Buying and investing in gold

There are 8 different ways to buy and invest in gold:
1- Bullion coins and small bars,
2- Big bars,
3- Mining shares,
4- E-gold,
5- Futures,
6- Gold Backed Securities,
7- Gold Pool Accounts,
8- Jewellery.

This article looks into the respective advantages and disadvantages of each type of gold investment.

Bullion coins and small bars

Gold coins come in two general classifications (i) numismatic coins and (ii) bullion coins. A numismatic coin has a price which doesn't relate to its bullion value so much as rarity and desirability for collectors. A bullion coin, on the other hand fairly accurately shadows the bullion price. Small bars behave similarly to bullion coins.

Advantages of bullion coins and small bars:

• Coins and small bars are generally a liquid market, so you can find sellers and buyers when you need them.
• They are relatively accessible to smaller investors. Coins in particular can be bought with modest amounts of money (while bars of 1 kilo start at about $12,000)
• Coins are mostly recognisable, which makes them exchangeable for goods in some circumstances. This monetary characteristic makes them attractive to people who want to take possession of gold as a means of surviving a catastrophe. It doesn't work always as they hope.
• Genuine coins have the added endorsement of a government mint which provides a level of guarantee.

Disadvantages of bullion coins and small bars:

• The local custody problem. It is often the case that when gold becomes really valuable gold coin usage is made illegal by governments, or is so heavily taxed and constrained that it is nonsense to use them 'above the counter'.
• There are fakes, and these are usually only spotted by dealers, although there are tools which might help the less experienced. Dealers rate themselves at spotting fake coins from their surface, but because bars are generally bigger than coins they can be 'drilled out'. This obviously illegal activity leaves the serial numbered bar skin behind and fills the interior with an alternate, like lead. This has a consequence on resale, even by the innocent. The dealer may not trust assay marks on bars which have been in private hands, and may require an analysis before payment. Even where the bar is perfectly sound it means the seller may still end up having to pay for the refining.
• Next to most types of investment the difference between buying and selling price is significant. On the face of it this can cost 7%, but the reality is usually worse. Demand tends to come in waves, with the market producing a surfeit of buyers or a surfeit of sellers at any given time. With a wide spread to play with the dealer will shade high when most customers are buyers, and low when they are sellers. For example an international incident which encourages gold buyers might set the underlying bullion price at $400 per ounce and encourage buyers. The normal 7% differential indicates a $28 spread, but instead of being centred on the $400 mark the dealer anticipates demand and makes a spread of $396 - $424. When things calm down and people liquidate their hoards the spread, even on the same underlying $400 bullion price, will shade to the low side, and the dealer will make a price of $376 to $404. It appears to be a $28 spread, but the result of being predictable will be an effective spread for the significant majority of £376-$424, which is 12.8% rather than 7%. These sorts of spreads greatly diminish the probability of worthwhile profits to the investor. (Although note the considerable advantage for those who trade against the crowd and enjoy a 2% spread.)

Coins and small bars can be an appropriate gold investment method for sums from $100 to $10,000 especially for people whose view is long term and for whom physical possession is all. In this range it would be typical to suppose dealing costs, delivery and ownership costs in the 10-15% range overall.

Big bars

The world's professional gold market trades 400 toz bars, equivalent to about 12 kilograms a piece. Big bar trading is reserved for big companies and institutions. It is competitively priced but inaccessible to the private investor.

Advantages of buying big bars:

• Big bars are a deep and liquid professional market.
• The bars are serial numbered, and usually do not leave the security of industrial strength vaults. Within the LBMA's chain of integrity fakery appears to have been completely eliminated.

Disadvantages of big bars:

• The bars cost a cool $160,000 each at $400 per toz. This is not an easily managed investment for most individuals. In fact to benefit from the truly competitive levels of the professional market 1 bar is insufficient. For most professionals the smallest trade size the markets will consider exceeds $500,000.
• The professional market trades 'Over The Counter' for physical delivery, and the costs of delivery and storage have to be borne by the investor.
• OTC trading can make price discovery difficult. Access to competitive and simultaneous market pricing is restricted to those with financial sector data feeds.

Gold mining shares

Shares in gold mines are a popular way of investing in gold.

