investing in gold

AHSON TARIQ ahson.tariq@aabaig.com GOLD – A SAFE HAVEN ? Why Gold Gold and Inflation For thousands of years, gold has been valued as a global currency, a commodity, an investment and simply an object of beauty. As financial markets developed rapidly during the 1980s and 1990s, gold receded into the background and many investors lost touch with this asset of last resort. Recent years have seen a striking increase in investor interest in gold. While a sustained price rally, underpinned by the fact that demand consistently outstrips supply, is clearly a positive factor in this resurgence, there are many reasons why people and institutions around the world are once again investing in gold. The value of gold, in terms of the real goods and services that it can buy, has remained largely stable for many years. In 1900, the gold price was $20.67/oz, which equates to about $503/oz in today's prices. In the two years to end-December 2006, the actual price of gold averaged $524. So the real price of gold changed very little over a century characterized by sweeping change and repeated geopolitical shocks. In contrast, the purchasing power of many currencies has generally declined. Investors in gold can point to a growing body of research supporting gold's reputation as a protector of wealth against the ravages of inflation. Market cycles come and go, but extensive research from a range of economists has demonstrated that, over the long term, through both inflationary and deflationary periods, gold has consistently maintained its purchasing power. In the short run, experience has shown that gold can deviate from its long-run inflation-hedge price, and, when enjoying a sustained buoyant period, as is currently the case, can offer opportunities for impressive returns. Portfolio Diversification Asset allocation is an important aspect of any investment strategy. By balancing asset classes of different correlations, investors hope to maximize returns and minimize risk. However, while many investors may believe that their portfolios are adequately diversified, they typically contain only three asset classes - stocks, bonds and cash. To counter adverse movements in a particular asset or asset class, many investors now strive to achieve more effective diversification in their portfolios by incorporating alternative investments such as commodities. While gold has shown strong returns over recent years, its most valuable contribution to a portfolio lies in the fact that it is not correlated with most other assets, as shown in the chart below. This is because the gold price is not driven by the same factors that drive the performance of other assets. Similar data and charts covering a range of countries can be downloaded from our investment statistics page. ENLARGE The sources of demand for gold are far more diverse - both geographically and sectorally than those for many other assets, which helps to explain the independence of the gold price as well as why identifiable demand has remained robust in the face of a rally that has spanned several years. The value of gold demand increased by 79% between 2003 and 2007, and by 158% between 2001 and 2007. Moreover, most spending on gold is discretionary. 68% of total identifiable demand over the five years to December 2007 came Page 1 AHSON TARIQ ahson.tariq@aabaig.com from the jewelry sector, with a further 19% from investment and 13% from industrial demand. This is, in itself, unusual for commodities, where demand is typically driven by non-discretionary spending and is consequently more exposed to the vagaries of the economic cycle. Gold offers enhanced diversification opportunities relative to many alternative assets. Independent studies have shown that while alternative assets and traditional diversifiers often fail during times of market stress or instability, even a small allocation to gold may significantly improve the consistency of portfolio performance during both stable and unstable financial periods. Gold and the Dollar Gold has long been regarded by investors as a good protection against depreciation in a currency's value, both internally (i.e. against inflation) and externally (against other currencies). In the latter case, gold is widely considered to be a particularly effective hedge against fluctuations in the US dollar, the world's main trading currency. But research in 2004, examining the relationship between the gold price and the exchange rate of various currencies against the US dollar from 1971 to June 2002, provided firm evidence of gold's effectiveness as a dollar hedge. The gold price was found to be negatively correlated with the US dollar and this relationship appeared to be consistent over time and across exchange rates. The research established that despite this period (1971-2002) being one of considerable economic turbulence, gold was, throughout, a consistently good protection against this instability and the exchange rate fluctuations it caused. Another recent study by the metals consultancy GFMS Ltd. examined the strength of the link between 22 commodities and the US dollar. The results clearly suggested that gold is not only a more potent hedge against the US dollar than other commodities, but also that it provides protection when most needed (when the dollar is losing value), with relatively little loss of upside during a period of dollar appreciation. Gold and Risk Financial instruments usually carry three main types of risk.  