Gold investment? Better than FDs!

Thought to be one of the first known metals, gold has been coveted throughout history for its beauty, scarcity, malleability, and uncanny resistance to rust and corrosion. Centuries ago, gold's unique combination of properties -- its sun-like colour, its soft hardness, and, especially, its imperviousness to decay and corruption -- imbued it with magical associations in the eyes of many.

Because of these unique properties, gold has traditionally been the currency of choice for much of the world's population. The value of gold has transcended all national, political, and cultural borders, making it the ideal currency.

Historically gold prices were determined by a combination of political and economical factors, till a universally acceptable concept of London and American gold price was institutionalised. An outcome of such initiatives was the Washington Agreement. However, in the past few years, the major factors impacting the gold price can be summarised as under:

• Weak US dollar
• Growth in demand for jewellery
• Increase in demand for exchange-traded paper backed products

Weak US dollar

Projections about a declining dollar due to an ever-increasing twin deficit supported by many investment veterans are met by much denial from politicians as well as from investors.

As long as foreigners are willing to pour in the amount of $2 billion every working day, the dollar won't crash. But if foreign confidence were to wane, the US dollar will be heading south.

No matter how you look at the US twin deficits and America's future fiscal liabilities, this problem is huge and some painful adjustments not only seem to be necessary but unavoidable as well. It should be obvious that one of these major painful adjustments will be a massive devaluation of the US dollar.

It seems that the idea of a dollar devaluation is gaining support from the Fed when the president of the Dallas Fed, Robert McTeer recently said: "Over time, there is only one way for the dollar to go -- lower."

Former ECB president Wim Duisenberg, quoted by Spanish Newspaper El Pais, recently said: "A dollar devaluation seems inevitable due to the tremendous US Current Account deficit." Furthermore he recently said on Dutch television that we can only hope and pray for a smooth economic transition in the US.

Why is this so important? Simple, the US dollar is the key driver for gold; as the dollar goes, so will gold; but in the opposite direction. Gold is the anti-dollar with a high inverse correlation to the dollar!

In the end, gold is still a monetary asset and trades like a currency.

Growth in demand for jewellery

In spite of the convergence of diamond and palladium, the demand for gold jewellery has seen a regular growth year-on-year. Countries primarily responsible for this growth are India, China, Italy, Turkey and the USA.

The demand for consumption of gold in jewellery was 6% higher at 735 tonnes and also comprised a new first-quarter record. The US, which accounts for 10% of world gold demand, is also one of the markets where public taste in gold jewellery is enjoying a renaissance.

The renewed interest in gold also extends to Japan, a market which showed a 19% increase in demand. The Indian market -- the world's largest for gold demand -- was 23% higher following the marriage and festival period which, in turn, has led to restocking by retailers.

The earthquake in India, however, is unlikely to hit demand significantly as it occurred in an area which comprises only 5% of the total Indian consumption. There were sharp falls in demand in Turkey and Taiwan -- down 38% and 31%, respectively. This was due to economic difficulties and continued weakness in investment demand.

Increase in demand for exchange traded paper backed products

For the first time in history, gold can be purchased like any listed stock at select stock exchanges of the world like London Stock Exchange, Australian Stock Exchange (Gold Bullion Securities) and New York Stock Exchange (StreetTracks Gold).

The World Gold Council initiated Electronic Traded Funds have displayed very good performance and growth in volumes since launch.

If we analyse the track record of gold in the past three years, we can conclude that gold prices have seen a steady and impressive northward growth.

In January 2002, gold prices per 10 gm stood at Rs 5,453. By November 2004, the price had gone up to Rs 7,005. The year 2004 has indeed been a great year for gold.

There has been a substantial increase in gold prices, but this has not dampened consumers' inclination towards investments in gold. In fact, investors have begun to recognise the effectiveness of gold as an efficient savings vehicle and an alternate asset class.

The graph below is indicative of the quarterly price of gold in Indian rupees per 10 grams from November 2002 to November 2004 showing the upward movement.

