Gold Slides as the Greenback Climbs

Earlier this week, I wrote about the mechanics and merits of hedging the foreign-currency exposure in an international-equity portfolio, a feat made increasingly straightforward in the wake of the recent proliferation of currency-hedged exchange-traded funds. These funds might take the sting out of a sliding yen or stumbling euro, which have been losing ground to the U.S. dollar of late. As the dollar has risen, one of the world's oldest currencies has also been suffering. The price of gold has slipped some 3% over the past year, while the ICE U.S. Dollar Spot Index has risen by more than 17%. (See chart below.)

Gold is denominated in dollars, so as the greenback climbs, it will inevitably create downward pressure on prices. Also, inflation fears have subsided as consumer price indexes in many major markets have been declining and in some cases are in negative territory, further diminishing gold's luster. However, despite all this, January marked the largest monthly inflows into gold-backed exchange-traded products in over three years, led by the largest of them all,

Suitability

Gold is traditionally sought-after as a store of value in times of severe economic dislocation, an insurance policy against financial Armageddon. Its historically low to negative correlations with most broad asset classes indicate that gold might be a worthwhile investment for a small portion of an investor’s portfolio. While gold has exhibited a low level of volatility relative to equities over the past quarter century, the massive price swings experienced from the early 1970s through the mid-1980s--as well as its sharp sell-off in 2013--serve as exhibits of the effects fickle investor sentiment can have on the price of the yellow metal. This type of volatility also underscores why an allocation to gold should probably only occupy a small portion of a well-diversified portfolio. As for an investment in physical gold through an exchange-traded product, gold ETPs are the least costly, most broadly accessible and most liquid vehicles for acting upon one’s gilded aspirations.

Fundamental View Gold has no intrinsic value. The yellow metal does not produce cash flows which it can share with investors, like equities. Nor does it throw off coupon payments, as a bond does. Financial theory states that a security's intrinsic worth is equal to the present value of the future cash flows it will generate. With no cash flows to project and discount back to today, gold is a purely speculative instrument: It is worth only what someone else is willing to pay for it.

The speculative nature of an investment in gold doesn’t differentiate it from other commodities like oil or wheat, which like gold, do not produce cash flow. What differentiates gold from most commodities is that it has little practical use. Gold cannot fuel an automobile or provide nourishment. According to the World Gold Council’s “Gold Demand Trends” report for the third quarter of 2014, just 8.2% of gold demand was tied to practical uses--such as dentistry and electronics. The largest source of gold demand (57.4%) is the jewelry industry. Meanwhile, 21.9% of the global appetite for the yellow metal could be attributed to investors during the third quarter of 2014. The remainder (approximately 9.9%) came in the form of official sector purchases. The world’s central banks have been playing an increasingly important role in the gold market in recent years. In the first quarter of 2014 the world’s central banks purchased a collective 122.4 metric tons of gold, well above the trailing five-year average of 72.7 metric tons. Also, investment demand for gold has surged in recent years as concerns over paper currencies have flared and the world’s most precious metal has been made more accessible to the masses via ETPs. However, ETP investors have been running for the hills. Holders of gold-backed ETPs have been net sellers for seven consecutive quarters, offloading about 964 metric tons in aggregate during that span.

While demand for gold in practical applications and for jewelry has historically exhibited normal cyclical behavior, investment demand for gold appears to be in a secular uptrend. Gold is now more accessible than ever and its safe-haven appeal seems to have staying power, which could signal that prices--while far from their peak--have trended too high. On the other hand, bloated sovereign balance sheets and a massive bout of monetary stimulus have many convinced that gold is the world’s one true currency, and perhaps it will only climb higher. While gold notched record high price levels in nominal terms in September 2011, the nearby peak was well below its inflation-adjusted record price of $2,358 per troy ounce--reached in January 1981. Whether the price of gold will tumble or spiral higher is impossible to tell. Though the gold price has demonstrated limited volatility over the past decade, past experience has been marked by episodes of massive price declines, as we’ve recently been reminded. Nearly two years after the real price of gold hit an all-time record in 1981, its value had fallen by two thirds. What can be said for certain is that gold-backed ETPs are an excellent way to gain exposure for investors and speculators alike.

Portfolio Construction Simply put, the fund is a "pass-through" vehicle for physical gold ownership, with each share worth about a tenth of an ounce of gold. The fund--technically, trust--is sponsored by World Gold Trust Services, LLC, and is marketed by State Street Global Markets, LLC, but the day-to-day management is conducted by the trustee, BNY Mellon Asset Servicing. The trustee calculates the trust's NAV, using the London P.M. fix price for an ounce of gold as its benchmark. The gold itself is held in the London vaults of HSBC Bank USA, N.A., though at times some of the gold will be held by other banks, or "subcustodians." The gold is insured by the custodian, but the prospectus makes clear the custodian doesn't have to maintain insurance to cover the full amount of gold held, and subcustodians aren't required to be insured. If you're hoping for total insurance, you're out of luck--the custodian is only "liable for losses that are the direct result of its own negligence, fraud, or willful default in the performance of its duties."

As far as U.S. federal taxes go, the trust is treated as a "grantor trust," meaning your ownership is taxed as if you owned the gold bullion directly. If you sell within a year of buying, your gains are taxed at ordinary income rates. Beyond a year, bullion, alas, is taxed at a special collectibles rate, which as of writing is 28%.

Fees This fund sells off a little bit of gold over time to offset its 0.40% expense ratio. The Trust's Sponsor (World Gold Trust Services LLC, which is wholly owned by the World Gold Council) claims an annual fee of 0.15%, while another 0.15% goes to the Marketing Agent--State Street Global Markets, LLC. The actual fee might be higher if assets under management fall below about $1.2 billion or if "unforeseen expenses" cause the fund's "ordinary expenses" to exceed 0.70% a year--neither is likely.

Alternatives

The fund's chief competitor,

Merk Gold ETF OUNZ is a relative newcomer. The trust levies an annual fee of 0.40%. Unlike its peers, the trust allows investors to take delivery of physical gold in an amount as little as one ounce in a variety of forms (coins and bars). The cost involved is significant (a minimum fee applies) and flat-out uneconomical for small amounts.

Intriguingly, U.S. investors in Canadian gold closed-end funds may be able to side step the 28% collectibles tax rate. The two biggest such funds are Sprott Physical Gold Trust Common PHYS and Central GoldTrust Common GTU. Both funds are "Passive Foreign Investment Companies" for U.S. tax purposes, allowing unitholders to make a "Qualified Electing Fund" election each year. Under this tax treatment, the CEFs are taxed as if they were U.S.-based mutual funds, according to Moskowitz LLP, meaning capital gains on shares held for longer than a year are taxed as long-term capital gains. Of course, you should consult your tax advisor before you pursue this path.

PHYS' total expense ratio as of Sept. 30, 2014, was 0.51%; GTU's expense ratio is 0.35%.

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