Reprinted with Permission
Gold Bricks, Glass Houses and the Web:
Retooling Gold Funds
Managers of gold mutual funds have not been reticent in their criticisms of Ashanti, Cambior and other heavily or imprudently hedged mining companies. Granting the validity of their complaints, they are not without some responsibility themselves for the problems recently plaguing gold investors, notably their own shareholders. As a group, gold fund managers are the principal professional investors in this sector. They have the required analytical skills and technical support. What is more, many of them understand both the monetary role of gold and the dangers of gold banking far better than the mining companies or even the bullion bankers. Yet many gold funds apparently bought the bear case for gold sufficiently to sprinkle their portfolios with a significant number of heavily hedged miners while failing to do very complete investigation or analysis of their hedge books. What is more, few gold funds with the authority to invest in gold bullion actually held any. Seeking the leverage traditionally associated with shares, they spurned bullion while failing to appreciate fully just how quickly ill-advised hedging could turn leverage against them.
The purpose of this commentary, however, is not to criticize gold fund managers for falling victim to the pervasive bearish sentiment that engulfed the gold market in recent years. Rather, it is to offer some thoughts on what they might think about now.
1. Requiring Greater Transparency. No group is better situated than gold fund managers to insist that gold mining companies make full disclosure of all relevant information, including their hedge books. Put bluntly, gold fund managers need to remember their ABC's, which in this case are Ashanti, Bre-X and Cambior. All these disasters blindsided more than a few gold fund managers who were just a little too careless, a little too ready to follow the crowd, and not demanding enough of the companies in which they were investing. Gold funds operate in a quite restricted universe, making it understandably difficult to avoid investing in a major company which others seem to like. In the gold sector particularly, the temptation to lower or waive established investment criteria because of the actions of others must be resisted.
2. Participating in Mining Finance. Due principally to their own greed and self-interest, the bullion bankers have failed the gold mining industry. With their eyes set narrowly on earning a spread, whether from mining finance or the gold carry trade, the bullion banks have failed to give their mining company customers sound and prudent financial counsel. This failure now gives gold funds a good opening to become more active in mining finance themselves. Gold funds, their shareholders, and the companies in which the funds invest all have a community of interest in stronger gold prices. Bullion banks searching for profit or official favor in trashing gold are not part of this community.
In this respect it is useful to compare a gold loan to a mining company with a gold bond or gold preferred issued by the company. In each case the basic idea is to repay the obligation out of future gold production. Interest costs are typically comparable, i.e., based on gold lease rates rather than ordinary interest rates. However, in a gold loan, gold is borrowed and simultaneously sold into the market at spot, putting immediate pressure on the gold price. With a gold bond or a gold preferred, the company receives cash but there is no immediate sale of gold, and the loan principal when due is paid directly out of production. While issuing costs for gold bonds or gold preferreds, particularly those which are publicly traded, generally exceed gold loan fees, the swift pace of financial reform could lead to a narrowing of this gap too.
Gold loans and forward sales have a legitimate role to play in mining finance, but when they are conditioned on margin requirements or required call/put hedging that jeopardize a company's financial viability, the time has arrived to consider other alternatives, e.g., debt instruments or preferreds convertible into equity or with accompanying equity options, gold bonds, gold preferreds. All these vehicles are appropriate investments for most gold funds, and to a limited extent could be bought by many even on a private placement basis. A portfolio consisting of bullion, gold bonds or preferreds, established producers who hedge prudently or not at all, and a few carefully selected smaller companies should more than hold its own against a portfolio of all the usual suspects, i.e., the better known gold equities.
3. Buying Gold Bullion. As of August 1999, the U.S. gold funds covered by Morningstar had total assets of about $2.5 billion. At $300 gold, 40% of that amount or $1 billion would buy more than 100 metric tons of gold, or more than three times the current COMEX stocks, more than Kuwait recently made available to the Bank of England, and four full tranches of the current BOE gold sales. At US$18 per share, the market capitalization of heavily hedged Barrick Gold is just over $7 billion, of which more than 75% is public float. Sale of 20% of Barrick's float at $18 would yield more than a $1 billion. In other words, gold funds have sufficient resources to be an important factor in a tight physical market, particularly if they take delivery or insist on allocated storage. And many if not most have the ability under their existing charters to substitute bullion for shares. What is striking in reviewing the August portfolios of the gold funds covered by Morningstar is how similar they were and how little bullion they contained.
Indeed, physical gold can be as or even more useful in a gold fund portfolio than an individual portfolio. Not only does it serve as insurance and to reduce risk and volatility, but also it enables a gold fund to stay reasonably fully invested in gold even when good mining investments are hard to find, such as during periods of low gold prices and excessively hedged mining companies, or periods of high gold prices and overvalued mining equities. A gold fund manager who prefers bullion at low gold prices to the shares of a mining company that has hedged away much of its upside does more than just benefit his fund's shareholders. He acts both to support the gold price and to discourage new or additional production at low prices.
4. Offering Internet Gold Bullion Accounts. So far as I am aware, only e-gold (www.e-gold.com) offers bullion accounts on the internet. My knowledge of e-gold is limited to what can be observed at its site. I have no connection with it, and I take no position on whether one should or should not use it.
An e-gold account, which can hold gold, silver, platinum or palladium, is fundamentally a storage or custodial account as opposed to a bank account, meaning that e-gold promises to hold a 100% metal reserve against its deposits, which e-gold describes as a "spendable bailment." Profits come from bid/ask spreads and certain transaction and storage fees. Through arrangements with online merchants and other intermediaries, an e-gold account can be used to make or receive payments in any of several major currencies converted to equivalent metal values at current market rates. Various other features and details of an e-gold account can be viewed at its website, which is well worth a visit if only to see the idea in practice.
The concept of online accounts that can be used for both investing in gold bullion and making or receiving payments appears not just viable but probably inevitable. What is surprising is that so far only one company is offering such an account, and it has no discernible connection with any of the big names in gold, be they bullion banks, gold funds or mining companies, nor with any of the recognized financial services firms so intent on worldwide growth via the internet.
The concept itself is really no more than applying in the internet age pretty much the same basic ideas that resulted in the development of gold banking by ancient goldsmiths. While the bailment concept may work best for a relatively small or unknown entity like e-gold, there is really no conceptual reason that old-fashioned retail gold banking could not be practiced on the internet by a financial or other entity with sufficient name recognition, reputation and resources to do so credibly.
Certainly there are numerous legal, tax and other questions that would have to be addressed, and probably a gold mutual fund itself could not offer such accounts. But open-ended gold funds that are tied into large fund groups or banks have the required electronic infrastructure and software capabilities largely in place, not to mention the necessary accounting and legal resources, regulatory contacts and political clout. Just as large fund groups offer linked investment and money market accounts, they could offer linked gold fund and internet bullion accounts. In the U.S. internet commerce enjoys various tax advantages, both existing and proposed, that could be particularly beneficial to gold. In the arena of international financial services, an internet bullion account might in many situations be of far more interest to prospective customers than retreads of existing American investment products.
Successful young internet entrepreneurs are driven by opportunities that the more experienced do not see, undeterred by obstacles others proclaim insurmountable. Someday, somehow, someone will offer internet bullion accounts in an increasingly prosperous India moving toward fuller and freer integration into the world economy. At internet speed that day may not be too far in the future. And most who could have been players will be spectators.
22 November 1999