2003 Gold Survey, Gold Fields Mineral Services Ltd shows that: • the total above-ground stock of gold is estimated to have been approximately 147,800 tonnes (4,800 m oz) at the end of 2002. • annual global mine production of gold over the past five years has averaged around 2,600 tonnes (83 m oz). This equates to an increase in above-ground stocks of only 1.8% annually. • annual global demand over the past five years has averaged around 4,000 tonnes (130 m oz). Mine supply is price inelastic in the short term, i.e. mine production does not respond quickly to price changes. Scrap supply (which is highly price elastic), central bank sales and, until 1999, producer hedging made up the shortfall between mine production and global demand. It is also worth noting that: • new mine supply has changed little in the last three years and there has been a reduction in ‘grassroots’ exploration since the peak year of 1997. Source: Metals Economics Group • analysts expect mine supply to remain broadly stable or even decline over the next few years • central bank selling has been largely controlled through the Central Bank Gold Agreement since September 1999 and it is expected that a similar agreement will be signed in 2004 when the current one expires. Published by World Gold Council 45 Pall Mall London SW1Y 5JG United Kingdom Tel: +44 (0)20 7930 5171 Fax: +44 (0)20 7839 6561 E-mail: info@gold.org Web: www.gold.org World Gold Council The World Gold Council is a commercially driven international marketing organisation for the gold industry with the objective of stimulating the demand and retention of gold in all its forms. Disclaimer This publication is published by the World Gold Council and its affiliates (“WGC”), 45 Pall Mall, London SW1Y 5JG, United Kingdom, Copyright © 2003. All rights reserved. Any part of this document may be copied and redistributed without charge subject to attributing the source to the WGC and where the facts or opinions are attributed to a non-WGC source such source should be similarly attributed. The information in this publication is based upon information generally available to the public from sources believed to be reliable. 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This publication is not, and should not be construed as, an offer to buy or sell, or a solicitation of an offer to buy or sell, gold or any gold related product, security or investment. This publication does not, and should not be construed as acting to, sponsor, advocate, endorse or promote gold or any gold related or other product, security or investment. This publication does not purport to make any recommendations or provide any investment or other advice with respect to the purchase, sale or other disposition of gold or any gold related or other product, security or investment, including, without limitation, any advice to the effect that any gold related transaction is appropriate for any investment objective or financial situation of a prospective investor. A decision to invest in gold or any gold related product, security or investment should not be made in reliance of any of the statements in this publication. Before making any investment decision, prospective investors should seek advice from their financial advisers, taking into account their individual financial needs and circumstances and carefully consider the risks associated with such investment decision.