Should Your Portfolio Take a Shine to Physical Gold?

by: Morningstar

By Paul Justice

Investing in gold isn't a priority for everyone, but it has some valuable uses. For one, commodities like gold offer diversification benefit from other asset classes. Unlike equities or bonds, commodities are nonearning assets that are worth only what another party is willing to pay. However, commodities in general offer an uncorrelated benefit that can traditionally be reaped when other securities markets are performing poorly.

Gold is also a good hedge against inflation and the dollar, as the two tend to have an inverse relationship. That is, when the dollar gets weaker, gold is generally going up, because it's a limited commodity that retains purchasing power even when price inflation ratchets up.

Conversely, when the dollar is strong, gold's value decreases because you may be able to get more bang out of the greenback than from the precious metal. And, because gold is generally uncorrelated to how stocks and bonds move, it can serve as a good diversification tool in your portfolio.

Finally, unlike paper currencies, gold isn't at the mercy of government policy. Governments have historically been lousy stewards of the value of their currencies, and a gold position can help hedge a portfolio against such losses because it's not something that can be easily issued or mined. Thus, you won't see its value decrease overnight as you may if the government suddenly decides to pump up the circulation of currency in the market.

Of course, investors may also wish to directly speculate on gold prices, but as a word of caution, many investors are horrible at deciding when to invest in gold. When bullion prices are soaring, it's all too easy to jump on the gilded bandwagon. The last time gold prices soared, back in the early 1980s, many speculative investors lost their shirts buying Krugerrands after the price of gold collapsed.

This history could prove to offer a timely lesson, as our equity analysts have tempered their previously bullish view on gold prices. Gold price behavior and strength were very much noticeable through most of 2009, but prices recently began retreating in the first quarter of 2010. We think that the price pressure, along with the overwhelming interest by new retail investors over the last two years, could lead to a fall in gold prices as quickly as the rise ensued.

During the last historical gold price peak in 1982, the average investor could not wait to sell physical gold, including the family jewels. Our equity analysts think that gold prices could be range bound between $1,000 and $1,250 over the course of the next several months. However, our approach to investing in gold to establish a hedge against inflation remains unchanged. We continue to believe that only a small portion of one's portfolio should be in gold.

Incorporating Gold in a Portfolio
As a way to invest in gold as a hedge or as part of an asset-allocation strategy, SPDR Gold Shares (NYSEARCA:GLD) or iShares COMEX Gold Trust (NYSEARCA:IAU) do the job. Each share of both funds represents about one tenth of an ounce of bullion at current market prices. They represent a direct investment in the underlying commodity and do not invest in equity securities or futures contracts.

When considered as a long-term core holding, we would recommend using a gold ETF fund only up to a weighting of 2% of total assets, if at all. Our research suggests that a 4%-10% total weighting for all direct commodities exposure is sufficient, and the majority of that weighting should be split among energy, agricultural, and industrial and precious metals. That said, a gold ETF can be used periodically as a satellite holding as an inflation hedge or store of value during periods of currency valuation uncertainty.

Thanks to their format, SPDR Gold and iShares Comex Gold offer direct exposure to the value of gold in a more liquid and convenient package than burying gold in your basement. Instead of buying guard dogs and a security system, you pay 0.40% per year. The fund sells gold held by the trust on an as-needed basis to pay the trust's expenses. As a result, the amount of gold represented by each share will fall marginally over time.

Both ETFs charge the same fee and have the same structural qualities, but the iShares fund has only approximately one tenth the assets invested. This means that transactional costs, caused by wider bid-ask spreads and lower trading volumes, are typically higher in the iShares product.

Newcomer ETFS Physical Swiss Gold Shares ETF (NYSEARCA:SGOL) also shares a similar structure and is ever-so-slightly cheaper at 0.39% per year, but its assets under management are less than one thirty-fifth of that of GLD. We doubt the lower fee is sufficient enough to make up for the fund's lack of liquidity. For these reasons, SPDR Gold Shares is one of Morningstar's ETF Analyst Picks.

Investors trying to get a piece of the action in the commodities space may opt for a more broadly diversified commodity fund, such as iPath Dow Jones-AIG Commodities (NYSEARCA:DJP-OLD). For a 0.75% fee, investors gain diversified exposure to 29 different commodities, including energy, agricultural, and metals. However, the fund is structured as an exchange-traded note and thus leaves investors exposed to credit risk from Barclays.

PowerShares DB Commodity Index Tracking (NYSEARCA:DBC) also charges 0.75%, but it uses a smaller sampling of six commodities and is more heavily weighted toward energy. However, it is structured as an ETF and thus minimizes the credit risk that is inherent in an ETN.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.