Credit risk: the risk that a debtor will not pay  Liquidity risk: the risk that the asset cannot be sold as a buyer cannot be found.  Market risk: the risk that the price will fall due to a change in market conditions. Gold is unique in that it does not carry a credit risk. Gold is no one's liability. There is no risk that a coupon or a redemption payment will not be made, as for a bond, or that a company will go out of business, as for an equity. And unlike a currency, the value of gold cannot be affected by the economic policies of the issuing country or undermined by inflation in that country. At the same time, 24-hour trading, a wide range of buyers - from the jewelry sector to financial institutions to manufacturers of industrial products - and the wide range of investment channels available, including coins and bars, jewelry, futures and options, exchange-traded funds, certificates and structured products, make liquidity risk very low. The gold market is deep and liquid, as demonstrated by the fact that gold can be traded at narrower spreads and more rapidly than many competing diversifiers or even mainstream investments. Gold is of course subject to market risk, as is clear from the experience of the 1980s when the gold price declined sharply. But many of the downside risks associated with the gold price are very different to the risks associated with other assets, a factor which enhances gold's attractiveness as a portfolio diversifier. For example, should a central bank announce its intention to engage in substantial sales of gold, as happened prior to the Central Bank Gold Agreement in 1999, this would be unlikely to have an impact on equity returns but could reasonably be expected to affect ENLARGE While this has been widely believed for many years, it did not, until relatively recently, have formal statistical support. Page 2 AHSON TARIQ ahson.tariq@aabaig.com the gold price in the short run. Similarly, the specific risks to which bonds and equities are exposed, including pressure on the health of the government and corporate sector during an economic downturn, are not shared by gold. One measure of market risk is volatility, which measures the dispersion of returns for a given security or market index. The more volatile an asset, usually the riskier it is. The gold price is typically less volatile than other commodity prices. This is because of the depth and liquidity of the gold market, which are supported by the availability of large above-ground stocks of gold. Because gold is virtually indestructible, nearly all of the gold which has ever been mined still exists, much of it in near market form. This means that sudden excess demand for gold can usually be satisfied with relative ease. As a result, gold is generally slightly less volatile than heavily traded blue-chip stock market indices such as the FTSE 100 or the S&P 500. GOLD PRICE TRENDS A review of the average annual prices for the last 20 years (from 1998 to 2008) both in US$ and £, reveals a 109% and 89% increase respectively. Surprisingly, in Indian Rupee terms, this increase has been over 500% during the last 20 years. In Pakistan, gold has seen a price increase of over 230% during the last 7 years alone. And this was during a period when the investors’ confidence in the global financial system was firm and not as shaken as it is today. Gold is unique because it is both a commodity and a monetary asset. Its tendency to move independently and not be influenced by external factors in the same way as other markets is rooted in its supply and demand dynamics. More specifically, the geographic and sectoral diversity of gold demand helps insulate the precious metal from western economic cycles. Rozanna Wozniak, Investment Research Manager, World Gold Council commented: “We are not surprised by the way gold has reacted. The gold price initially dipped slightly in the wake of this week’s financial market problems, because it was acting as an insurance policy and coming to the aid of stricken investors or holders and being sold accordingly. With the cataclysmic downfall of a financial institution that was seemingly indestructible, investors around the world are on tenterhooks for the next piece of bad news. In just one day we have seen 6 per cent increase in GLD, the world’s largest gold ETF, up from 614 tonnes to 650 tonnes. This