Advantages of gold mining shares:

• The advantage of investing in a gold mine's shares is that its value is much more sensitive to the price of gold than even a gold bar. This is because gold mines are valued on the basis of their anticipated cashflows through the life of the mine, and these depend on the on the reserves, and on the relationship between production costs and the anticipated value of the gold extracted. Suppose a mine has 1,000,000 ounces underground and the above ground value is $400 per ounce. If the production cost is $300 per ounce the mine will make $100,000,000 over its life. But if the gold price rises by 25% to $500 the mine will make $200,000,000 overall. This demonstrates a 'gearing' effect of four times, i.e. for a rise in bullion of 25% the share will rise by 100% (all other things being equal). Of course the flip side means that these gold shares would fall four times as quickly on a falling bullion price.

Disadvantages of gold mining shares:

• The quantity of a mine's reserves is never accurately known. Reserves (and their poor relative 'resources') are assessed by miners' core drilling programs which sample a prospective gold seam to measure gold concentrations in the rock. The amounts discovered in chemical analysis are extrapolated over a wider area to identify the likely reserve amount overall, but there is no guarantee it will be found in mining. Consequently there is a risk that recorded reserves do not reflect reality. Human nature gets in the way of accurate sampling, especially in companies whose function is principally exploration rather than the operation of mines. Prospectors raise money by encouraging investors that there is gold underground, and although a great deal of effort may be made to keep the process honest you only have to overlook a couple of poor rock samples (let's just call them damaged) to manipulate the likely reserves upwards. In the end the investor must trust both the geologists and the company's financial controller, both of whom may have to make the occasional fine judgement. It is almost always in their interest to err on the side of optimism. A pessimistic outlook rarely got a mine built.
• There can also be unforeseen engineering problems in extracting ore. These can increase the production costs, and only small percentage increases can eat into the mine's profitability.
• Another issue is that the costs of the mine can be borne in a currency other than dollars, the trading currency of the output. Exchange rate movements can greatly affect mine profitability by creating currency translation adjustments, both profits and losses.
• Perhaps the greatest variable is shareholder sentiment. Because of the wide attraction of gold shares in good gold markets the shares tend to greatly outperform not only gold, but also any reasonable valuation of the mine's future cash-flow. Investors are often not familiar with the yield numbers they should expect on a mine compared with say a supermarket, because whereas there is no reason that using a supermarket will wear it out, the mine certainly will be worthless within a few years, once its ore is gone. So the return on a mine must pay back both the original investment and provide some profit during its life. A 20 year lifetime mine must yield in excess of 5% per annum before it makes any profit for the long-term investor at all. Few mining shares can do this, so in effect the share price of many mines already discounts a substantial bullion price improvement.
• Corporate culture is another problem. These days many companies (not just mining companies) are run more for the benefit of their managers than their shareholders. Many managers don't like paying dividends because it diminishes the cash pile remaining for staff salaries and new corporate adventures, like exploration or takeover activity. Very few mining companies could be accurately described as vehicles for the straightforward exploitation of underground ores in the interest of shareholders. Instead the assets can become the playthings of boards of directors whose best interest tends to be served by punting shareholders' money on opportunities which are sufficiently credible to grant a possible future beyond the current working mine's life. In the absence of strict and generous dividend policies shareholders in gold mines are investing in the strategic competence of their board at least as much as in gold.

Gold shares are potentially risky but simultaneously an exciting investment. They tend to be reasonably correlated to gold prices but typically much more volatile, and subject to many variations which are independent of bullion market forces.

Mining shares might be considered an appropriate gold vehicle investment for sums from $5,000 range upwards, but investors should remember the gearing and invest appropriately less than they would in bullion. Buying and selling costs vary from market to market. Not uncommon is a spread of 2% (lower for the bigger mining companies) and transaction costs of 1-1.5% each way. Combined, the trading costs would amount to up to 4-5% of the capital cost for each investment undertaken.

E-Gold

The internet spawned e-gold. The basis of e-gold is that international debts, and even some domestic debts, can be paid more efficiently in gold than in foreign currencies, which have to be converted back into host currency through the bank. So wherever a supplier and a customer both have an e-gold account they can transfer ownership of gold between themselves across the internet, and this constitutes payment.

To get started you use your own currency to buy grams of gold. The gold is delivered into a depository, and is credited to your own e-gold account. You then get a secure internet identity, and thereafter you can instruct your e-gold provider to debit your e-gold account in favour of your supplier - another account holder in the system. Whatever you have bought from them is delivered to you independently. It is primarily a payments system, but it doubles as a route for owning and storing gold.

