Forget futures -- go back to gold's basics

By Myra P. Saefong
MarketWatch.com
Friday, July 6, 2007

http://www.marketwatch.com/news/story/story.aspx?guid=%7BB5C0738A%2D740E...

SAN FRANCISCO -- Forget gold futures and exchange-traded funds. For the individual investor, there's nothing like the "fondle factor" of bullion.

"Gold has been a physical asset for 5,700 years," said Jon Nadler, an analyst at Kitco Bullion Dealers. "The very tangible nature and high 'fondle factor' that is associated with gold has traditionally made it an investment that people tend to actually hold in coin or bar form."

So why do some investors shy away from it?

"Western thinking in gold buying implies heavy insurance costs, expensive vault construction and expensive transportation," said Julian Phillips, an analyst at GoldForecaster.com.

All of that puts people off from buying gold in its physical form, "except for the large investors who could afford such," he said.

And traders can be a bit overwhelmed by the many ways to invest in the market that has seen gold prices trading at or near the $700-an-ounce level all year.

There are "paper" representations of gold available, including futures contracts, certificates, pool accounts and exchange-traded funds, said James Turk, founder of GoldMoney.com.

They provide investors with exposure to the gold and silver price but have "counterparty risk," he said.

"You only own someone's promise to give you the metal if you ask for it, and even a cursory look at monetary history clearly shows that promises are frequently broken," he said.

On the other hand, the "physical metal does not have any counterparty risk when you own and store it safely," he said.

... Trading vs. investing

Even so, the concept of "physical" ownership is a bit more complicated than you might think.

"The physical sector tends to be one of the unique quirks limited to the precious metals complex, as the metals offer not fixed returns -- as you would expect with treasuries or equities -- and cost you money, as you have to pay insurance and storage costs," said James Moore, an analyst at TheBullionDesk.com.
And right now, "times are changing in the physical gold bullion investment market," said Nadler. Investors "who wish to acquire gold have a much larger universe of products to choose from."

Physical gold is sold in the form of bars, bullion coins and rare coins.

One "emerging trend" that Nadler observed is that U.S. and Canadian mints sold about 3 million one-ounce Eagle and Maple Leaf gold coins to global investors from 2001 to 2005.
Those are considered bullion coins, as is the South African gold coin, the Krugerrand, which Mark O'Byrne, director at Gold & Silver Investments Ltd., refers to as a "modern" bullion coin.

Modern bullion coins retail for between 2% and 4.5% over the live market spot rate for gold, so they "track the actual gold price," he said. Most small and medium investors opt for these types of coins, he said.

"They are highly liquid, but they are not meant for traders -- rather buy and hold investors and savers," he said.

Meanwhile, gold bars are a "popular way to buy precious metals in bulk," he said. "Large investors, jewelers and institutions with significant requirements generally prefer to buy larger bars."

Bars are more common in Asia and Europe, while coins tend to dominate in North America, said Nadler. "Although bars have lower premia [about 1% or 2% lower than coins], they are not nearly as easy to re-sell due to authenticity concerns," he said.

... A league of their own

Then there's the whole market of rare coins.

Bars, bullion coins, and rare coins, which are dated pre-1933, are all tangible assets, but there are "completely different thought processes" involved, said David Beahm, director of marketing and economic research at Blanchard & Company Inc.

"Investors only want to make money. Collectors want to be the only one that has that coin, the only one that has that set [and] they want to look at a wide variety of coins," he said.

"Rare coins [are a] better hedge against inflation," he said. "There's a collector aspect and an investor's aspect in rare coins."

On the downside, "once you get into special or rare coins, you have to consult coin dealers to get the different prices these fetch over and above the gold content," said
GoldForecaster.com's Phillips.

But if you look at the art market, which is a good way to gauge the rare coin market, "it has exploded recently," according to Beahm.

Bill Rummel, a coin collector and investor for decades, predicts that "all collectables are ready for ignition -- again."

