With Paulson and Soros Buying Gold, Should You?
Jay is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you had bought gold around 2008 and 2009, when it was trading at about $800 - a new high at the time - as the recession was causing all other assets but Treasuries to drop in value, you would have doubled your investments today with gold hovering above $1,600. From 2001, around the time of the last U.S. recession, till 2011, gold has not posted a loss in a single year during this 10-year period and is poised to register another yearly gain in 2012. Will this trend continue, especially given the prolonged anemic economic conditions both in the U.S. and around the world? Well, some big-name investors are betting on it, such as John Paulson and George Soros both having recently increased their gold investments. Faced with an increasingly complex modern financial system whereby liquidity breakdowns happen more easily than ever before, tempering economic growth and diminishing society wealth, investors are increasingly looking to gold, an old-time asset, as a safe heaven during economic and financial uncertainties.
Despite the abandonment of the gold standard in 1972 by the Nixon administration, which set completely free the modern fiat paper currency system, gold being a scarce and precious metal remains the ultimate value measurement by convention and custom. Directly priced in dollars, gold can closely gauge and track changes in the state of the U.S. money supply, inflation expectations and relative economic conditions among countries, which all play into forming the value of the dollar. The dollar has strengthened against other currencies lately, the euro in particular amid the European debt crisis, and this could add pressure on the rising gold price. However, through two rounds of monetary easing, and potentially more on the way, the Federal Reserve has flooded its financial system with extra dollars in the trillions, a far more negative effect on the dollar. With the dollar potentially dropping in value, gold will have nowhere to go but up. A slow economic growth may further compound the Fed-inflated dollar, as limited economic activities cannot fully absorb the impact of the monetary stimulus.
Until the economy is firmly on a growth trajectory and previously increased money supply can be recycled back to the Fed system through its bank-reserve mechanisms, gold investors are in for a ride up going forward. For modern-day investors, a convenient way of having gold exposure is buying shares of gold-related ETFs. Incepted in November 2004 and the largest physically backed gold ETF, SPDR Gold Shares Trust (NYSEMKT: GLD) has been a popular gold investment vehicle for both institutional and individual investors. Designed to closely track the price of gold, the SPDR gold ETF holds physical gold bars that are purchased through its authorized market participants, designated financial institutions as chosen by the SPDR gold ETF sponsor. The SPDR gold ETF is sponsored, or created, by the non-profit organization World Gold Council through a wholly-owned trust services company.
Another popular physical-gold-holding ETF is iShares Gold Trust (NYSEMKT: IAU), formerly from Barclays Global Investors and now part of BlackRock. The iShares gold ETF has a much smaller asset base, compared to the one from SPDR. This may explain why the iShares gold ETF has a lower average daily trading volume, and potentially a smaller scale in gold trading by its authorized market participants, a potential disadvantage to their competitive gold-market pricing. But the expense ratio of iShares is only about half the amount charged by SPDR, allowing added cost savings to net total returns.
Some gold ETFs are based on gold futures contracts, making them more suitable for risk-tolerant investors. For example, PowerShares DB Gold Fund (NYSEMKT: DGL) from Invesco buys and sells gold futures contracts as opposed to holding physical gold bars, with the goal of achieving higher returns from ongoing price fluctuations. However, trading futures contracts may incur settlement losses at maturity dates. This can happen for long positions when the market is a contango and for short positions when the market is a backwardation. A contango is a market condition whereby prices of futures contracts for a specified maturity date decrease over time and a backwardation is the opposite market condition in which prices of futures contracts for a specified maturity date increase over time. Unlike holding physical gold, which may allow an eventual recovery from previously recorded paper losses, trading futures contracts must recognize any losses from adverse price changes at a contact’s settlement date.
On the other hand, futures trading may also augment profits under the right market conditions, because of the leveraging effect of the amount of capital deployed. Capital required in futures trading is used to cover potential losses from cash settlements, and the value of futures contracts purchased can be many times the amount of capital deposited. More actively involved with their investment management, futures contract-based gold ETFs, such as the Powershares gold ETF, often charge higher expense fees, which may or may not justify their actual returns.
While the price of gold may fluctuate in some intermediate periods, gold is most likely to reach higher over the long run as inflation inches up each year, even under normal economic conditions. The current headwind for a positive gold price development may come from the relatively strong reading of the dollar index, mostly as a result of the weak euro caused by the underperforming European economies. However, lower Treasury yields and range-bound equity indexes in the U.S. will likely provide the necessary backstop for higher gold prices.
JJtheArdent has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