Advantages of e-gold:

• The great virtue of the system which sets it apart from our national currencies is that at all times the number of grams credited to all accounts is guaranteed to be exactly the same as the number of grams in the depository. It is to all intents and purposes a private currency system based on the gold standard.
• You do not have to spend your gold grams. You can sit on them, in which case you are using the system not as a payments mechanism but as a store, and you can then sell the gold back in return for straight cash (usually this is done through a liquidity provider, not to the e-gold provider itself).
• You can buy small amounts of gold at relatively economic prices - well below the costs of coins and small bars
• The costs are competitive on larger holdings too.
• You benefit from an unallocated share of an allocated quantity of gold. This mixing of the two statuses of stored gold sounds as if it offers what really counts - which is 100% backing of positions with stored metal.
• The custody charge is very competitive under normal circumstances. E-gold has turned out to be a convenient payment mechanism for ebay (the internet's highly successful auction system) because it offers rapid guaranteed payment without all the sellers' overheads and expenses of credit cards. This makes it work very well for once off sellers who want quick, sure, electronic settlement. Because of its use as an ebay payments mechanism it has a large number of users with tiny amounts of gold, so it has opted for a fixed price custody service at an incredible $1.30 per month - including insurance. This pricing subsidises the very few serious gold investors who use it, and they can currently get a great deal; storage and insurance for $500,000 of gold for $16 a year! Unfortunately they tend to reserve the right to charge on 'commercial quantities' - whatever that means. In effect they are just covering their backs against a sudden rush of volume hoping to benefit from the cheap custody.
• If you have a foreign currency bank account this may well provide your cheapest way of currency conversion. Banks can be very expensive because they charge such a high FX trading spread. Here the service may allow you to buy gold for your home currency and sell it for your holiday money. With an overseas bank account this may be your cheapest way of getting money into it.

Disadvantages of e-gold

• The main disadvantage of e-gold is the inevitable up-front load. For new customers the load may start at 3% and diminish to 1.6% - (the 1.6% rate is for trades over $100,000). Even on those large quantities of gold that amounts to $6.40 on a $400 ounce, which makes the product look expensive next to futures. In theory this would be paid back over several years of cheap storage, but it is unlikely the cheap storage is sustainable if serious investors start using this service in any volume.
• There is a degree of intermediation in the holding. Your gold is the legal property of trustees who have a fiduciary duty to you. This appears to be a reliable mechanism in normal circumstances but is still not quite the same as outright ownership.
• The system was designed for payments, and in order to make it acceptable for suppliers outward transfers may not be repudiated. The system's direct competitors - visa, mastercard etc - are very big and can offer suppliers guarantees about payment which do not necessarily mean that customers forfeit all rights after a payment has been correctly initiated. The e-gold providers perhaps do not feel big enough to wear the risk of customer repudiation, so the gold holder ends up wearing the risk of an unauthorised payment being made out of his account. The worrying element of that is the relative ease with which serious hackers can break internet access (using such devices as keyboard grabbing software).
• The providers are not especially liquid. If you want to buy a serious quantity (1kg in one case) they may deny you immediate execution. This means you must wait until the following day's gold 'fix'. You might well miss your intended dealing price.
• There may be some obscure charges. For example, your right to exit at the 'spot' price is not altogether clear because the spot is itself unclear. There is no central spot price for gold. Similarly there may be charges for sending money in and out.
• There is a custody charge, (but it includes insurance, and is so low that it has been included in the advantages section)

This is a useful internet way of owning real gold. Although the up-front costs are significant they may pay themselves back - particularly if you are going to hold gold for a considerable period. Through the custody charging policy alone it makes for a cost-effective long term reserve against calamity. Some of the providers allow you to freeze an account. This is a useful extra facility which allows you to be a bit more relaxed about the internet access issue.

Gold Futures

Gold futures are a sophisticated financial product and have been described in some detail in the gold futures section of this site. This small section summarises what was said there.

