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Why you should diversify into alternatives?

The key to balance is to diversify

Guest blogger – Richard Broughton

Everyone knows you should diversify your investments. Academic studies show that this reduces investment risk and smoothes-out volatility. Indeed, the benefits of diversification are felt most during recessions and bear markets.
But too few investors diversify away from security-based investments such as equities, bonds and hedge funds etc which are all, to some degree, related to each other.
True diversification can only be achieved by having a mix of assets that are not correlated. Alternative assets such as fine wines, rare coins, stamps and gold are perfect counterweights. Studies* have shown that most categories of portable alternative assets (with the exception of art) have low volatility and little correlation to equity markets; in many cases negative correlations with Bond markets.
There is an alternative view of ‘why diversify’ and that is the more you diversify into other assets the greater chance you have of one asset disproportionately outperforming the other assets … but more on this next time …
* Campbell, Koedijk & De Roon (2006)
If you fancy investing or looking at this market please contact Mallory Scott Alternatives on 020 7016 6750 or 07976 764129.
Insider's Guide to gold and silver
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Physical Gold – 6 reasons it beats gold funds and ETFs

Gold funds or physical gold?

1. Security and Integrity

While ETFs have provided an accessible way for investors to gain exposure to the gold market there are many fears circulating about their security and integrity. For starters, the fact it is a structured paper asset that not everyone fully understands tends to defeat the object of owning a simple tangible asset like gold. So many investors have been stung over the past 5 years investing into asset-backed securities that were rated AAA by the credit rating agencies, only to see them downgraded to junk status overnight when everyone realised that the subprime mortgages they were linked to would not payout. It transpired that many very sophisticated investors never really knew which assets the bond was linked to or understood their lack of protection against such defaults. So are you more comfortable understanding the risks of holding gold coins or gold funds or ETFs?

Press reports are speculating that only 10% of the traded ETF value is backed by actual gold. With a distinct lack of auditing, its difficult to know for sure what the exact figure is.

Jefferey Christian of the CPM Group confirmed that gold is leveraged around 100:1 at a Commodities Futures Trade Commission (CFTC) Hearing on March 26, 2010. This means that there are around 100 claims for each ounce of gold in existence and so not enough gold to be delivered to everyone who has been promised paper gold.

So the question remains would you be able to access the value of your ETF if half or more of the investors decided to withdraw at the same time?


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2. Counterparty Risk

The term counterparty risk has become far more used and relevant over the past few

PHYS01_Animated_Gif_2_MPUyears. This term didnt seem relevant to bank deposits a decade ago it went without saying that leaving savings in a high street bank was safe. But things have changed dramatically. Now weve seen our major high street banks on the brink of collapse. Who would have believed me 5 years ago if Id have predicted that RBS, Nat West and Lloyds would be mostly Government owned?

Weve seen bankruptcies to seriously major corporations from General Motors to Lehman Brothers. I saw many friends who had built up shares in Lehmans over many years of work and anticipated those stocks providing their retirement. No-one could have predicted that they would lose value so quickly and Lehman would go under.

Were now seeing the next phase of counterparty risk with Sovereign debt. Investors who thought they were taking on very little risk by investing in Government bonds now face the very real prospect of not being paid out in full. Countries such as Ireland, Greece, Portugal and Spain need help from the EU and IMF to repay their debts. There is every chance that bondholders will not receive all the capital back.

With physical gold, there is NO counterparty risk. It doesnt matter if a Government fails to repay bonds, a corporation goes bankrupt or even if the gold dealer you bought the gold from ceases trading. You will always have the physical asset to do with as you like.

By investing in gold mining stock, ETF or Gold funds each poses some sort of counterparty exposure and a threat to the value of your asset. Remember paper gold is a promise to pay, not the real thing!

3. Risk Profile

If youre considering a choice between mining stocks and physical gold, its crucial to realise that these are different asset classes with entirely different risk profiles. Firstly, investing in mining stocks means your investment is linked to the performance of one company. As a paper asset, if that company underperforms, or even worse goes bankrupt, there is a chance that your investment becomes worthless. The value of gold coins and bars can never fall to zero or anywhere near because of the intrinsic gold content. During times of global economic turmoil mining stocks and bullion perform quite differently. Terror threats, currency depreciations, huge unemployment, record deficits and banking crises dont provide conducive conditions for equity markets, which is why weve seen more and more people fleeing to the safety of gold bars and coins. Generally, while mining stocks have the potential for impressive returns they tend not to outperform physical gold during times of crisis such as the recent credit crunch. During sharp market declines such as the 1987 stock market crash, mining stocks become correlated to the broad equity markets rather than the price of bullion.

4. Comprehensive Insurance

If the reason you want to invest in gold is for portfolio insurance then make sure you have a Comprehensive policy! Everyone knows that gold provides security against economic and political unrest, making it the perfect safe haven asset in the current world in which we live. In that case, you want this wealth protection to be thorough. By investing in paper gold its like buying an insurance policy with get-out clauses. In other words, it doesnt provide full coverage. There are still risks attached such as counterparty risk. By investing into physical gold, its like having the most comprehensive insurance available, putting your mind at rest that no matter what the next financial headline is, your physical gold holding will provide the necessary balance.

