Mr. Ian MacDonald on Gold Investing for Institutions

Posted by Susan Mangiero on March 24, 2011

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Given the interest in commodity investing on the part of institutions, Mr. Ian MacDonald offers some insight about investing in gold. He is a member of the Advisory Board of Gold Bullion International and a former executive director of the Dubai Multi Commodities Centre and various global financial organizations.

Q: What is the appeal of investing in gold on the part of pensions, endowments, foundations, college plans and sovereign wealth funds?

A: Gold has been a top performing asset for nearly a decade. Investors attribute several benefits to investing in gold including diversification potential and the preservation of purchasing power. Gold has been a good hedge against inflation.

Q: There are many ways to invest in gold and other metals. One could take possession of the physical asset or buy stock issued by a gold mining company. How should an institutional investor evaluate the risks and returns of these two choices?

A: Pension funds normally store gold with one of the large banks or a company like Brinks. There are many ways to store gold. A pension plan, endowment, foundation or other type of institutional investor should not take possession of the physical gold and cast it aside. There has to be care applied to where the gold is stored so that it can be easily transferred elsewhere in the event of future transfers. In the case of gold stocks, investors should pay close attention to how closely they track (or don't as the case may be) the price of gold. The price of stock issued by any gold mining company will logically reflect the quality of its management, the geopolitical risks of expropriation and a host of other factors.

Q: Please comment on the risk-return structure of gold Exchange Traded Funds ("ETFs").

A: ETFs are typically established as a trust vehicle with prices that tend to historically track those of physical gold. An interesting issue however is what happens if an ETF fund manager goes bankrupt. The investor's recourse may be limited if the ETF is registered with the U.S. Securities and Exchange Commission and under its regulatory purview but the actual gold is sitting in a vault in the United Kingdom and therefore under the ultimate control of the Financial Services Authority.

Q: Is possession of the physical gold a problem with respect to the kind of liquidity that some pension plans and other types of institutional investors may require?

A: Based on my experience, liquidity risk is relatively low for both choices as long as physical gold is safekept in a major market facility. Suppose for example that gold bullion was stored in a bunker in a remote part of the United States. It would not be ready for sale until it was shipped to a central location and reassayed.

Q: Gold has had an interesting history in terms of possession. Please elaborate.

A: Following the Great Depression, President Roosevelt had ordered all individuals who held gold to sell it to the U.S. government in order to avoid a weakening of the dollar. Those rules changed in 1976. Individuals can now readily purchase one ounce American Eagle coins or 400 ounce bars.

Q: Who is the biggest producer of gold?

A: According to Gold Fields Mineral Services, a leading London-based research group, China ranks first, followed by Australia and then the United States. South Africa was the leading producer for many decades but its production has fallen dramatically. This is due in part to geopolitical risks and the difficulty in raising capital from global lenders to support extraction from deep mines. It should not make a difference as to where gold comes from as long as it carries a recognized brand such as that belonging to the London Metals Bulletin Association ("LMBA").

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Two Takes on Gold

Posted by Susan Mangiero on February 22, 2011

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Gold has received a thumbs up from J.P. Morgan as a form of collateral for repurchase and securities lending transactions. This means that someone will need to assign a value for each unit of physical bullion and then store the amount that relates to estimated counterparty risk. According to "J.P. Morgan Will Accept Gold as Type of Collateral" by Carolyn Cui and Rhiannon Hoyle (Wall Street Journal, February 8, 2011), illiquidity fears have discouraged financial institutions from accepting gold as collateral in the past. The World Gold Council website reports that trading is a 24-hour operation, rendering the global gold market as "deep and liquid."

In contrast, a few days later, it was reported that a 300 million euro pension fund, the Stichting Pensioenfonds Vereenigde Glasfabrieken ("SPVG"), was directed to reduce its gold holdings from 13% of its assets to between 1% and 3%. The reported concern on the part of the Dutch pension regulatory body, the Nederlandsche Bank ("DNB") is price risk. Although gold has risen from $600 per ounce to in excess of $1,000 per ounce since 2008, when the Dutch glassmaking company's retirement scheme purchased bullion, a drop in value could lower the solvency ratio.

Several issues come to mind about the use of gold for financial purposes. For one thing, if I am investing in the stock of a bank that accepts gold as collateral for a large amount of transactions, I'd like to know if the bank is hedging the metal and, if so, to what extent. I'd also like to understand how they price commodities like gold and the frequency with which they reassess counterparty risk. For an institutional investor like a pension fund that holds gold as an investment, it would be helpful to understand: (a) whether they own physical quantities or stock in a company that mines the metal (b) how value is assessed and on what basis (c) whether gold holdings are hedged and, if so, to what extent (d) what role gold plays (i.e. diversification, safety, etc). An economic analysis of the risk-return for gold, like anything else, is paramount and must consider multiple factors, some of which are listed here.