Advantages of gold futures:

• For traders who don't want custody it eliminates the hassles and costs of settlement and storage. This significantly reduces costs.
• Investors need much less money to participate even in quite large scale. Futures are 'margined'. In effect you don't have to pay for what you buy when you buy it, and if you sell reasonably quickly (i.e. usually within a month or two) you will never pay for all the gold you bought. Instead you will pay about 2% of the value up front, and any profit or loss will be adjusted on your down-payment and paid back to you net.
• You can short sell. Provided you buy an equivalent contract back before the contract expires you will have been able to profit from a falling price. This can only be done on spot markets with great difficulty, because it requires a seller to borrow gold for delivery, which is next to impossible for retail investors.
• The market is deep and liquid.
• It is quite easy to track the true worth of your futures contract by following the exchange price.

Disadvantages of gold futures:

• Artificially volatility. Futures have to be closed out periodically, usually every three months, and at these times trading is suspended in the current contract. In the final run up to suspension trading becomes a difficult game of 'chicken', with high volatility, which can be extremely painful for people who do not have the privilege of being on the floor of the exchange.
• Futures contain a built in price differential which can obscure their true value. When gold is cheaper to borrow than cash the futures price is higher than the spot price. By how much depends on the market's view of interest rates for cash and gold in the period between buying and suspension. Predicting this is not straightforward. In reality you can usually assume that market arbitrageurs have done the job on their computers and have removed any value differential. What investors need to understand is that if they buy a future at $1.50 above the spot price 30 days ahead of suspension then the value of that future will fall out at about 5 cents a day for the next 30 days.
• Credit risk. This is the risk of default during the period from trade to future settlement date - leaving someone entitled to a profit but unable to collect it. Almost all futures traders are unconcerned by this risk, but it is material and gold buyers as a breed are aware of it. The issues are discussed in detail in the gold FAQs.
• Automatic instability. With all futures (not just gold) a rapidly falling market will force selling, which further depresses the price, while a rapidly rising price forces buying which further raises the price. Either scenario has the potential to produce a runaway spiral. This is manageable for long periods of time, but it is an inherent danger of the futures set-up. The same phenomenon of structural instability was paralleled in 1929 by brokers loans.
• The stop-loss. The stop-loss sounds like a great idea and is offered and encouraged by many brokers for reasons of safety. But it can work profoundly against the interest of the investor.

Seeing where the costs are in futures trading is not easy to do. A $10,000 margin down-payment could probably finance a notional $500,000 gold future purchase, and transaction costs would be very small. But the position would be very thin on margin, and even a touch of weakness in the gold price would see the $10,000 lost.

A more conservative approach would allow some tolerance of a market moving the wrong way. If a $10,000 down-payment financed a $100,000 position successfully for a year the costs assimilated over the period would include the commissions (four sales and four purchases) 4 trading spreads on a notional $100,000 position, and the loss of interest on the margin. On the most generous interpretation this will cost about $1,000, i.e. about 1% of the notional principal but a high 10% of the down-payment. After adding the marked effects of predictable volatility as the contracts are rolled forward, and the depleting differential between the spot and futures prices, the trading costs could be significantly higher. Above all do not be fooled into thinking you are saving the cost of financing the trade. It's in that depleting price.

For investors who are prepared to underwrite for a short period the systemic risks of derivatives gold futures remain a sensible and cost effective way of executing a short term gold punt.

Gold Backed Securities

These are a relatively new innovation. They aim to combine the benefits of physical gold bullion with the liquidity and infrastructure of traditional securities market. Currently they are available in Australia, London and Canada, in slightly different forms.

To create a gold backed security a company is set up which has the right to issue a paper instrument which can only be issued in direct proportion to gold deposited in a vault. The securities are then traded on a normal stock exchange, or by a broadly equivalent market mechanism.

The price of those securities actually reflects only supply and demand for the shares themselves in the relevant market for the securities, but this will tend to shadow bullion because there is usually a right of redemption, allowing them to be surrendered in return for the gold which backs them. There will be a fee for redemption which is fixed, and relatively high to prevent lots of nuisance redemptions, but it allows market professionals to leave a bid on the exchange consistently near the value of the gold. In the absence of other bidders they will pick up securities which can eventually be redeemed profitably. This tends to hold the security price at or near bullion value.

Advantages of gold backed securities:

• Gold backed securities are close to owning bars in a vault. The bars should be stored on a proper allocated basis, which means they are not lent or made subject to any form of derivative transaction.
• There is an accessible market for relatively small investments, certainly more accessible than true bullion.
• The dealing spreads are considerably lower than coins and small bars. Typically they are 0.5%.
• The custody problem is resolved. A professional vault is used to store the gold, and this is statistically much safer than any form of private storage.

