The Gold Dilemma

If you want to invest in gold, buy gold

Originally published in the December 2008/January 2009 issue

When people first hear about buying gold bullion, many ask about storage costs: isn’t there a cost involved in physically holding onto this stored wealth? It’s true that there are costs, but these tend to be more than offset by the lease income available for holders of bullion. The leased metal is used as loan collateral by borrowers in market transactions: the gold never leaves one’s ownership, or its vaults. Lease rates vary hugely, but for gold, they have reached as high as 6% in the past decade. Platinum lease rates, also volatile, topped 19% in 2002. In general, though, they are high enough to substantially offset storage costs and occasionally to add a pleasing, if unreliable, income for investors.

To have and to hold
Some gold equity funds have performed well for investors in recent years, but if you wish to have exposure to gold, you should have exposure to the actual metal. In the first three quarters of 2008, gold prices rose about 6.5%, versus an average decline of around 20% from gold equity funds. Investor confidence in stocks slumped as the fallout of the credit crunch advanced, taking its toll on all equities: that included the stock of gold producers and mining corporation which might otherwise been expected to rally with higher gold prices.

Why the diversion? Firstly, there is the eternal perception of gold as the ultimate safe haven, the last resort store of value you can trust to remain precious in even the most calamitous economic situations. It’s a tangible, real, precious asset, with no counterparty risk. When investors are shedding risk, they don’t shed gold. Second, there is the precious metal’s reputation as ahedge against inflation. Whether it possesses this property over a long-term horizon is much debated, but it certainly does in periods of rapid inflation and when individual currencies’ values slump. Gold stocks, regardless of the strengths they undoubtedly possess, will always be stocks. They will suffer alongside fellow equities when economic growth prospects moderate and when risk aversion triggers selling. They also expose investors to corporate risk, a much greater concern in today’s post-Enron climate, now also a post Lehman Brothers, post Northern Rock, or post Iceland climate. While they undoubtedly offer some modest correlation to gold prices, in volatile times, they will tend to show a much stronger correlation to general equities. Adding gold stocks to other equities might well improve returns over certain investment horizons, but it isn’t real diversification. Since 2003, the annualised return of physical gold is 9% versus that of the TSX index which is 0%. This is a substantial difference in return (see Fig.1).


Once markets leave behind the volatility mayhem that afflicted stocks, bonds, commodities, and indeed precious metals, the stage is set for gold to outperform once again. Supply constraints are one influence: ongoing problems are afflicting gold production. South Africa, the major producer after China, has been unable to maintain output, let alone raise it to take advantage of increased gold prices. The nation’s mines have faced months of power shortages as South Africa’s ageing electricity network has struggled to keep pace with rising demand for power. There is no sign of a resolution: the nation’s electricity supplier Eskom has admitted the country faces shortages for at least seven years.

South Africa is not the only troubled producer: Zimbabwe’s monthly gold output plummeted to 125kg in October 2008, the lowest since records began. At the height of its success, Zimbabwe produced more than 2,400 kg of gold monthly, but few industries can function in economic meltdown with inflation above 231 million percent.

Growing awareness among investors of the importance of diversification is another key influence. Those who previously thought a balanced portfolio consists of both stocks and bonds are growing fewer.

Increasingly, investors are aware that to capture the best long-term returns and avoid volatility wherever possible, a broader approach to asset allocation is needed. The best performing assets in one year can give the worst returns the next.

To maximise returns and minimise risk, only a diversified portfolio of investments will do. Taking a stake in each of the six asset classes: stocks, bonds, cash, hedge funds, property and commodities is essential and gold is one commodity that should always be on the list (see Fig.2).


In recent months, the gold price has moderated, not because people don’t like gold any more, but because they need cash. That trend won’t last, and before long, investors will see gold prices heading higher once more.


Angus Murray is Founder and joint Chief Executive of Castlestone Management, which runs the Aliquot Gold Bullion Fund. He is also a manager of the Porcupine Global Macro hedge fund.