Gold: to have and to hold

With turbulence in global markets reaching boiling point thanks to a deepening of the eurozone debt crisis and pessimism about the ability of the US to keep its finances in order, risk shy investors have flocked to gold as a safe haven investment. With the yellow metal reaching new highs it might seem that gold hasn't got have much further to rise. However, analysts are convinced that as long as there is uncertainty, gold will continue its upward climb. So it's not too late to up your exposure and with gold mining equities significantly lagging bullion, a fund investing in the former could be the best way.

The sky's the limit

Last week, gold traded at an all time record-high of $1,662 with predictions that it could hit $1,800 within weeks and $2,100 by Easter.

Tom Hall, co-manager of the BlackRock World Resources Income Fund, comments: "The current fundamentals in the gold market are supportive of these higher prices. The key factors that have been driving investment demand for gold - concerns about sovereign debt burdens, the long-term value of certain reserve currencies and fear of persistent inflation - are likely to continue for the foreseeable future."

Another factor supporting gold's upward trajectory is the insatiable demand from emerging markets. "The rise of emerging markets has also provided a floor for gold prices - central banks in emerging economies are looking to diversify their surplus funds away from the US dollar in particular and are buyers of gold at the margin. Similarly, increasingly affluent consumers in these countries are also playing their part in the gold story - demand for jewellery has historically been one of the main drivers of the gold price," says Ayesha Akbar, manager of the Fidelity MultiManager Growth Fund.

Central banks are now net buyers of gold - the World Gold Council last year recorded no central bank sales - the first time since they began recording in 1989. In 2010 the IMF sold 403.3 tons of gold which was bought almost entirely by emerging markets such as India, China, Sri Lanka and Bangladesh. Very recently the Bank of Korea bought 25 tons of gold.

Of course there are threats to gold's rise. In South Africa, gold producers are facing numerous pressures - wage negotiations are underway resulting in strikes while a strong rand and political pressure for more government intervention in the sector is adding to gold mining companies' woes. But the biggest risk to gold overall is an increase in real interest rates. If this happens the opportunity cost of holding gold will encourage investors to sell the metal. However managers like Mr Hall are confident that the interest rate and exchange rate environment will remain bullish for gold.

Increasing portfolio exposure

Gold's attributes - a real asset which retains its intrinsic value - make it a valuable strategic asset that investors can use to manage risk during periods of economic uncertainty.

Fund managers, including Fidelity's Anthony Bolton, like to describe gold as a currency rather than a commodity, which races ahead when paper currencies are weak.

"The two stories dominating markets right now are the spectre of European sovereign defaults and the raising of the debt ceiling in the US. Both of these have implications for the euro and the US dollar, and it is therefore not surprising that investors are looking for alternatives to currency and gold has fulfilled this role for millennia," says Mr Akbar. Simply put: There is no default risk with gold.

The arguments for holding gold are manifold and well-recited - but do investors have enough exposure to the yellow metal?

A recent study by Oxford Economics entitled 'The impact of inflation and deflation on the case for gold' suggests that typical investor allocations to gold are sub-optimal.

The findings show that gold's share of an optimal portfolio is around 5 per cent in a long-term economic scenario featuring 2.25 per cent growth and 2 per cent annual inflation. Gold's optimal share in an efficient portfolio rises higher in a more inflationary long-run scenario and also does so for more risk-averse investors in a scenario featuring weaker growth and low inflation. Inflation and weak growth typify the UK economy at present, yet the vast majority of investors still have little or no allocation to gold, which places significant capital at risk. Jens Tholstrup, UK managing director of Oxford Economics, said: "Because of its lack of correlation with other financial assets, the report shows that gold has an important role to play in stabilising the value of a portfolio, even where the conservative assumption of a modest negative real annual return is made."

Bullion or equities?

There are various ways to invest in gold but broadly it comes down to a choice between investing in gold bullion or in gold mining shares - whether directly or via a fund.

Exchange-traded commodities (ETCs) such as ETFS Physical gold offer direct exposure to gold bullion, while other funds mainly invest in equities. Angelos Damaskos, fund advisor on the Junior Gold Fund, explains that shares in gold mining companies are equities first and proxies for gold second. "As such, in times of risk aversion and weak equity markets they can become oversold, offering an attractive buying opportunity to those investors who believe the gold price will trend higher."

This has been manifested over recent months - gold mining shares have languished creating a disconnect between the gold price and the miners. "Investors have panicked that the gold price will retreat (they were wrong) and that margins would be squeezed by high oil prices (oil is now not tracking gold higher so margins are expanding). To be frank too many gold companies also issued new shares which also weakened the sector," says Tom Winnifrith, manager of the SF t1ps Smaller Companies Gold Fund.

The net result of this is that gold equities are trading at attractive valuations relative to bullion prices opening up some interesting investment opportunities which should benefit gold mining funds. "The valuation gap between gold shares and gold bullion is quite large and gold mining shares are now quite cheap which would suggest that a gold fund has better growth prospects. However, they will be more volatile," says Meera Patel, senior analyst at Hargreaves Lansdown.

Tim Cockerill points out that if markets are in crisis, as we have witnessed in recent weeks, even gold mining shares will fall, in which case pure exposure via a physical gold ETF would be a better option.

Gold funds performance so far in 2011

Notes: Table shows performance of Lump sum invested on a bid-bid basis, in GBP with gross income reinvested

Source: Morningstar

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