Gold has been a substance of value for millennia, and remains valuable today with the price of one ounce of the precious metal surpassing $1,300. Many investors seek to hold gold as a store of value and as a hedge against inflation, but it can be difficult and cumbersome to hold large quantities of physical gold. Security efforts are often put in place to prevent its theft which can also be expensive. Fortunately, there are a number of ways to gain exposure to movements in the price of gold without physically holding it.
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It has been speculated that the earliest form of credit banking took place via goldsmiths who would store the gold of members of the community. In return, those depositing gold would receive a paper receipt which could be redeemed for their gold at some point in the future. Knowing that at any given moment only a small fraction of those receipts would be redeemed, they could issue receipts for a larger amount of bullion than they actually kept in their coffers. And thus a fractional reserve credit system was born.
Today, it is still possible to invest in gold receipts which can be redeemed for physical gold. Although most government mints do not deal privately with gold any longer, some enterprising private "mints" do. For example, the Royal Canadian Mint (not affiliated with the Canadian government) offers electronic tradable receipts (ETRs) backed by their vaulted gold, as well as collectible coins minted from precious metals.1 These ETRs can trade on an exchange or change hands privately and track the price of the gold that backs it.
While receipts are backed by gold and can be redeemed for it on demand, derivatives markets use gold as the underlying asset and are contracts that allow for the delivery of gold at some point in the future. A forward contract on gold gives the owner of the contract the right to buy physical gold at some point in the future at a price specified today. Forward contracts are traded over-the-counter (OTC), and can be customized between the buyer and seller to arrange such terms as contract expiration and nature of the underlying (how many ounces of gold must be delivered and at what location).
Futures contracts operate in much the same way as forwards, the difference being that futures are traded on an exchange and the terms of the contracts are predetermined by the exchange and not customizable. Because forwards trade OTC, they expose each side to credit risk that the counterparty may not deliver. Exchange traded futures eliminate this risk. Often times, forward or futures contracts are not held until expiration and so physical gold is not delivered. Instead, the contracts are either closed out (sold) or rolled over to another new contract with a later expiration.
Call options can also be used to gain exposure to gold. Unlike a futures or forward contract which gives the buyer the obligation to own gold in the future, call options give the owner the right but not the obligation to buy gold. In this way, a call option is only exercised when the price of gold is favorable and left to expire worthless if it is not. In other words, the price paid for the option (known as the premium) can be thought of as a deposit for the right to buy gold at some point in the future for a price specified today (the strike price). If the actual price of gold rises above that specified price, the owner of the option will make a profit. If, however, the price of gold does not rise above the strike price, the buyer of the option will lose the premium – like losing a deposit.
Derivatives markets are efficient ways to gain exposure to gold and are generally the most cost-effective, as well as provide the greatest degree of leverage. For the average investor, however, derivatives markets are unaccessible. Instead, a typical investor can gain exposure to gold via mutual funds that buy gold, or using gold ETFs which are traded like shares on stock exchanges . The SPDR Gold Trust ETF (GLD) is popularly used; the investment objective of the Trust is for its shares to reflect the performance of the price of gold bullion. There are also leveraged gold ETFs that provide the owner with 2-times long exposure, ProShares Ultra Gold (UGL), or alternatively 2-times short exposure, Goldcorp (GG).
While it may seem like a good way to gain indirect exposure to gold, owning the stocks of companies that mine for and sell gold, such as Barrick Gold (ABX) or Kinross Gold (KGC), may not give the investor the exposure to the precious metal that they wanted. The reason for this is that the majority of gold companies are in the business to make a profit based on the cost to mine for gold versus what they can sell it for. They are not in the business of speculating on its price fluctuations. Therefore, most gold companies hedge their exposures to gold price risk in derivatives markets, and owning shares of these companies mainly gives the investor exposure to the operating profit margins of that company.
Still, if an investor wants to own gold stocks to diversify an equity portfolio they may want to consider a gold miners ETF such as the Market Vectors Gold Miners (GDX).
Owning gold can be a store of value and a hedge against unexpected inflation. Holding physical gold, however, can be cumbersome and costly. Fortunately, there are several ways to own gold without keeping a physical stash of it. Gold receipts, derivatives and mutual funds/ETFs are all viable strategies to gain such exposure. Shares of gold mining companies, while seemingly a good alternative on the surface, may not give the gold exposure to investors that they want since these companies usually hedge their own exposure to price movements in gold using derivatives markets.