Will gold fever continue, and how secure are client investments in gold?

By year-end, precious metals mutual funds had gained 41.56% for 2010, compared with more than 29% for the two leading gold exchange-traded funds. Nevertheless, both fund categories, which typically invest in gold, hammered the 15.06% return of the S&P 500 index. By year-end, gold bullion vending machines had debuted in shopping malls!

Raising eyebrows was the fact that recycled gold, which includes melted-down jewelry, has been setting historic records. The gold supply from recycled gold rose 41% in the third quarter of 2010 above year-earlier levels, reports the World Gold Council, New York, the gold industry's market development organization and sponsor of the largest exchange-traded fund, SPDR Gold Trust (GLD). Mine production of gold over the same period rose just 3%.

Nobody seems to know whether mom's gold wedding band bought by Joe's pawnshop is finding its way into gold bars, lodged in bank vaults. Rather, the gold standard used by the largest ETFs to ensure purity revolves around "London Good Delivery" bars. These are bars between 350 and 430 troy ounces that have been produced to specifications of weight, fineness and dimensions set by the London Bullion Market Association, a trade association. Only LBMA-accredited refiners can manufacture these bars. If an LBMA investigation turns up a justified complaint about a good delivery bar, LBMA would write to the refiner seeking "appropriate restitution to the customer."

One gold scam was so sophisticated it tricked some of Hong Kong's largest jewelers, the Financial Times reported in early December. Jewelers and pawnshops, so far, have turned up at least 2,000 ounces of fakes that had passed basic scrutiny. Other published reports indicate that gold-plated tungsten bars have shown up in China's Central Bank, in vaults in Hong Kong and Fort Knox and at a German LBMA gold refinery.

Michael White, a spokesman for the U.S. Mint, denies the report of fake gold bullion at Fort Knox. In fact, he says, you can track the nation's gold supply online at www.fms.treas.gov, and it is audited annually.

"There's been a controversy over the last couple of years whether gold bars are really gold or gold-plated tungsten," says James Turk, founder of the online gold trading and storing Web site, GoldMoney.com. "The only way you can [test it] is through ultrasound testing. Turk says he recently implemented such a system through GE Inspection Technologies, Billerica, Mass.

The leading gold exchange-traded funds-SPDR Gold Trust (GLD) and iShares Gold Trust (IAU)-disclose in their prospectuses that neither the trustee nor custodian independently confirm that their gold bars meet London Good Delivery standards. IAU goes so far as to say its custodian's review of the accuracy of the bar list "does not include any chemical or other tests designed to verify that the gold received does, in fact, meet the purity requirements referred to in the Trust agreement."

Gold investment, largely through gold bars and coins, represents an average of 34% of demand for gold, the World Gold Council says. Demand through ETFs has swelled to an average of 40% of investment demand over the past three years, dropping slightly to 32% in the year ending September 30.

While mutual fund gold mining stocks in 2010 were the darling performance-wise, investment companies also can hold gold bullion. Seven of 21 precious metals mutual funds hold gold bullion or legal tender gold coins, according to Morningstar Inc., Chicago. There are four funds that invest in the SPDR Gold Exchange Traded Fund or iShares.   

Funds with the largest share of gold bullion are First Eagle Gold, Fidelity Select Gold and Tocqueville Gold, with 15%, 4% and 8% respectively in gold bullion.

Morningstar analyst Janet Yang says the reason for the decline in gold bullion holdings is that mining companies stopped hedging their exposure to gold around August. As a result, their stock prices should move much more closely with the price of gold, and on the upside, mining stocks should outperform bullion due to operating leverage.

Joe Foster, portfolio manager of the Van Eck International Gold Fund, says that although he can invest in gold bullion, he holds none. "Gold stocks generally outperform bullion in a rising market," he explains. "Gold is a defensive investment. If I thought the gold market were going to decline, I would go into gold bullion."

How he defensively invests in gold, he says, would depend upon his projected time horizon. He might consider gold bullion for a three-to-five-year time horizon. But if the time horizon were only up to one year, he probably would invest in a gold ETF instead because it's easier to trade.

When Joe Wickwire joined Fidelity in July 2007, he demanded, as a condition of employment, that the gold fund he manages be able to hold gold bullion. Wickwire, portfolio manager of the Fidelity Select Gold and the Fidelity Global Commodity Stock Fund, says, however, that he does not invest in gold exchange-traded funds. Fidelity doesn't want counterparty risk, he says.

