Precious metals, gems a risky way to hedge risk
The headlines are hard to miss. There’s the seemingly endless tariff war between China and the U.S. Then there’s the truly endless sabre rattling in the Middle East, most recently between Turkey and the Kurds in Northern Syria. How about the tit-for-tat oil tanker attacks and hijackings between Saudi Arabia and Iran? Brexit anyone? Efforts by Democrats to impeach U.S. President Donald Trump. Mass rioting in Hong Kong, Chile, Bolivia. Separatist sentiments rising in Canada following the election of a weak minority Liberal government. For some investors, it’s all a bit much, and many are asking if market risk has cranked up to new highs. Is now the time to switch at least some of your funds to so-called portable hard assets, like gold and gemstones, which tend to keep their value in times of turmoil?
Before you go shopping for the best deals on gold bullion or raw diamonds, there are a few things to consider.
Start with diamonds. They’re nice to look at and they do seem to command a high price. But the trouble with diamonds is that in purely investment terms, they are a non-producing asset. They don’t pay interest or dividends. What about capital gain? Possibly. But have you ever tried to buy or sell an unset diamond? You soon discover that it’s akin to trying to buy or sell a used car. Where’s the market? Where are the dealers? Whom can you trust?
Diamond markets are still tough for the novice trader to access. For example, chances are you had no idea that the world’s largest diamond trading complex is the Tel Aviv Diamond Exchange (or Bursa), while 60% to 80% of the world’s diamonds are cut and traded in Antwerp, Belgium.
Diamond trading involves much more than going to your local jewellery store and buying a small diamond ring of questionable quality. It’s a large global network of interconnected dealers, traders, and exchanges, and it’s definitely not one for novices. Steer clear of diamonds except on rings, bracelets, pendants, and earrings.
The bugs in gold
Then there’s gold. Gold does tend to be a kind of “fear barometer,” and it’s easier to trade as an asset than diamonds. But it’s volatile, and its predictive value is questionable. Still, gold is considered a “safe haven” asset when financial conditions deteriorate badly. It also continues to be in demand both for jewellery and industrial applications, and these factors also tend to influence the price, albeit on a cyclical basis.
Against this backdrop, the price of gold has climbed steadily this year as global geopolitical anxieties ramp up and recession clouds appear to be gathering on the horizon (as signalled by the persistent inverted yield curve in U.S. Treasury bonds and negative interest rates in eurozone bonds). Gold is up about 16% year to date, as nervous traders rediscover its “safe haven” appeal.
If you’re truly nervous about global business and financial conditions, it doesn’t hurt to have a small allocation to gold as a cushion against troubled times. But bear in mind that gold is also a non-productive asset – it has no yield and produces no income. The only growth available is through capital gain, and that depends entirely on the vagaries of the commodity markets. When you buy gold in the hopes of selling it later at a profit, you are speculating, not investing.
There are a number of ways to buy gold.
* Bullion, certificates, and coins. Buying the physical commodity and locking it up in a safety deposit box is the most straightforward way of buying gold. But there are always safekeeping charges, trading costs, and in the case of coins, numismatic premiums to pay. Certificates are available, of course, but it’s one step away from the physical commodity. If purchasing a certificate, make sure it’s from a large, reputable financial institution, usually a bank.
* Gold funds. You can purchase units of an exchange-traded fund (ETF) that holds nothing but gold bullion. Your ETF unit represents a share of the physical gold bullion that the fund has a claim on either through physical holdings in a warehouse or in certificates it has purchased or some combination. In Canada, the iShares Gold Bullion ETF (TSX: CGL) is one such fund, while Central Fund of Canada (TSX: CEF.A) is a closed-end physical-gold fund that’s been around for 55 years. The U.S.-based SPDR Gold Shares (NYSE: GLD) is the granddaddy of gold ETFs, and the largest physically-backed gold ETF in the world, holding some 918 tonnes of gold worth over US$44 billion at recent prices. With their low MERs, ETFs are the most economical way to hold physical gold if you don’t want the hassle of buying the stuff directly from a dealer yourself, and most investors go this route.
Some mutual funds also invest in physical gold, but such funds typically also hold at least some gold-mining equities, and so cannot be considered a pure gold holding.
* Options and futures. These are the riskiest vehicles to stake a claim on gold. Options and futures contracts represent in interest in a specified amount of gold at a specified price and time. These types of instruments, called derivatives, carry the very high risk of 100% loss of your stake. They are for expert commodity traders and speculators only, and I recommend all others avoid them.
Speculating versus investing
Unlike an investment in, say, a stock or a bond, where you expect the asset to produce a return in the form of interest or dividends, gems and precious metals provide no return at all. You essentially hope that you can sell your commodity down the road to someone who’s willing to buy it at a higher price than you did. Will there be such buyers down the road? Will there be such a big demand for (or a sudden shortage of) diamonds or gold or silver to the degree that you’ll profit handsomely when you sell? Who knows? When you purchase these types of assets, you’re betting that there will be. And note the key word there: “betting.”
I’m not saying you shouldn’t buy some gold as a crisis hedge, or that you shouldn’t own some diamonds. Just be smart about it. Stick to ETFs for gold, and buy diamonds for their value as jewellery. What I am saying is that when it comes to investment assets, it makes a whole lot more sense to purchase ownership in something that grows intrinsically while rewarding you along the way than it is to hold a shiny rock or a bar of inert metal.