Insure Your Portfolio with 'Glitter'

03/08/2013 10:30 am EST

Focus: COMMODITIES

Samuel Lee

Editor, Morningstar ETFInvestor

The rally in gold may be winding down, says Samuel Lee of Morningstar ETF Investor, but it should still hold a small place in your portfolio.

When the market questions the safety of a currency, investors often demand a hefty risk premium (higher real interest rate) to own it.

However, gold is perceived as being ultra-safe because no central bank can mint it with abandon, so there is no risk premium for gold. The more investors question the future purchasing power of paper currencies such as the dollar, the greater the demand for gold and the greater its price.

Right now, the main players in the gold market are central banks and institutional investors, in that order. Since 2008, emerging-market central banks have begun diversifying their foreign-exchange reserves by buying gold. Meanwhile, developed-markets central banks have slowed selling their gold reserves.

Some institutional investors such as pension funds and sovereign wealth funds have begun implementing strategic allocations to gold. The net effect has been to raise the demand for gold.

Finally, exchange rates over the long run tend to gravitate toward purchasing power parity, or PPP—the exchange rate that would equalize one’s ability to buy a basket of goods and services in either country. If, for instance, you convert $10,000 to Chinese renminbi to buy goods in China, you will be able to buy more goods than you could in the US. According to PPP, this would mean that the US dollar is overvalued and the yuan is undervalued.

Gold’s PPP analog is the ratio between its price and the Consumer Price Index, compared with the ratio’s historical average. Currently, gold’s real exchange rate is at historically high levels last touched in the 1970s. Over the long run, gold’s price will probably converge toward its historical ratio.

Gold’s valuations versus real goods are stretched to extreme levels. Over the long run, gold’s real value will likely converge to its historical average. In other words, if you hold gold for the next few decades, you should fully expect to lose your shirt.

However, in the short and medium run, gold’s price is supported by the lowest real interest rates in history and emerging-market central bank purchases.

Curiously, gold’s price has, over the past year, been oddly unreactive to falling real interest rates. This could either reflect a slowdown in central bank purchases or increases in central bank sales, or reduced fears of currency debasement. I don’t believe fears of currency debasement have fallen noticeably, so I suspect central banks may have slowed purchases of gold.

Gold should be considered insurance against the collapse of the fiat money system. Right now, a lot of investors are clamoring for protection, and low real interest rates are taking the sting off of owning the metal.

As a general rule, insurance policies are not supposed to make you rich. Despite my long-term bearishness on gold’s price, I think owning some in a strategic allocation makes sense—5% of your portfolio is a reasonable figure at today’s valuations, perhaps 10% if you’re confident that central banks will buy more, or you’re very risk-averse.

The biggest and most liquid gold exchange traded fund right now is SPDR Gold Shares (GLD). It’s a great choice if you intend to trade frequently. Buy-and-hold investors should consider iShares Gold Trust (IAU), because its 0.25% expense ratio is lower than GLD’s 0.4%.

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