follows evidence of widespread physical buying in key gold markets around the world. Gold, as no one’s liability, is looking like a good place to be right now.” In addition to gold’s safe haven attribute, the World Gold Council notes that despite the recent decline in the oil price, inflationary pressures in many parts of the world remain significant. Gold is seen as a RECENT EVENTS World Gold Council issues update on gold’s response to financial market turmoil 18 September, 2008 | The gold price rose $50 today to $863/oz at the PM fix, the largest one day rise since February 1980, as investors took a ‘flight to quality’ to protect their wealth from the corrosive effects of the current uncertainty that has spread throughout financial markets across the globe. Like all physical commodities, gold is an asset that bears no credit risk and therefore involves no counterparty and is no one’s liability. ENLARGE For a broader range of volatility statistics >> Page 3 AHSON TARIQ ahson.tariq@aabaig.com hedge against inflation; while its real value can vary in the short term, its purchasing power has remained stable over centuries. These short-term factors have, however, occurred on top of longerterm movements in supply and demand fundamentals that have supported the rise in the gold price since 2001:  Mine output. The gradual reduction of mine output in recent years, with only a small number of major gold finds by the mining industry, is constraining supply. The cost of extracting gold has also increased substantially in recent years.  Jewelry demand. Robust global jewelry demand reaching $54bn in 2007, a third successive annual record. In tonnage terms, overall jewelry demand in 2007 was 5% higher than in 2006  Both institutional and retail investors are increasingly familiar with gold’s portfolio diversification benefits. The reason for holding diverse investments is to protect the portfolio against fluctuations in the value of any single asset class or set of assets that move in a similar direction. Portfolios that contain gold can be more robust and better able to cope with market uncertainties than those that do not.  Easier access to investing in gold. Gold exchange traded funds (ETFs) have been instrumental in providing easy access to investing in gold. ETFs have stimulated demand because it has become as easy to trade gold as it is to trade any stock or share. Gold coin sales halted after retail rush www.ft.com September 25 2008 | The rush by retail investors into gold on Thursday forced the US government to "temporarily" suspend the sales of the popular American Buffalo oneounce bullion coin after depleting its inventories. The shortage of gold coins is the latest sign of investors seeking a safe haven into bullion amid Wall Street woes. Gold prices this week surged above $900 an ounce, up about 20 per cent from its level before the collapse of Lehman Brothers. Gold set to cement safe haven status http://www.ft.com/cms/s/0/9d0022 28-8eb9-11dd-946c0000779fd18c.html?nclick_check=1 September 30 2008 | Gold prices will rise next year as the financial crisis pushes more investors into the precious metal safe haven, according to delegates polled on Tuesday during the London Bullion Market Association annual meeting in Kyoto. The gold industry forecasts bullion prices at about $958.6 a troy ounce by November next year, according to the annual LBMA poll among delegates. The poll, which has been a reliable indicator in the past, compares with current prices just above $902. Last year, LBMA delegates gathered in Mumbai correctly forecast gold prices surging to record levels and predicted that by September 2008 prices will be at about $840 an ounce, almost the correct level just ten days ago. Jeremy Charles, the LBMA chairman, told delegates that gold's role as a safe haven has returned as a vengeance amid Wall Street's woes. "High bullion prices are here to stay," he said. His bullish comments came as many delegates said they forecast gold prices in 2009 in a $700 to $1,200 an ounce range. Gold prices hit an all-time high of $1,030.80 an ounce earlier this year. Some delegates, however, said that while they were bullish on gold prices on the short-term because investors seeking refugee and forecasted prices as high as $1,000 an ounce, also warned that it was unlikely that record prices could be sustained during a long period as jewelry demand was likely to suffer. The majority of the LBMA's delegates – a mix of about 500 mining executives, precious metals traders and brokers, bankers, consultants and central bankers – said that the US dollar will be weaker by November 2009 than today. The majority – a 56 per cent – said the financial system will be in a better shape. A minority 21 per cent said the crisis will worsen in the next 12 months, while a 23 % said the crisis will be basically as bad as it is today. Page 4 AHSON TARIQ ahson.tariq@aabaig.com Mr. Charles, who