Financial advisers, institutions and portfolio managers are increasingly turning to gold to diversify client portfolios, protect against inflation and safeguard wealth.
Yet in the current financial climate and with a growing variety of choices available to clients looking to purchase gold, a word of advice is necessary: Not all gold investments are created equal.
In an attempt to safeguard client wealth, financial advisers may unwittingly lead clients to purchase a fractional-based investment, a gold-price-tracking vehicle or simply a liability of the issuer. There are risks in all these choices, of which advisers should be aware.
First, a bit of history.
In the early 1960s, a fraud was perpetrated in the United Kingdom by a promoter offering a seemingly straightforward kind of commodities investment. City dwellers were given an opportunity to own a sow for future consumption without buying a farm. As evidence of ownership, an investor received a certificate with a serial number, and the same number was imprinted on a tag and clipped in the sow's ear.
For a few years, the sow scheme ran smoothly, until an accountant decided to visit the farm to ensure that the sows existed. Upon arriving at the farm, he saw the sows, but to his horror, he also saw that there were 10 different tags on each sow's ear. Each pig had been sold 20 times.
As much as the story sounds like a fairy tale, it highlights important considerations when guiding your clients to purchase physical assets such as gold. You must help your clients by ensuring that the bullion actually exists, that there is clear title to it, that your client is its only owner and that the title is passed to your client.
Remarkably, financial advisers routinely caution their clients to perform such prudent and rational steps when purchasing other assets such as homes, land, automobiles and boats. But these precautions are not taken when buying assets such as gold.
Many clients of financial advisers focus on the lowest costs and low or nonexistent storage fees. Just as the British accountant discovered that each investor owned just one-twentieth of a pig, clients with “a portfolio allocation to gold” may discover that they don't own what they think they own. Their stake may be partially backed by gold, leased to third parties or backed by unsecured promises.
As a first step to owning gold, advisers must decide, along with their clients, if they want gold for trading purposes or to hold the metal for the sake of wealth preservation.
With this in mind, the following are key questions to consider with your client:
• -Are precious metals a short- or long-term investment?
• -Is the purpose of the purchase portfolio diversification?
• -Is protecting wealth from a financial crisis a fundamental motivation?
• -Does the client prefer physical bullion or a paper proxy for bullion?
One way to think of the various ways to own gold is a pyramid. At the top are the riskiest and most illiquid vehicles. As you go down to the base of the pyramid, safety and liquidity increase.
For example, speculation is the top of the pyramid, and investors can choose from options, futures and the riskiest and most illiquid pink-sheet stocks.
One step down, in the growth segment, there are open-end mutual funds, closed-end bullion funds, bullion exchange-traded funds and the shares of producing mines.
For income, about halfway down the pyramid, there are the bonds of companies involved in gold mining and production.
For security, there are pooled accounts and bank certificates of gold ownership. And for the ultimate in safety and security, the pyramid rests on a foundation of physical-gold currencies and physical bullion.
There simply is no substitute for physical bullion purchased outright and held on an allocated basis.
For those who do not care to own bullion and simply want to track the price of gold for trading purposes, futures contracts and options, certificates, pooled accounts, exchange-traded funds or mining stocks may be the way to go. For these investors, losing the safety advantages offered by direct ownership of precious metals may be acceptable.
Investors should think of owning gold as a kind of insurance. Just as insurance protects against the risks associated with owning such assets as homes, cars and boats, gold can be used to insure an investor's largest or second-largest asset, their portfolio. Given the risky world in which we live, an extra measure of safety may not be a bad thing.
Paul de Sousa is executive vice president of Bullion Management Group Inc.