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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 Center 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.

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 safe kept 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").

Q: What is the most important determinant of the price of gold?

A: The relationship between supply and demand is a big factor. Supply peaked in 2001 and has not grown. There has been a steady production of gold at around 2,500 tons per year. Until recently, the other big suppliers have been central banks. A little known fact is that President Obama authorized the sale of more than 400 metric tons of IMF gold in order to help finance aid to poor nations. The authorization to sell the gold was embedded in the "Cash for Clunkers" program, H.R. 2346. England, Switzerland, Spain, France, Portugal and the Netherlands are just some of the countries that sold reserves at historically low prices such as $280 per ounce. It's only been in the last six to nine months that central bank sales have switched from selling gold to become net buyers.

A notable pattern is emerging, namely Asian countries are worried that Western nations do not have their national budgets under control and that their respective currencies will be devalued as a result. China is buying less and less of U.S. treasury bonds and bills. Gold is becoming the preferred currency for many nations. The International Monetary Fund has been talking about the creation of a super currency and the longevity of the U.S. dollar and European currencies (with the possible exception of the British pound and the Swiss franc) are being called into question. Up until the 1970s, we had no time in history when the paper currency system was not linked to gold. Times have now changed whereby the modern day paper currency is linked to deficit spending and is not backed by tangible assets. History has shown us that currencies can lose their values quickly. The Weimar Republic and Argentina are just a few examples. Economists are paying close attention to the gold buying patterns of countries that include China and India. Price increases are easy to explain when increased demand and static supply are taken into account.

Q: Do you think the gold market will top off any time soon?

A: I think that depends on how politicians address out-of-control spending. If important decisions to curtail budget excesses continue to be put off until tomorrow, gold prices are unlikely to drop anytime soon. Economic sanity must prevail in the United States and Europe. A $2,000 per ounce price is not far-fetched. It may take between 20 and 30 years for investors to trust politicians to take fiscal responsibility seriously.

Q: For those who want to hedge part or all of their gold portfolio, what do you recommend as the best way to go?

A: The best way for anyone owning physical metals and wishing to protect themselves against a price decline(s) is to sell a future contract on the CME. The state of contango has historically prevailed. This means that the spot price of gold is lower than the forward price. Note that margin requirements continue to climb and must be considered when evaluating the economics of any proposed hedge.

Q: How do banks hedge?

A: Assuming that banks are holding physical gold in their vaults for proprietary trading purposes, they too will likely employ CME gold futures. Unlike banks, a jewelry company may encounter basis risk if it is using a standardized futures contract to hedge a complex gold alloy. Having said that, most jewelry manufacturers are well-versed in managing this risk.

Q: Should institutional investors allocate monies to metal fund managers via a consultant?

A: That depends on the knowledge of the consulting firm and its relationship managers. Due diligence in selecting an asset manager to trade metals - whether directly or indirectly - is still important. Focus must be placed on where the gold is stored, how gold company stocks are selected and whether projected economics augur favorably for gold and other precious metals.

Source: Ian MacDonald: Insight on Gold Investing for Institutions