"It's asset redeployment," he said. "Most people are momentum investors and don't buy until prices are much higher -- too high -- and will sell in despair near the bottom."

"Don't attempt to jump aboard a runaway train," he warned.

... Fine line

Of course, don't forget the plethora of other investing options for the precious metal.

There's the gold futures market, mining shares, ETFs that invest in gold itself and others that invest in mining companies, and custodial gold products. Some of these choices straddle the fine line between physical and paper ownership of the metal.

First, it's important to remember that gold is money and should therefore go in an investment portfolio's cash component, said Turk. And cash is "liquidity and savings."
Mining stocks are an investment and clearly go in the stock component of a portfolio, he said.

Then the question to ask yourself before you decide in which form you should buy gold is "are you a speculator, investor or saver?" said O'Byrne.

"Physical [gold] is bought for investment, saving and financial insurance," he said.

"Futures are highly leveraged instruments and are primarily the preserve of institutions and hedge funds speculating on future gold prices," he said. "Rarely are futures contracts used to take delivery."

In fact, Blanchard strongly recommends against transacting in futures contracts, which it says "exposes the individual investor to unacceptable risk."

A gold ETF trades like a stock and its worth is meant to track a percentage of an ounce of gold, according to Blanchard. "This is a method of paper trading in physical bullion."

But in an ETF, you don't own or have title to the underlying asset, points out O'Byrne. "ETFs are great for speculators and those with short-term horizons who wish to go long and go short."

"The 0.4% to 0.5% per annum administration charge, stock broker fees and stamp duty in some jurisdictions make ETFs uneconomical for the investor with a medium- to long-term investment horizon," he said.
And "mining companies are more risky than physical bullion as there is extra risk in owning a company that mines or explores for gold than owning gold itself," he said.

Meanwhile, gold custodial products can be a cost-effective way to buy and hold physical metal. GoldMoney's goldgrams represent ownership of a portion of the gold held for the company's customers in a secure vault.

"If a person wanted to buy one ounce of gold, the cost of a gold coin would be about $650 plus at least a 10% premium to cover the costs of the mint, the dealer, shipping costs, etc.," said GoldMoney's Turk. "The cost of one ounce of gold in GoldMoney is $650, plus 3.49%."

He said his company doesn't charge a storage fee for gold, but instead charges 1/10 of a gram [about $2] per month account fee.

As of June 30, GoldMoney stored $187 million of gold and silver for its customers, with an average account size of just over $6,000, according to Turk.

... Physical drawbacks

Of course, physical gold ownership isn't without its own challenges.

Turk points out that that smaller bars or coins can sell for high premiums over the spot price because of fabrication and handling costs.

On average, a person must pay from 5% to 8% over spot gold to acquire the simplest of one-ounce coins, according to Nadler. "The spread between bid and ask can be as large as $30 or $50 for some coins."

So the "break-even proposition for physical coin buyers is substantially higher than that of certificate, electronic or pool account buyers," he said.

There are also "storage headaches," he said. "Most people have no clue that their bank safe deposit boxes are uninsured. Homeowner policies make no provisions for bullion coverage. Storage costs at specialized vaults or banks can run form 0.5% to 2% of the value of the metal per annum."

For vault storage, Blanchard refers its clients to the Security Center in downtown New Orleans, according to Beahm. There, a safe deposit box with the dimensions of 2 inches by 5 inches by 24 inches costs $119 per year, according to Jan Girlinghouse at the Security Center.

When asked if the contents of the boxes are insured, she didn't offer any specifics, but said, "we don't insure what we don't know."

Rummel, the coin collector, doesn't really see safe deposit box insurance as an issue at all, making his point by asking, "how many banks have had their boxes ripped off?"

Julia Tunis, a spokeswoman at Wells Fargo, said the contents of a safe deposit box at Wells Fargo banks are not insured by Wells Fargo or the Federal Deposit Insurance Corp.

According to the FDIC, unless a bank is found to be negligent in the way it handled or protected your safe deposit box, don't expect the bank or its private insurance to reimburse you for any damage or loss.

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