Should You Have a Shine for Gold?

Fear and uncertainty have prompted a consistent interest in gold, fueling the metal's decade-long upward tear. Gold's runup has likely left many investors wondering whether they should build a position or keep their distance from the shiny metal entirely.

Investing in gold is not necessarily a priority for everyone. Speculators might be attracted by the potential for eye-popping returns, but history has shown that successfully timing a short-run gold investment is not an easy task. When bullion prices are skyrocketing, it's all too easy to jump on the gilded bandwagon. Gold prices soared in the early 1980s, and many speculative investors poured into the market only to lose their shirts after the price of gold collapsed.

But beyond being a tool for speculation, gold has some valuable uses in a dollar-based portfolio, and the rise of gold bullion exchange-traded funds has allowed investors seeking the diversification potential of gold to attain straightforward access to the shiny metal. 

What Drives Gold?
Gold's primary demand drivers are jewelry consumption and investment, which account for roughly 48% and 39% of gold's total demand, respectively. They can exert opposing price pressures. Welling concerns of a global recessionary period might curb discretionary spending on jewelry, but gold's use as a store of value is likely to offset the trend. All tech- and industrial-related uses account for a mere 12% of total annual demand for the metal.

For investors, one of gold's most attractive features is that it is not at the mercy of government policy. Gold is a limited commodity that retains purchasing power even under strong inflationary pressures. It cannot be easily issued or mined, so its value won't decrease overnight as a currency might if the government were to significantly expand the monetary base. This isn't a trivial point. It is difficult to ignore the long-term inflationary impact of the recent dramatic increase of our monetary base.

In an attempt to avoid a deflationary spiral, the Federal Reserve engaged in successive rounds of quantitative easing. The broad antideflationary monetary policy played to gold's strength, and is certain to have contributed to the metal's rise. The Fed will eventually be forced mop up this liquidity through higher interest rates, but it isn't the most pressing concern. Fed chairman Ben Bernanke has made clear that to preserve stability of our financial markets, he will hold interest rates at historic lows for at least the next couple of years. On this basis, we believe a small position in gold should be considered as an insurance policy.

The instability of the eurozone has recently provided for conflicting price drivers. Although fears surrounding the potential downfall of this globally economically significant region have bolstered demand for gold as a safe haven, a weakening euro strengthens the U.S. dollar. This, in turn, places downward price pressure on dollar-denominated assets including gold.

The largest risks for gold will be associated with increased market confidence and the dissolution of the inflationary pressures that were provided by growth in the money supply. Under these circumstances, demand for gold as a safe-haven asset and inflationary hedge would dry up. Although the shorts have been screaming that gold has been at a top since it passed $800 per ounce, there has been no indication that confidence or a stringent monetary stance have returned to global economies.

Incorporating Gold in a Portfolio
For commodities' asset-class-level benefits, inflationary hedging, and diversification, we are in favor of maintaining a modest-sized core-commodity exposure of up to about 10%. Additionally, that exposure should be split between energy, agricultural, and industrial and precious metals.

For their ability to better manage geopolitical, currency, and operation-specific risks, gold-related exchange-traded funds and mutual funds are move favorable, in our opinion, over individual mining-company stocks for dedicated gold exposure. Furthermore, because of the complications of several futures-based commodities funds, funds that actually hold the physical underlying commodity--such as  SPDR Gold Shares (GLD) and  iShares Gold Trust (IAU)--have been the better choice for investors in the past several years. The commodity-investment boom coincided with the proliferation of commodity ETFs, and the futures markets became a bit distorted. The effective end result recently has been poor performance for commodity-futures funds regardless of the price changes in the underlying spot market. Given that these market inefficiencies might remain today, we lean toward an investment backed by physical gold rather than one that invests via the futures market.

By holding bullion, both IAU and GLD offer investors the price performance of the spot commodity. GLD's bullion is held in London vaults under the custody of  HSBC Bank USA (HBC), while IAU's bullion is held in London, New York, and Toronto vaults under the custody of  J.P. Morgan Chase (JPM). Both funds rid investors of the inefficiencies and inconveniences associated with transporting and storing the metal.

Although IAU is cheaper, GLD is the largest and most liquid physically backed gold offering on the market. Frictional costs, caused by narrower bid-ask spreads and higher trading volumes, are typically lower in GLD, but the all-in cost of ownership might be lower in IAU.

Investors also might opt for a more broadly diversified commodity fund, such as
 iPath Dow Jones-UBS Commodities Index Total Return ETN (DJP). For a 0.75% fee, investors gain diversified exposure to 19 different commodities, including energy, agricultural, and metals. However, the fund is structured as an exchange-traded note and thus leaves investors exposed to credit risk from Barclays. Further, a recent analysis by Morningstar's Sam Lee suggests that investors should also carefully consider the true cost of some so-called path-dependent fees with DJP and some other ETNs.

 PowerShares DB Commodity Index Tracking Fund (DBC) charges a slightly higher 0.85%, uses a sampling of 14 commodities, and is more heavily weighted toward energy. It is, however, structured as an ETF and thus minimizes the credit risk inherent in an ETN.

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Disclosure: Morningstar, Inc., receives fees for licensing its indexes to ETF/ETN providers. These fees are mainly based on fund assets under management. BlackRock Asset Management; First Asset; First Trust; Invesco; Merrill Lynch; Northern Trust; and Scottrade currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.