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Gold's Dull Future?

Reviewing the biggest, oldest gold exchange-traded fund.

Samuel Lee, 03/29/2013

There are many ways to own gold. Because the metal is a bet on disaster, some gold owners prefer physical possession, preferably beyond the knowledge of the tax man. They fret the government could criminalize the private ownership of gold, which last happened when President Franklin D. Roosevelt signed Executive Order 6102 on April 5, 1933. If you're truly worried about such a scenario, no exchange-traded fund is worth consideration. In fact, no mode of ownership that relies on the rule of law--gold accounts, structured notes, certificates, futures, warrants, and so on--will shield you from the government should the unthinkable occur.

For investors who aren't worried about confiscation or a Mad Max scenario, exchange-traded funds are likely the most efficient way to own gold. SPDR Gold Shares GLD is synonymous with gold investing, owing to its massive size and liquidity. GLD has at times held more assets than any other ETF. You pay up for liquidity, though. GLD charges a 0.40% expense ratio, whereas its closest competitor, iShares Gold Trust IAU, charges 0.25%. Traders are more than willing to bear that extra 0.15% annual charge because GLD's share price is about 10 times greater than IAU's. Penny-wide bid-ask spreads (the difference between the prices of buying and selling shares) translate into much smaller transaction costs as a percentage of total assets traded (0.01% in round-trip trading costs for GLD versus 0.06% for IAU).

The best way to think of gold is as a nonyielding currency with a special trait: The only way to "print" it is to pull it out of the earth at great cost. As a currency with no yield and limited practical use, it's unreasonable to expect gold to appreciate by more than gross domestic product growth over the long run. Warren Buffett is right: A century from now gold will almost certainly be less valuable than an investment in stocks compounded over the same period. Gold's investment case largely rests on its ability to insure against currency depreciation. Few people expect to make money by taking out insurance policies. I don't recommend allocating any more than 10% of a portfolio to gold.

Fundamental View
Even though gold's long-run return is almost certainly abysmal, I'm reminded that a great economist once said, "In the long run we are all dead." Gold, as a currency, can do well for all the reasons currencies do well: It can yield more than alternatives, be perceived as safer, or have a favorable real exchange rate. We'll treat each factor in turn.

The biggest determinant of gold's price is its relative yield, not inflation, as many believe. The gold run got its legs when short-term interest rates hit zero in 2008 and the Federal Reserve began its first round of "quantitative easing," reducing fears of deflation. When short-term interest rates went negative, the opportunity cost of holding gold as opposed to cash became positive. Should real rates rise, gold investors will be slaughtered. Therefore, gold is a bet that real interest rates will remain low for a long time.

Another big determinant of gold's price is market's perception of the dollar's safety. Since 2008, emerging-markets central banks have bought gold to diversify their foreign exchange reserves away from the currencies of the big debtor nations. Prominent investors, such as Bridgewater Associates, have advocated for gold as a strategic holding. John Paulson, who famously made a fortune betting against subprime mortgages, is GLD's biggest shareholder. There's a lot of fear baked into gold's elevated price, so investors will have to get a lot more fearful than they are today for this factor to come into play.

Finally, gold has a real exchange rate, just like any other currency. Exchange rates tend to converge on the point where purchasing power is equalized. Gold's purchasing power of real goods is at an all-time high: Since 1975, the gold price/CPI ratio averaged 3.5, but now is higher than 7, suggesting gold is overvalued by 100% in real purchasing power against its history. However, unlike with normal currency pairs, there's no mechanism for arbitragers to buy goods in the cheap currency and sell them in the expensive one, so gold can remain expensive for a long time.

Samuel Lee is an ETF Analyst with Morningstar.
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