From the April 2013 issue of Research Magazine • Subscribe!

April 1, 2013

Metal Gets Less Precious

Never mind that gold is posting year-to-date losses and never mind that gold mining stocks are already in a bear market. Is this the start of bad things to come for gold investors?

Gold volatility (^GVZ) spiked over 18.03% in trading on Feb. 20 and the bumpy ride in gold is getting even bumpier. Although gold registered its 12th consecutive yearly gain in 2012, it’s actually been in correction mode since September 2011. Is there too much money chasing precious metals?

Fundamentals 

On the supply/demand side, the investment demand for gold has been declining. The 17% drop in demand for bars and coins was offset by a 51% gain in ETFs, but still resulted in a 10% demand reduction, according to the World Gold Council. India, the largest consumer of gold, experienced a 12% decline last year in gold demand to 864.2 tonnes.

One positive growth area was central bank purchases. In Q4 2013, global gold investments by bankers topped 145 tonnes, second only to the peak achieved toward the tail end of the credit crisis in Q2 2009. 

Taxation on imported gold is another factor that’s weighing on the precious metals sector. To reduce its account deficit, India wants to increase taxes on gold coming from outside its boundaries. 

The current gold import tax is just 6% but that may go up. “There’s a feeling that the government is looking at increasing the duty again, maybe to 8%,” said Bachhraj Bamalwa, chairman of the All India Gem and Jewellery Trade Federation.

As the world’s largest gold buyer, this may cut India’s future demand for bullion in jewelry and investment. India’s 2012 drop in gold demand was the second straight year of decline, after consumption was curbed by a jewelers’ strike for three weeks to protest a 1% excise duty on non-branded ornaments. While the excise duty was later abandoned, the shutdown cost the industry $3.7 billion in revenue, according to the jewelers’ federation.

Although gold gets most of the attention, other precious metals have recently outperformed it on a relative basis. Despite these short-term discrepancies, metals tend to imitate each other. And it’s interesting to see how silver (SLV), palladium (PALL), and platinum (PPLT)—all areas of outperformance—have trended lower just like gold. 

The trend of lower prices for metals is extremely problematic for one particular industry sector: Mining stocks. Since August 2012, the Market Vectors Gold Miners ETF (GDX) has fallen 19.75%. Conversely, inverse funds like the Direxion Daily Gold Miners Bear 3x Shares (DUST) have soared 44.15% in value. 

Decelerating metal prices when the costs of mining are increasing make a bad combination. 

Gold in Portfolios 

“Commodities have done well over the past decade and gold gives a portfolio diversification,” said Lawrence Carrel, author of ETFs for the Long Run (Wiley, 2008). “Physically backed gold ETFs give you liquidity and a good proxy for the spot price of gold.”

But Carrel warns that gold is taxed at higher rates compared to equities, plus it doesn’t generate any earnings. “Gold probably shouldn’t be more than 15 or 20% in a portfolio,” adds Carrel. 

A new ETP called the Gold Shares Covered Call ETN (GLDI) attempts to generate cash flow on gold by selling covered call options.

“Gold is often criticized as a portfolio investment because of its lack of any yield,” said Greg King, head of exchange-traded products in Credit Suisse’s Investment Bank. “Covered call strategies however, are designed to enhance yield in exchange for sacrificing part of the upside of an investment position. GLDI seeks to provide investors and their advisors an interesting new way to introduce monthly cash flows into their portfolios.”

Advisors that don’t like the GLDI’s ETN structure because of its credit risk have other choices. Selling covered call options on physically backed ETPs like the SPDR Gold Shares (GLD) or the iShares Gold Trust (IAU) is another option.

In a covered call strategy, an investor holds a long position in an asset and sells call options on that same holding. Call options provide the seller with an upfront premium payment, but require the seller to deliver to the buyer any upside an asset experiences beyond a set level. 

While holding possession of physical gold may have certain psychological comforts, it has its drawbacks. For instance, one of the disadvantages of owing physical gold as coins or bars is they can’t be easily hedged against price declines. On the other hand, gold equity and physically backed gold ETPs can be protected with insurance or put options.

Purchasing a put option on GLD, for example, could minimize the impact of a severe downturn in gold. Any losses in the value of GLD would be offset by gains in GLD put options. It’s this sort of financial flexibility that gives gold investors more choices versus holding physical bullion. 

Keeping Perspective 

Precious metals have the historical tendency to go through long periods of boom and bust. After peaking in 1980 at $850 per ounce, physical gold was dead money for 20 years. Then, just as it seemed gold would continue to lifelessly linger, it began a streak of 12 consecutive yearly gains in 2000. 

Gold education is an important aspect of the equation. Income oriented investors, particularly retirees, should have a very small amount of their money allocated to precious metals. Some advisors forgo exposure to metals altogether, opting instead for commodity focused equity sectors like basic materials (XLB) that pay a small dividend. Ultimately, advisors will have to decide what’s best on a client by client basis. 

“I believe that exposure to gold should play a part in the alternative investment bucket of a well-diversified investment portfolio for most long-term investors,” said Christopher Tasik, CFP, with Tasik Financial Strategies in New York. “When appropriate I utilize gold ETFs in my client portfolios.”  •

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