The following is an excerpt from the paper i wrote sometime back on Gold as an investment. I came across this article in one of the magazines and researched a more on the same. The references are mentioned underneath.
At close to USD 1550 per ounce, “Astounding” is one word that describes the recent run in Gold prices. For some sceptical souls out there, Gold prices are at height of a bubble waiting to burst. So, without wasting more time, let us clarify what we mean by bubble being formed. An investment is in a bubble when the asset price is highly inflated. Quite simple, isn’t it? But when we are saying inflated then there must be a reference of some sort to measure the degree of inflation. For investments, this reference value is known as intrinsic value. This brings us to our very first question.
Can Gold be considered an investment?
Before we answer this question, let us ponder for a moment on how an investment is evaluated. An investment is evaluated using its underlying value (intrinsic value). The father of value investing, Benjamin Graham, proposed that a value investor buys undervalued securities and sells the ones that are overvalued. On the other hand, speculative bets are placed looking at the price of something and simply hoping the price goes up. So, in a nutshell, investment is about value while speculation is all about price. Carl Richards, a certified financial planner based in Utah, USA in his New York Times article “Gold is not an investment” uses the definition of investment just stated, to classify Gold as a speculative bet rather than an investment.
The problem with Gold is nobody knows what a bar or a coin of Gold is really worth. It has no underlying real value. It neither produces anything, nor are there any cash inflows associated during the period you hold a bar of Gold. Warren Buffet, legendary investor, compares buying Gold to buying a piece of art which you hope will sell for more than you bought it for. "Gold really doesn't have utility," the 80-year old told shareholders at Berkshire Hathaway's annual general meeting this year. "I'd bet on a good producing business to outperform something that doesn't do anything. But with gold, you can sit on your Gold, stare at it, polish it and do whatever makes you feel good but it is not going to produce anything.”
What drives the price of Gold?
The price of Gold is a function of perceived economical and geo-political risks as well as the risks associated with other commodities or currencies. The greater these risks, greater would be the demand for Gold and greater the upswing on the price of Gold.
Take for example, year 2008 when Gold hit USD 1000 per ounce and crashed and then rebound. Looking at the series of events in 2008, in March of 2008 one of the big US equity firms Bearstones collapsed. This created a huge amount of panic in the global markets with the result that people started moving away from equity, from the debt market etc into Gold and that was the reason for the upward spiral in the Gold prices.
Come July 2008, Lehman Brothers collapsed and that created another huge crisis of confidence globally. The immediate impact of Lehman Brothers collapse was a 'sell everything and hold cash' syndrome. Everybody had only one motivation in mind and that was selling everything and holding cash as an asset. Not even stocks, not even bonds, not even Gold.
February last year, Gold prices hit their low at USD 1035 per ounce. The slide ended as soon as the news of Greece default came up and within 48 hours of bailout announcement Gold had hit USD 1235 per ounce. With the recent developments in Eurozone, Gold can be expected to react to sovereign debt concerns for the “PIGS” economies.
Besides these, geo-political instability in Middle East and North Africa region has also contributed to rising Gold prices. Earthquake in Japan and its ultimate impact on already shrinking Japanese economy as well as rising oil prices have also made a positive impact on the Gold prices during last year.
Where is Gold heading now?
Uncertainty in Eurozone and weakening of US dollar during recent times has caused central banks around the world to limit their exposure to greenback. According to a report by World Gold Council, purchases by central banks in the first quarter of 2011 jumped to 129 tonnes (USD 5.7 billion), more than the total for 2010 as a whole. Central banks, especially in the emerging economies, are using Gold as a mean of diversifying their reserves and limiting the exposure to US dollar. Such moves have led to the recent rise in Gold prices. How long this run would continue? “No one knows”.
Gold Exchange Traded Funds
Let’s suppose you as an investor who wants to gain exposure to Gold. You could either buy Gold in physical form or go for Gold Exchange Traded Funds. Investing in Gold ETFs gives the investor all the advantages of investing in Gold while eliminating drawbacks of physical Gold -- cost of storage, liquidity and purity, among others.
Gold ETFs are transparent investment vehicles that conform to rigid regulations on investment. This assures the quality of Gold that the fund invests in and transparency in calculation of NAVs and, consequently, the market price at which these units trade.
Gold ETFs allow investment in Gold in small denominations, which makes it easier for the retail investor to participate. On the secondary market, the minimum lot is one unit. The units can be redeemed either from the fund directly or from the market.
Further, investing in paper Gold gives investors’ tax advantages over investing in physical Gold. Gold ETF units held for more than one year qualify for long-term capital gains at 20 per cent, whereas the holding period in physical form has to be three years to qualify for long-term capital gains. For less than three years, the gains are taxed at 30 per cent. Also, Gold held in paper form is not liable for wealth tax.
In India Gold ETFs is a relatively new phenomenon with the first Gold ETF being Gold Benchmark ETF launched in Feb, 2007. It raised 96.26 Cr Rupees, while today its assets under management (AUM) stand at 1703.49 Cr Rupees as on March 31, 2011. Overall, since Feb 2007, Gold ETFs in India raised around 941 Cr Rupees. As on Mar 31, 2011, their current assets total more than 5643 Cr Rupees. The number of retail folios in Gold ETFs has doubled over the last financial year.
Gold vs SENSEX
If we look at the past three year duration 2008-11, the yellow metal shines bright making equity look like its poor cousin. The following graph shows how two Gold ETF’s, Gold BeES and Kotak Gold ETF, have beaten the BSE SENSEX in last three years considering an investment of INR 10,000. Kotak Gold ETF’s return is shown in green while the return of Gold BeES in blue is not visible since it exactly matched the return of Kotak Gold ETF. SENSEX return is shown in Yellow.
Source: www.moneycontrol.com
On the other hand, if we take last three decades, the story is different. Gold delivered an annual return of 2.5 percent, barely beating inflation while the sensex generated 17 percent per annum over the same period. This leads us to the conclusion that just like any other speculative bet, Gold beats the market return over a short duration but over a rather longer duration of time, “Market” prevails.
Should you invest?
Stability, reduced volatility in a well-diversified portfolio, inflation-plus returns, convenient investment vehicle to get tax-efficient exposure, are all good reasons to invest in Gold ETFs. However, there are certain issues that investors must keep in mind. Liquidity may become an issue for small investors who want to exit, especially in times of crisis. Finding buyers at a fair price in the markets may become a problem if you need to convert gold to money.
Redeeming units directly from the fund may not be an option available always. During periods of financial crisis like hyperinflation or failure of banks, the large investors may convert paper holdings to physical Gold. Small investors who do not have this option may be left holding illiquid paper. In such a situation, Gold loses its edge as a store of value.
On the returns front, while Gold ETFs can add lustre over smaller periods, the returns they generate in the long term are not very encouraging. Entry loads and fund management costs further reduce returns. You could consider buying the units in the secondary market, where brokerage costs may be lower than the applicable entry load.
If an investor is clear about the reasons for investing in Gold and the issues related to it, there is every reason to include Gold as an asset class in the portfolio and the Gold ETF may be just the ideal vehicle to join in the Gold rush.
References:
www.valueresearchonline.com
www.moneycontrol.com
www.etfgold.net
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