Gold and silver have exploded in recent years. The contributing factors of low interest rates, economic uncertainty, global fear and pending inflation have done their share to boost precious metals’ outsized gains relative to the stock market. Gold has rallied more than 150% over the last five years while the broad stock indexes are all flat to lower, depending on the day. Silver, for its part, has nearly doubled in the last five years. Given our still historic low interest rates and the growing economic trouble overseas as well as our ballooning governmental budget deficit, it’s reasonable to believe that the forces behind this trend continue to remain intact. The question has changed from, “Should I be invested in precious metals,” to “What’s the most cost effective way to maintain a presence in precious metals.”
The boom in the precious metals market has brought with it the familiar hype of the gold bugs. It has also fostered the invention of precious metal Exchange Traded Funds (ETF’s) and cash for gold TV commercials. Commodity futures markets have also benefited from the added attention being paid to gold. Each of these has a place in the marketplace and each has a vested interest in hyping their product as the one that’s best suited to your needs. However, if you are ascribing to efficient portfolio theory and seek to include precious metals ownership as a part of your portfolio diversification plan, the best bang for your buck is through commodity exchange traded contracts which are regulated by the Commodity Futures Trading Commission (CFTC) and guaranteed by their appropriate exchange.
The market sectors mentioned above can be lumped into two categories: small speculators and investors. Gold bugs and cash for gold are for people with left over jewelry, some family heirlooms and gold coins like American Eagles or South African Krugerrands. Typically, this type of gold ownership sell side biased. This means owners of small pieces or collections are keeping an eye on price and hoping to sell when they think the market has peaked. When they bring their physical collections to market, they will end up at the coin shops, pawn shops, cash for gold, or their local jewelry shop. The willing buyers are always waiting and ready to pay below market value for collections that may have taken a lifetime to accumulate. Upon recent survey of the available outlets, prices to be paid were typically $40 per oz under market value for gold and $.30 per oz under market value for silver. Those on the buy side of this equation, looking to add to their private physical collections will find themselves paying up $30 - $50 per oz over market value in gold and up to $1.20 over per oz in silver. Therefore, small speculators in the physical precious metals market may lose more than 10% of the value of their collection in the buying and selling process.
Passive investment in the precious metals can be done in two ways, ETF’s and commodity exchange traded products. The benefits of ETF’s are that the amount to be invested can be determined beforehand and the investor can pick their own allocation, even if that amount is less than the price of one ounce of gold. The downside is these ETF’s typically underperform the actual market they are designed to track. Typically, one would expect a dollar for dollar rise and fall between the price of the metal and the value of the account. However, due to administrative fees, expenses, incentive fees, cost of acquisition, advertising, etc, the longer the ETF trades, the further behind the actual price they fall. Therefore, it is possible to lose money in a flat market, or realize a smaller return than one would expect in a rising market.
Finally, exchange traded commodity contracts like those listed with the Chicago Mercantile Exchange Group are the actual proxy to which ETF’s and local dealers tie their prices. Perhaps the single biggest drawback to these products is their preset size. There are about half a dozen precious metals products listed ranging in full cash value from $18,000 to $125,000. These contracts have several benefits for passive portfolio diversification. First, these are standardized products fully assayed and certified by the appropriate exchange. This assures the investor that their 100 ounces of gold is 24 carat and their silver is .9999 fine and that the value of your holdings can be found 24 hours a day, rather than being quoted by the guy in the shop down the street. Secondly, there are no administration fees, advertising costs, or incentive fees. The only charge is a one- time commission to your commodity broker, typically, around $50 per contract. Also, you will control the actual metal and not find yourself invested in mining sales or land right options because you didn’t read the prospectus thoroughly. Finally, the biggest reason exchange traded products are so much more cost effective is the use of margin and the amount of cash it frees up for the individual investor. The $18,000 contract mentioned above requires a cash deposit with the exchange of $1,150. This allows the individual investor to use the remaining $16,850 in excess cash for a money market account and earn interest on top of any return produced in the actual market itself. Therefore, those wishing to pursue efficient portfolio theory and diversify their holdings can most efficiently implement this process through the use of commodity futures markets.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.