The following table gives us the all-time high gold prices touched in the period, Jan 2000 to Nov 2004.
All time high

In 2004, gold prices saw a slight dip in April 2004, only to pick up again in July 2004.

Globally, the price of gold has historically been impacted primarily by the US dollar. However, in the past few years, oil prices, the US dollar and the demand-supply equation for gold have become equally significant contributors to the price of gold.

Gold as investment

Demand for gold for the purpose of investment has outpaced the demand for the yellow metal for jewellery in 2004. Indians purchased 74.0 tonnes of gold for investment from January to September 2004, while it was 67.8 tonnes during the same period in 2003.

While the advantages of having gold in an investor's portfolio has been talked about time and again, 'what should be the amount of investment' is always a question asked by the investors. There are two schools of thought on this subject. The recommendations are in the range of a 15% to 20% allocation of the total portfolio.

• 15% of the investment portfolio -- European Central Bank decision at the time of establishment in 1999 based on internal studies.
• 20% of the investment portfolio -- Based on a model done by Germmill & Hillman on 20 years data.

Ideally, however, allocation to gold from an investment perspective should be based on comprehensive financial planning.

It should always be remembered that investment in physical gold must always be in the form of coins/bars and should be in addition to the jewellery held by the household. Advantages of gold in a portfolio can be explained through the following points:

• Gold has a low to negative correlation with most other asset classes.
• An investment portfolio with an allocation to gold improves the consistency of portfolio performance during both stable and unstable periods.

• The price of gold is not linked to the performance of economy, industry or companies.
• Gold offers the benefit of diversifying portfolio risks.

Let us consider an example where an investor invests Rs 10,000 each in various options like equities, fixed deposit, PPF and gold in March 1999.

Let us see what the returns are in each case, taking the deposit period 1999 to 2004 into consideration.

In gold, by March 2004, his investment would have fetched him Rs 15,063, a substantial increase.

The money invested in PPF would have grown to Rs 16,025 by March 2004. A fixed deposit of the same amount would have yielded Rs 13,794 by March 2004. (Refer to the data below for varying interest rates)

By March 2004, his investments in equities for the same amount would have become Rs 18,916. This is provided the investor had remained invested in the market throughout the five years, even during periods when the Sensex saw huge downward movements.

Cost efficient ways of investment in gold internationally

Owning gold has been possible over the years in the form of mutual funds or stocks of gold mining companies. However, investors have been awaiting a more cost effective platform for owning gold.

The World Gold council recognized this fact and launched the following ETF gold products across the world.

Gold Bullion Securities

For the first time in history, gold was made available at the stock exchange just like an equity share to the investors through a World Gold Council initiated ETF product called Gold Bullion Securities.

Each share of Gold Bullion Securities (GBS) is equal to 1/10th of an ounce of gold and is supported by physical holding of gold in the custody of HSBC.

This is the first time ever that a metal has been listed on an international Stock Exchange and can be conveniently traded or invested by institutional investors as well as individuals. GBS is listed on the London Stock Exchange and also the Australian Stock Exchange.

At present GBS is the most cost efficient way of investing in gold, as a potential investor has to only pay 0.3% p.a. as management fees, which includes the cost of storage and insurance apart from the 'brokerage' that they have to pay to the brokers.

Street TRACKS Gold Shares -- ETF Gold fund on NYSE The first US exchange-traded fund that tracks the price of gold, called Street Tracks Gold Shares, was launched on the New York Stock Exchange in November 2004. This is the first ETF in the US that will track a commodity.

It is designed to give investors the opportunity to invest in gold without requiring actual custody of the metal, which can be expensive. The ETF is expected to attract both institutional and individual investors who are looking for a hedge against inflation and currency exchange rates, or for diversification.

It is sponsored by the World Gold Council and marketed by ETF provider State Street Global Markets. Each share will represent one-tenth of an ounce of gold bullion as priced by the London Bullion Market Association. The 2.3 million shares trade under the ticker symbol 'GLD.'