is also head of precious metals at HSBC in London, said that investors were returning to gold as confidence in the US dollar and some assets classes was shaky. He said that the change was likely to be a structural change, rather than a short-term phenomenon that will fade away with calmer markets. "Gold will be looked in a different way even when the credit crisis ends," he said. Jonathan Spall, head of commodities sales at Barclays Capital, added that the gold market was witnessing a "sea change" as bullion was attracting new players, such as hedge funds, that previously considered the metal as a relic. "Hedge funds see those days gold a much interesting place to be in," Mr Spall said. Bankers at the Kyoto's meeting said spooked investor were so deeply worried about the stability of the financial system, that rather than just investing in gold, they were placing their money into physical gold, taking delivery of bullion bars and coins, placing their investment outside the financial system. "Vault staff is doing a lot of overtime this weeks," a banker said. How to Invest in Gold COINS AND SMALL BARS The first gold coins were struck by King Croesus, ruler of Lydia in western Asia Minor from 560 to 546BC, whose wealth came from the gold from the mines and sands of the River Pactolus. Gold coins have been legal tender ever since. Bullion coins and small bars offer private investors an attractive way of investing in relatively small amounts of gold. In many countries - including the whole of the European Union gold purchased for investment purposes is exempt from Value Added Tax. between coins and dealers. The premium tends to be higher for smaller denominations. Bullion coins range in size from 1/20 ounce to 1000 grams, although the most common weights (in troy ounces of fine gold content) are 1/20, 1/10, 1/4, 1/2 and 1 ounce. It is important not to confuse bullion coins with commemorative or numismatic coins, whose value depends on their rarity, design and finish rather than on their fine gold content. Many dealers sell both. For more information, visit http://www.islamicmint.com Small gold bars Gold bars can be bought in a variety of weights and sizes, ranging from as little as one gram to 400 troy ounces (the size of the internationally traded London Good Delivery bar). Small bars are defined as those weighing 1000g or less. According to industry specialists Gold Bars Worldwide, there are 94 accredited bar manufacturers and brands in 26 countries, producing a total of more than 400 types of standard gold bars between them. They normally contain a minimum of 99.5% fine gold. The Gold Bars Worldwide website provides a wealth of additional information regarding the international gold bar market. Bullion coins Investors can choose from a wide range of gold bullion coins issued by governments across the world. These coins are legal tender in their country of issue for their face value, rather than for their gold content. For investment purposes, the market value of bullion coins is determined by the value of their fine gold content, plus a premium or mark-up that varies Page 5 AHSON TARIQ ahson.tariq@aabaig.com EXCHANGE-TRADED GOLD Gold-backed securities Gold is traded in the form of securities on stock exchanges in Australia, France, Hong Kong, Japan, Mexico, Singapore, South Africa, Switzerland, Turkey, the United Kingdom and the United States. By design, these forms of securitized gold investment, all regulated financial products, are generally referred to as Exchange Traded Commodities or Exchange Traded Funds (ETFs), and are expected to track the gold price almost perfectly. Unlike derivative products, the securities are 100% backed by physical gold held mainly in allocated form. These securities have had a major impact on the gold market, representing 38% of identifiable investment and 7.5% of total demand in 2007. Financial advisors and other investment professionals can provide further details about these products. Gold accounts Gold bullion banks offer two types of gold accounts - allocated and unallocated: Allocated account Effectively like keeping gold in a safety deposit box, this is the most secure form of investment in physical gold. The gold is stored in a vault owned and managed by a recognized bullion dealer or depository. Specific bars (or coins, where appropriate), which are numbered and identified by hallmark, weight and fineness, are allocated to each particular investor, who pays the custodian for storage and insurance. The holder of gold in an allocated account has full ownership of the gold in the account, and the bullion dealer or depository that owns the vault where the gold is stored may not trade, lease or lend the bars except on the specific instructions of the account holder. For more details visit www.goldmoney.com Unallocated account Electronic Currencies | E-Dinar There are also electronic 'currencies' available - linked