Disadvantages of gold backed shares:

• There is a degree of intermediation in the ownership of the gold. Although the shares confer a right on the gold it is neither owned by the investor nor in his possession. Technically the gold is owned by the trustees whose duty it is to defend the entitlement of the beneficiaries under the trust. The legal position is that even though it is properly allocated the entitlement to bullion still rests on the trustees' promise to pay, and on the custodians ability to do so.
• Of course trust arrangements cost money to set up and to keep running, and this manifests itself in a steady depletion of the amount of gold which underpins the investment. The gold backing is removed via a monthly management charge.
• Although the dealing spreads are smaller the brokers in a stock exchange tend to remunerate themselves with commissions - absent when you trade direct with a gold dealer. Commission levels vary widely from stock market to stock market, and from broker to broker. Sometimes they can be flat fees and suitably small, but these tend to be on internet dealing sites, where deals are done automatically at what is known as 'best price' but which is really best quote, which is often less attractive than on a parallel order board.
• Some stock exchanges impose extra charges on each transaction. In the UK, for example Stamp Duty applies, which levies an additional 0.5% on each purchase. Other levies may also apply.
• Some of the advantages of private investment in shares, like tax shelters, are not applicable to securities whose purpose is to act as asset stores.

Gold backed securities have a lot to recommend them. The security of gold seems more solid than the margin based security which underpins futures. They do not incur the periodic volatility inherent in futures. The custody charges, although still quite high, are generally lower than other forms of custody available to medium sized investors and the transaction costs are consistent with stock exchanges (which could be improved). On balance these are innovations which appear to encourage private gold ownership at manageable cost and with a good degree of security.

Gold Pool Accounts

Gold pool accounts allow the customer to buy a gold liability from the account provider. Effectively the customer pays cash, and the supplier treats him as a creditor for bullion which may or may not have been actually bought. Pool accounts are synonymous with unallocated gold.

The advantages of gold accounts are:

• They are relatively accessible.
• They have relatively low dealing costs, frequently there is no commission and the spreads are fairly tight, at about 1%.

The disadvantages of gold accounts are:

• Unallocated gold grants very substantial unsecured credit to the account provider and places the bullion 'owner' at material risk. The owner actually owns nothing but a promise, and unlike the bank's promise to repay there is no assurance underlying the promise that the provider is competent to operate in much the same way as a bank. Read this section for details on problems with unallocated gold.

In spite of the apparent attractions of unallocated gold [pool] accounts it is extremely hard for any serious investor to recommend them - because of the unquantifiable risks. The customer's investment rests as a liability on the provider's balance sheet and there is no obligation whatsoever on the provider to buy the gold. If there were unscrupulous individuals in the gold industry (and nothing here would suggest that there are) their natural service would be offering gold pool accounts. That way they can take customers' money and put it to work for their own profit, without even paying interest. If they make a lending mistake the gold liability will be unpayable, but probably no-one will have broken the law.

Jewellery

Jewellery is a profitable business for those who buy at wholesale and sell at retail. It also works for people who have a good feel for fashion, and the time to trawl through catalogues finding stuff which maybe they can re-sell. But it's a poor way of investing in gold.

Froom a gold investment viewpoint, jewellery has two main advantages and many disadvantages.

The advantages are:

• It is the form of gold which gives some benefit from ownership, namely the enjoyment of being worn.
• It is very easy to buy.

The disadvantages are:

• The acquisition costs are high. Retail jewellery is often marked up by 300% or more in the shops. (Note that insurance valuations are a fantasy based on replacement cost at retail. No piece can be sold at this value.)
• The real value of jewellery is in the gemstones, the design and the craftsmanship. These greatly outrank the value of the gold.
• All pieces are different and their values are subjective. If you don't have experience you probably won't know a fair value.
• It is the most easily stolen form of gold.

If you choose to invest in gold through jewellery the best advice must be to avoid the retail mark-ups as far as possible by buying at auction, where buying premiums (the fee paid to the auction room) is typically 10 - 15%. Alternatively seek out parts of the world like Dubai where it is possible to buy gold not too far from its bullion value. There, machine made chains are sometimes sold as little as 20% above bullion content. Take care though, you might find it difficult to transport in any serious quantity without tax and security implications.