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The rise and rise of gold

Ten years ago, gold was languishing at around $A400 an ounce. But since 2006 the price of gold has skyrocketed, reaching $A1,450 by late July 2011. Felix Stephen, Manager of Strategy & Research at Advance Investment Solutions says there are several reasons behind gold’s stellar climb.

The availability of gold hedge funds

Gold has historically offered protection against inflation and elevated levels of social or political uncertainty. The downside has been the limited opportunities for ordinary investors to dabble in gold. This changed when a number of exchange traded funds (ETFs) became available that focused on gold. These ETFs made it easier for investors to buy into the precious metal, thereby increasing the popularity – and price of gold.

Demand from India and China

“Economic prosperity is also seeing households in India and China – two of the world’s most populous nations; increase their demand for gold along with the sharp increase in household wealth,”says Stephen.

A defence against inflation

Amid continuing economic uncertainty, Stephen points out that many central banks have invested in gold as a form of protection against depreciation in the value of major reserve currencies, in particular the US Dollar.

Psychological benefits

The interesting aspect of gold is that while the yellow metal is a relatively good conductor of electricity, it has relatively little intrinsic value. In fact, as an investment gold has significant shortfalls including the absence of ongoing return.

“Gold has purely psychological benefits for people who want to hold it as a hedge against currency and other investment risks,” says Stephen.

Traditionally, gold producers would “cap” the rise in the price of gold by hedging production costs. This was achieved by selling exchange traded futures contracts when the gold price was attractive.

However, as the price of gold continued to accelerate due to reasons outlined earlier, the resulting price appreciation forced produces to liquidate these futures hedges with significant drawdowns.

Since then, gold producers have not been participating in futures hedging, as actively as they once did. The exponential growth in ETFs in futures-based commodity investing has resulted in “gold now behaving much like any other financial asset”, meaning it has lost its original value as a real asset and/or a hedge against inflation or adverse currency movements.

Be wary of a gold ‘bubble’

So while gold may offer psychological comfort to investors, the transition of gold to a fundamentally ‘paper’ asset underpins the need for caution.

Stephen says, “The fact gold has become a financial asset driven by hordes of speculators makes it essential for investors to ‘watch this space’. If speculators bale out of the market en masse, the price of gold could fall quickly.”

In particular, investors need to be on the lookout for the turning point when the price of gold reaches ‘bubble’ levels and perhaps, with a corresponding rise in the US dollar. Investors should also pay close attention to regulators who may not hesitate to act to dampen excessive speculative activity in derivative markets.

“When there is a structural upward shift in the US Dollar, the gold price may fall.” according to Stephen.

Undoubtedly at that point, gold will quickly lose its lustre among investors. Stephen warns that a turnaround could happen quickly. “Investors could suffer – but that’s the risk of investing in gold.”

For investors keen on tapping into the market for gold, speak with your financial adviser about the investment options available and the risks involved.

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