to gold bullion in allocated storage which offer a simple and costeffective way of buying and selling gold, and using it as money. Any amount of gold can be purchased, and these currencies allow gold to be used to send online payments worldwide. What is e-dinar? Investors do not have specific bars allotted to them (unless they take delivery of their gold, which they can usually do within two working days). Traditionally, one advantage of unallocated accounts has been the lack of any storage and insurance charges, because the bank reserves the right to lease the gold out. Now that the gold lease rate is negative in real terms, some banks have begun to introduce charges even on unallocated accounts. Investors are exposed to the creditworthiness of the bank or dealer providing the service in the same way as they would be with any other kind of account. As a general rule, bullion banks do not deal in quantities under 1000 ounces - their customers are institutional investors, private banks acting on behalf of their clients, central banks and gold market participants wishing to buy or borrow large quantities of gold. Other opportunities for smaller investors include: e-dinar is the name of an internet based electronic payment and exchange system that facilitates online transactions 100% backed by physical gold and silver. e-dinar and e-dirham are the electronic units used within the e-dinar system. Each e-dinar electronic unit corresponds to an exact, fixed weight of 4.25 grams of pure 24k gold. Each e-dirham corresponds to an exact, fixed weight of 3 grams of .999 silver. These units are infinitely divisible thus allowing large as well as very small transactions. The physical gold and silver bullion backing e-dinar and edirham units are always equivalent or larger than all electronic e-dinar and e-dirham in circulation. The physical gold and silver bullion is held securely in internationally renowned bullion repositories. Transactions are executed using e-dinar and e-dirham units and, Page 6 AHSON TARIQ ahson.tariq@aabaig.com as a rule, do not result in physical movement of gold or silver in the bullion repository. The exceptions are large transactions of at least USD 150,000 where gold bars are physically moved between pallets. Account holders always have the option to exchange their e-dinars and e-dirhams into any major national currency or redeem them and take physical possession of an equivalent amount of gold dinar and silver dirham. For further details, please visit www.e-dinar.com Gold Accumulation Plans Gold Accumulation Plans (GAPs) are similar to conventional savings plans in that they are based on the principle of putting aside a fixed sum of money every month. What makes GAPs different from ordinary savings plans is that the fixed sum is invested in gold. A fixed sum of money is withdrawn automatically from an investor's bank account every month and is used to buy gold every trading day in that month. The fixed monthly sums can be small, and purchases are not subject to the premium normally charged on small bars or coins. Because small amounts of gold are bought over a long period of time, there is less risk of investing a large sum of money at the wrong time. At any time during the contract term (usually a minimum of a year), or when the account is closed, investors can get their gold in the form of bullion bars or coins, and sometimes even in the form of jewelry. Should they choose to sell their gold they can also get cash. Reference Material:  Short-run and Long-run determinants of the Price of Gold by Eric J Levin and Robert E Wright, 2006  Inflation Protection: Why Gold Works better than 'Linkers' by David Ranson, 2005   Gold as a Store of Value by Stephen Harmston, 1998 Gold as a Strategic Asset by Richard Michaud, Robert Michaud, Katharine Pulvermacher, 2006   Investing in gold: The Strategic Case by Natalie Dempster Digital Gold Currency Resources      What sets the precious metals apart from other commodities? by Rhona O'Connell, 2005 Why is gold different from other assets? An empirical investigation by Colin Lawrence, 2003 Gold as a Hedge against the US Dollar by Forrest Capie, Terence C Mills and Geoffrey Wood, 2004  Commodity Prices and the Influence of the US Dollar by Nikos Kavalis, 2006 Digital Gold Currency Online Magazine - e-dinar Issue Malaysia-Based Mint for e-dinar All gold related figures and stats were taken from World Gold Council’s website www.gold.org Registration at www.gold.org is necessary to access and download the above PDF files, which is free and involves a five-minutes process. Page 7 AHSON TARIQ ahson.tariq@aabaig.com Disclaimer - Whilst every effort has been taken to verify the accuracy of this information, I do not accept any responsibility or liability for reliance by any person on the information, opinions or conclusions contained in this document. 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