Alternative Investment: Precious Metals (2 of 8)

Alternative Investment: Precious Metals (2 of 8)

alternative-investment-gold

There are three key drivers behind precious metals prices - investors looking for a store of wealth, industrial demand and speculators expecting price growth

Risk Level

'Precious Metals' are Risk Level 2 of 8 in Alternative Investments.

Investment Case

Store Of wealth

The trend that has seen a number of investors turning to precious metals as an alternative store of wealth continues, following disillusionment with negative real returns on cash, depreciating currencies and the possibility of future inflation and volatile markets in other assets.

The search for a sensible store of value has been one of the factors behind the rise in the gold price over the last 10 years. Investors of all kinds, from retail investors to central banks and sovereign wealth funds, view gold as a secure store of wealth and currency of last resort or safe haven. Some investors are also choosing to store wealth in silver and diamonds – taking the view that rare tangible assets provide some security from inflation and financial repression.

Industrial Demand

There is limited industrial demand or utility for gold with much of its value lying in its function as this store of wealth and currency.

Silver is a halfway house – it has value because it is recognised as a tradable store of wealth but, as opposed to gold, is also used in the electronics industry and therefore industrial demand accounts for over half of total silver fabrication.

For diamonds there is a huge industrial demand, but this is met through the production of synthetic diamonds. Gemstone diamonds are mined and are much more rare, and have value as a store of wealth.

Rare earth metals are at the other end of the spectrum to gold. They are valuable only because they are rare and in demand for use in high-end electronics, clean energy and defence applications. However, as the technology market inevitably grows, their restricted supply will increase their investment value.

Other valuable industrial metals include platinum, palladium and copper. But these are considered to be more of a commodity-style investment and there are no directly held alternative investments in these metals.

Speculation?

There has been a lot of speculative investment in precious metals. Steep rises in the price of gold make headlines in the media, drawing further investor interest – and raising concern it is moving into ‘bubble’ territory where soaring prices could eventually pop and then fall. Silver also attracts inflows from more adventurous investors and a smaller minority of investors have also tried to speculate on the price of diamonds and rare earth metals.

Speculation can drive prices higher, but it also highlights the key issue with these assets – it is very difficult to know when they are over-valued and a sudden change in sentiment towards them could lead to steep price falls. Also these assets do not provide any income.

Findings

There has been a steady growth of direct investment products in this sector – reflecting the sustained price hike of precious metals. The majority of products focus on gold and offer investors the opportunity to own gold. Some providers offer allocated ownership – bars or coins the client can take possession of or have stored on their behalf. Other providers offer unallocated ownership, where the client has a share of gold held in a central vault by the product provider. Unallocated ownership may be more risky as the investor is essentially an unsecured creditor of the product provider. Investigating whether providers hold enough gold to cover all of their investors or if they are operating a fractional reserve system is vital as clients might lose out if everybody tries to realise the value of their gold at the same time. However, unallocated gold is the most widely traded form of gold globally.

Minimum investment levels are attractively low and there are options to hold the investments in personal pensions – although stringent rules apply. The positioning of the product in marketing literature is also interesting. Physical gold is perhaps the safest way to hold the precious metal, but it is also the most expensive, making it less suitable for short-term speculation and more suitable as a long-term diversifier or ‘portfolio insurance’. Not all providers reflect this in their literature. Charges and costs to consider when purchasing gold include the initial price, the bid-offer spread (the difference between the price you can buy and sell at), and the cost of delivery, insurance and storage.

Physical gold can also be tax efficient as it is VAT exempt, gold bars are SIPP acceptable and UK gold coins are not liable for Capital Gains Tax (CGT) as they are legal tender.

There are a number of opportunistic companies trying to capitalise on the surge of interest in gold and if gold sees another sharp price rise it would be no surprise if more of these companies cropped up. Several gold product providers also give investors the opportunity to purchase silver, although this is seen as a more risky investment. It is also liable for VAT, less liquid in investment terms than gold and, as a consequence, has a higher bid-offer spread. Silver may also be a more volatile investment than gold.

There are a small number of UCIS (Unregulated Collective Investment Schemes) style vehicles that historically have given investors exposure to a range of precious metals. These are illiquid (removing one of the key benefits of gold and silver) and targeted at sophisticated and high net worth individuals. There is also a Genuinely Diverse Commercial Vehicle (GDCV) product giving exposure to diamonds. In addition, there are an increasing number of providers giving investors the opportunity to purchase baskets of rare earth metals, primarily being sold through call centres. Rare earth metals should be treated as a high ‘beta’ play as price rise depends heavily upon growth in consumer demand for electronics.

Summary

There is a strong case for holding a discrete allocation of gold in a portfolio as a diversifier to hedge against a number of risks. If purchasing gold for this purpose, directly owned physical gold with no counterparty risk may make the most sense. More speculative investors should stick to cheaper substitutes such as ETFs. Silver can also fulfil a role as a diversifier, although for most people gold is the more logical choice. The same rationale can be applied to other precious metal investments but baskets of precious metals and investments in diamonds or rare earths are even more specialist so are not typically a first choice as a diversifier – but may offer good value for investors who can afford to speculate.

Investment Fundamentals

  • Secure physical asset
  • Recognised store of wealth
  • Established market and past performance
  • Limited supply
  • Liquid

Investor Conclusions

For investors and their agents, physical gold and silver are simple to understand – they are liquid, tradable stores of wealth that provide an alternative to cash and other assets in turbulent times. But be wary of opportunistic companies. Look for providers with a simple proposition, realistic marketing literature, informed trustees and a strong track record.

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