From Fidelity's standpoint, the financial crisis of 2008 demonstrated the importance of making sure that you are comfortable with counterparty risk, he says. The most that Fidelity Select Gold has kept in gold bullion is about 10% of assets.

While it's rare for a mutual fund to hold gold bullion, Wickwire views it as a key to his investment strategy. "Having gold bullion gives you a very liquid investment vehicle," he says. While it's very liquid, he says, it has a low relative volatility when compared with gold stocks.

The Select Gold Fund, he says, contains five categories of gold in one portfolio. The other four: larger gold companies, intermediate-size gold companies, junior gold companies and exploration and development companies. "One of the things investors are looking to diversify is U.S. dollar risk," Wickwire explains.

Gold bullion is the only commodity that is also a currency, and it's the only currency that is not someone else's liability, he says. "The people I'm investing for are U.S. dollar-based investors. One of the things my investors are asking me to do is give them an attractive risk-reward exposure to an asset class which has unique performance characteristics. It has the capacity of outperformance when stocks, bonds and U.S. dollars disappoint."

Wickwire says he decides when he wants to hold gold bullion. "I call up the bullion bank and say here's what I want to buy and it's allocated for us and stored for us. It's one of the easiest transactions you can make. There is no counterparty risk. It's an electronic transaction." It's basically the same order entry system as buying and selling stocks, he adds. 

Rival Vanguard Group, however, shuns gold bullion as a mutual fund investment. Christopher Philips, senior investment analyst in Vanguard's investment strategy group, likens investment in gold to the technology bubble. He challenges would-be gold bullion investors to look at gold today relative to five or ten years ago.
He cites three chief reasons most investors hold gold bullion:
A hedge against inflation.
A hedge against the dollar to diversify paper currency.
Disaster insurance.

Philips contends, however, that there is zero link between gold and inflation: Just look at the last ten years in which there has been minimal inflation in the United States. If gold were linked to inflation, you'd expect gold prices to be flat, he asserts.

If you're considering it for clients as a dollar hedge, look at the price of gold in other currencies, he suggests. You'd expect to see performances somewhat different across currencies, he says, but if you look at the euro, yen, pound and Australian dollar, you see gold appreciating across all currencies.

While a lot of advisors would say to put no more than 5% of your portfolio in gold, the flip side of that: "If you do have 5% in your portfolio, the aggregate impact to your portfolio isn't that great," he says. Meanwhile, "it's a very, very volatile asset class. You may be buying at its peak."

If a financial disaster doesn't happen, he reminds that gold prices went through 25 years of year-to-year negative returns. The recent stock bear market has only run for ten years.

Turk and other gold bullion traders have warned that a greater risk to gold investing than fraud and inferior gold quality may be the short-selling of gold in paper transactions and careless use of subcontractors. As gold bars are lent out, they may or may not come back intact. In fact, John Paulson, the famed hedge fund manager, holds an ownership stake worth more than $4 billion in the SPDR Gold Trust, according to the SEC 13F form filed by Paulson & Co. Inc for the quarter ending last September 30.

"Let's say John Doe buys 100 shares of GLD thinking his shares are backed by gold," Turk says. Those shares can be lent to a hedge fund, which sells the fund short. You don't actually own the gold. You own paper saying you own the gold."

A third party audit may help mitigate this risk, Turk suggests. But beware that the quality and scope of audits on paper gold investments can vary dramatically.

SPDR Gold Trust makes public its audit, by Inspectorate International Limited, Wiltham, Essex, in the United Kingdom, which last September was acquired by Bureau Veritas, Neuilly-sur-Seine, France.

At this writing, its most recent audit, released November 1, 2010, represented a count as of June 30, of 105,513 bars of gold. It cited "anomalies" in 441 gold bars. The errors involved incorrect numbering and incorrect refiner brands on the bars.

Turk says that if you're considering paper transactions that invest in gold bullion, you might consider that more comprehensive audits are conducted by a Calgary, Alberta closed-end fund, Central Fund of Canada Limited, and the Toronto-based Sprott Physical Gold Trust.

"I'm not trying to belittle GLD [SPDR Gold Trust]," he says. "It's a useful tool for people who want exposure to the gold price as a professional trader."