How to invest in gold ETFs - if indeed you should at all

Investor interest in bullion has soared over the past few years with many savers who are worried about inflation looking into how they can invest in gold and whether ETFs (Exchange Traded Funds) are the best way of getting exposure to the precious metal.

Gold as an inflation hedge
Before even considering an investment in gold you need to look closely at the rest of your portfolio of assets. Bullion's traditional role has been to protect against inflation based on the idea that because it is scarce and you can't print more of it at will, that it will hold its value even if paper money doesn't. Yet it hasn't really done a great job at that. People owning bullion would have done fine through the 1970s to gold's peak in 1980 but would then have taken a bath. for almost two decades. It is only really since 2007 that gold has spiked up in nominal terms (not adjusted for inflation).People holding it will have incurred huge cost over the years with very little to show for it over most of that period.
The first is that although gold can hold its value against paper money, it is also an asset that doesn't produce returns. If you have gold just sitting in a vault you have to also figure out the opportunity cost of holding it. At the very least you could be getting a couple of percentage points a year return from investing in government bonds or treasury bills. Over most periods cash, bonds or shares will have done better than gold, even if they are a bit riskier.



Gold as catastrophe insurance

Another role that bullion plays is as a safeguard against turmoil in the financial system. Many bugs call it the ultimate assets because unlike, say, a government bond, no-one owes you anything so nobody can default. That may well be true, but it is worthless having the only assets left worth anything if everything else has devalued completely. If you really anticipate a complete breakdown of all society then you're probably better off investing in shotgun shells, as there will be a ready market for those as well as ready need if you have to defend your hoard.

Even so, worries about turmoil in the financial system and about inflation rising again have clearly played their part in gold's big run in late 2009.  Now plenty of people have argued that this is just the start and we are seeing predictions of gold hitting $2000 in not too long. But most pundits have short memories. I was covering the gold markets in the late 1990s and early 2000s when central banks were tripping over one another to sell and the price had to be artificially supported by an agreement not to sell too much at once.
I'm not going to completely stick my neck out with forecasts, but I'd be inclined to think that over time the price of bullion will be lower rather than higher. The Economist magazine's Buttonwood columnist recently ran a post quoting a really interesting figure suggesting just how overvalued gold has become. The figures from Tim Lee of pi Economics  show that:

*On average, it has taken 400 ounces of gold to buy the median new home. Now it takes 185.

Houses and mortgages as inflation hedges
 That figure is really interesting. What it suggests to me is that gold should be thought of as just another currency which has appreciated against the dollar and which in turn has been outpaced by the growth of bubbles in other assets such as houses. It is not to say that gold won't be the next bubble and won't rise further. But it is to say that buying gold is far more like speculating on a currency than it is about hedging against inflation.
The more important point is that many people are naturally hedged against inflation if they have bought a house (which over time should rise in line with other prices) and have a mortgage. If you have then the loan you used to buy your house is falling in value during times of inflation while your house is rising. There is then little need for extra protection.
If you have paid off your house and retired then the case for buying protection is greater, but I would think it could be achieved far better through buying inflation-linked bonds (I'll have more on these in a later post).

Investing in gold ETFs
If you're still with me after all these reasons not to buy gold you must be pretty persistent. Have you thought hard about whether it is right for you?

Okay then.

There are three main ways of investing in gold. The first is to buy coins and hide them under your bed or, if you're rich enough, bullion bars and paying your bank to look after them. I guess that if it is catastrophe insurance you want (and you already have your cans of beans and shotgun shells) then this is the way to go.
The second way is to hand your money over to one of several bullion vaults that have jumped up in recent years. Think of these as the bank deposits of gold. You buy an amount, usually paying by the gram and they mark up "your gold" in their vault. You can trade it at any time and they charge you a spread between the selling and buying price as well as a fee for looking after your gold. You can't touch or feel it and have to trust it is there.
The third way is to buy a gold exchange traded fund such as the SPDR Gold Trust ETF or iShares COMEX Gold Trust. These are, as the name says, funds that trade like shares. The advantages of this approach is that you are buying a security that is transparently traded on an exchange in an open market so the spreads (between the price for buying and selling) will be competitive.If you use on online stockbroker for your share trading you shouldn't pay too much in commission. The rules that govern ETFs are also pretty strict. so you need not worry about whether your gold will still be there in the morning (what it will be worth is a different question entirely). This is because the gold is held in a trust structures that keep assets separate from the companies that manage them. Even if iShares or State Street Global Advisors, which manages the SPDR funds, were to go bust, their clients need not worry. The gold in the trusts is allocated to them and kept safe.
The management costs are also reasonably competitive and are usually about 0.4% of the value of the assets in the fund.
I'll look at some of the funds in more detail in a later post including how much each one charges and also whether they use derivatives to get exposure (and thus incur a risk that their counter-party may go bust).
For now I'm afraid to say that at current prices I won't be joining you if you do, but if you insist on buying bullion I hope this guide on how to invest in gold ETFs has been helpful.