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Five reasons to buy gold

FEATURE: Gold may be regularly maligned but, as Jonathan Eley reports, it can still play an important role in a truly well diversified portfolio

Whether gold is hauled up from the hull of the Titanic or picked from the desert sands of Egypt, it's always still pure and shining. This durability partly explains its enduring appeal; it's easy to believe that something so physically resilient is also dependable in a financial sense.

But, for most investors, gold's prettiness and its historic status as the ultimate store of value are of secondary importance compared with its recent price performance. In a decade where shares have, in aggregate, posted mediocre returns, it has sparkled. Its outperformance accelerated in the aftermath of the financial crisis, and it finished the noughties as the best-performing mainstream asset class.

Past performance is never a guide to the future, of course, but we can think of five reasons why there should be a place for gold in a properly diversified portfolio.

1 Supply and demand

Of all the reasons to buy the yellow metal, this is surely the most compelling. Mines take a long time to develop and after a long period of fallow prices in the 1980s and 1990s, mine supply is still catching up. Gold Fields Mineral Services, a consultancy, puts world mine supply in 2010 at 2,543 tonnes, compared with total demand of 3,812 tonnes. The shortfall was made up by sales of scrap gold, which are volatile, seasonal and highly price-sensitive.

Meanwhile, demand has been recovering after the financial crisis. Traditionally, the jewellery industry was the biggest consumer of gold. It is of huge religious and cultural importance in south Asia and the Middle East, and the newly enriched middle classes of China and Brazil are showing quite a taste for it, too. But the big story of the past few years has been the emergence of investment demand. This used to take the form of small bars and coins bought by private individuals, and that's still the biggest component of it, but the rise of exchange-traded commodities (ETCs) has consumed a lot of gold. Many of these instruments, especially in the US, must be backed by physical gold holdings, so new ETCs can only be created once the metal that backs them is safely tucked away in London, New York or Zürich. Overall investment demand – exchange-traded funds plus bars and coins – was 35 per cent of total demand in 2010, compared with less than 10 per cent in 2001, according to the WGC figures.

And that's before a second new form of investment demand is taken into account: central banks. Again, there's been a sea-change here. Central banks were traditionally net sellers of gold. From their point of view, it was expensive and cumbersome to store, could not easily be lent out, and did not earn a return. In short, it was a pain. Bonds that paid coupons, or foreign exchange that could be lent out, seemed a much better bet. Famously, the Bank of England sold much of its gold holdings at prices below $300 an ounce.

Central bank selling so frustrated the world's gold producers that they lobbied for annual restrictions. The Washington Agreement, signed in 1999, restricted sales by 11 key central banks to 400 tonnes a year initially, and 500 tonnes a year in its second incarnation.

There is, arguably, no need for it any more. Amid unprecedented concerns about the stability of the world monetary system, central banks turned net buyers of gold in 2010 for the first time in 21 years, according to World Gold Council figures.

2 Forward selling has stopped

The normal state of commodity markets is known as contango, where prices for future delivery are higher than for immediate – the difference, in theory at least, reflecting the cost of insuring, storing and financing the metal for that period. Many big gold producers used to sell their output for future delivery, taking advantage of the premium in the price but without actually incurring the costs, because the gold was still in the ground. In the 1990s, especially, this was seen as a smart thing to do, even though it effectively put a lid on future prices.

According to VM Group, a consultancy, the net forward hedge book was over 100m ounces in 2001. Today, it's less than 5m ounces. Barrick closed out its hedge book in 2009 and AngloGold Ashanti wound up its forward sales in the final quarter of 2010.

3 Global uncertainty

Yes, this is a sentimental line of reasoning. But in the days after Lehman Brothers collapsed, the prices of mainstream assets such as shares and bonds fell in tandem. In the aftermath of the financial crisis, governments ran up vast debts supporting banks and pump-priming national economies, while central banks' balance sheets ballooned. The full consequences of this will take years to play out, but a period of sustained higher inflation looks likely. And every time stock and bond markets get the collywobbles, investors scuttle to the same places: Treasury bonds, the dollar and gold. There will be many trading rallies.

Gold's advocates are no longer a bunch of eccentric conspiracy theorists. The asset class has gone mainstream as its price has risen. High-profile financiers from John Paulson to Jim Slater have extolled its virtues – and made a pile of money out of it.

4 It's a great diversifier

Gold is not quite the inflation hedge that many believe it to be. But it is a great portfolio diversifier because of its relative lack of correlation with other asset classes. In particular, it tends to rise in periods when shares are doing badly, such as during the final quarter of 2008 and the first quarter of 2009.

5 It's easier than ever

As recently as 10 years ago, there were basically only two ways to get exposure to gold. You either bought small bars and coins, or you purchased shares in a mining company. Now your choice of mining stock is vastly greater; there are two pure-play gold miners (Randgold Resources and African Barrick) in the FTSE 100 alone, and dozens of small explorers on the junior market. You can spread-bet on gold free of capital gains tax and foreign-exchange risk, you can get geared exposure with fixed downside through covered warrants, you can hold a share in a good-delivery (400-ounce) gold bar in a vault, and you can buy exchange-traded products that track the price of bullion.

And some reasons not to buy into gold...

Just another bubble

Gold isn't some mystical metal, it's just another commodity. Its price is entering bubble territory and it's rapidly becoming a 'greater fool' market – with people buying only in the expectation of being able to sell to some even more deluded individual.

It's useless

At least the other precious metals have practical industrial uses. Gold is used only for adornment and hoarding. The former is discretionary, and so vulnerable to economic swings, and the latter is volatile – gold-backed ETFs account for 617 tonnes of demand in 2009, but almost half that in 2010.

No income

Like all commodities, gold generates no income, so all your returns must come from rising prices. That hasn't been a problem in the past few years, but look at the 10, or 20 years prior to 2005 and the picture is rather less inspiring.

Silver

Unlike gold, the 'forgotten metal' has not been setting new price records lately. That's because silver's big moment of fame came in the 1980s, when the Hunt brothers almost cornered the market and forced the price up to over $50 an ounce.

But, while it has yet to retake that rather artificial price level, silver's recent performance has been even better than gold's. Over the past 12 months, it's returned over three times what gold has (see chart below).

Silver has a monetary role that's every bit as venerable as gold's – why else would we refer to 'pounds sterling'? – but it has far more industrial uses than its yellow cousin. The complete collapse of demand from the photographic film industry, thanks to the rise in digital imagery, has been offset by growing usage in electronics, medicine, solar energy and batteries.

Silver supply is constrained because it's only rarely mined as a primary metal. In most cases it's a by-product, either of gold mining, but also of lead or zinc production, both of which are relatively stagnant.

You can buy silver in most of the same ways as gold: small bars and coins, exchange-traded funds or derivative products based on underlying silver prices. However, the choice of shares in silver-mining companies is much smaller. The large-cap option is Mexican-focused miner Fresnillo, but our favourite play is Arian Silver, whose shares trade on the Alternative Investment Market. They've risen fivefold in the past year – partly because of the silver price, but also on hopes that the key San Jose deposit will turn out to be much more extensive.