Insider's Guide to gold and silver

5. Tax Efficiency

In the UK, there is the opportunity to own physical gold coins which are completely tax-free. All investment grade gold is VAT exempt. You pay no income tax while holding the gold and UK coins such as the Britannia and Sovereign are Capital Gains Tax-free due to their status as legal tender. Compare this to paper gold such as a mining stock or gold funds where youll have to pay income tax on any dividends and capital gains tax if you sell the shares at a profit. With CGT now up to 28% for higher rate taxpayers, thats nearly a third of your profits!

6. Accessibility

Accessibility in times of crisis is crucial. After all, gold should act as your crisis hedge. Over the past month, weve read about the attempted ink-cartridge bombers and MI5 revealing renewed threats to the UK, France and Germany. The Eiffel Tower has been evacuated twice in recent months. If one of these attempts gets through and the financial system collapses for a week or so how easy is it to access funds through your gold ETF, mining shares or Gold funds? By holding the physical metal itself, especially in the form of globally recognised coins, you hold the ultimate liquidity.

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Industry News

Gold Demand Trends – New World Gold Council Report

New Gold Demand Trends and updated Supply and Demand Statistics

GDT AND DEMAND STATISTICS FOR Q3 2010

We published the latest issue of Gold Demand Trends for Q3 2010 today, which suggests demand for gold for the rest of 2010 will be underpinned by the following market forces:

Outlook

  • Increasing demand by the world’s two largest markets, India and China, as rising income levels, high savings rates and strong economic growth continue to push up consumption.
  • Gold jewellery demand is likely to exceed that of 2009 due to an anticipated recovery in India, the most significant gold jewellery market, and continuing strength in China. While jewellery demand may face challenges ahead, the latest figures show that demand in key markets has shown resilience in the face of higher prices levels.
  • Concern over fiscal imbalances and currency tensions will continue to support investment demand for gold. Aside from the recent additional US$600 billion of quantitative easing by the US, the weakening of the US dollar and associated fears of inflation, demand is also likely to be driven by higher gold price expectations, as well as increasing availability and accessibility of gold investment products to retail investors.
  • Industrial demand, which has returned to long-term levels, is expected to remain firm on the back of renewed growth in the electronics industry, due to the majority of semi-conductors being wired by gold.

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Key demand statistics:

  • Total gold demand was 922 tonnes, an increase of 12% from Q3 2009. In US$ value terms, demand grew 43% to US$36.4 billion over the same period.
  • Demand for gold jewellery increased by 8% from Q3 2009, with four of the best performing markets – India, China, Russia and Turkey – accounting for 63% of global demand. In value terms, global demand for the 12 month period ending September 2010 hit a record US$137.5 billion.
  • Retail investment rose 25% from Q3 2009 to 243 tonnes. The largest contribution to total demand growth came from bar hoarding, which increased 44% from the previous year. The total value of net retail investments during the quarter was a record $9.6 billion, representing a 60% increase from Q3 2009.
  • Total gold ETF demand fell by 7% from Q3 2009 to 39 tonnes. Following a remarkable surge in the previous quarter, which was supported by heightened sovereign risk and currency worries, this quieter period for ETFs reflects consolidation in the market, as it contemplated the prospect of QE2.
  • Industrial demand has recovered back to pre-crisis levels of 110 tonnes, reflecting an increase of 13% from Q3 2009. This recovery was driven by improving demand for consumer electronics goods globally, in particular from emerging markets such as China and India, as well as an increased range of new technology products with gold components.
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Secure your gold lifejacket before the QE2 sets sail

What is QE?

With all the talk of another round of huge stimulus in the US, this latest attempt at kick starting the largest economy in the world is being deemed QE2.

For those in the know, the QE refers to Quantitative Easing – the method of injecting funds into an economy when all else has failed.  The 2 in the title refers to the fact that it will be the second huge cash injection the US have performed in the past couple of years.

In the UK QE2 is best known for our luxurious flagship cruise liner.

But this round of QE would be better compared to another famous historical luxury cruise liner – The Titanic.  Like the Titanic ship, QE2 will be huge. Its not worth the US Government injecting peanuts.

But this time we can all see the iceberg coming. Any QE program is an obvious sign of desperation for a Central Bank.  Indeed figures last week showed the US economy growing at half the pace of the UK’s economy last quarter, which is pedestrian itself.

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Spiralling Quantitative Easing

The fact that the previous stimulus program failed to steady the ship is not a good omen for the latest sticky plaster being placed over the US economy. Simply adding more Dollars poses a huge threat to inflation by its very nature of undermining the value of a currency which has already lost 12% of its value in the past 2 months.

Let’s not fool ourselves, it’s the US tax payer who will have to repay the debts being taken on to provide the stimulus. Just like we are experiencing now in the UK, tax hikes and future spending cuts will have to be implemented to pay back the money.


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The gamble is for the economy to grow quicker than the rate of interest on the QE, otherwise you see a spiralling debt large enough to sink any ship.

So as we set sail on this latest round of stimulus, surely it’s wise to have protection in case we cannot navigate around the iceberg. We all know that holding physical gold acts as a lifejacket when economic and political catastrophe strikes. It can provide the lifeboat- for the average saver and investor to escape going down with the ship.

The saying goes that when the US sneezes, the UK gets a cold. So we’re all on board as the latest QE2 sets sail. Let’s make sure we hold some investment gold in our portfolio, or we risk sinking with the ship’s band and captain!