History and Hedge Strategies of Gold

American Eagle and South African Krugerrand gold bullion. Scott Olson/Getty Images News/Getty Images

Gold can be used as a hedge against (or as safe harbor from) inflation, stock market declines and falling currency prices, especially with the US dollar. But what is the best way to invest in this precious metal and commodity — with mutual funds or ETFs. Let’s begin by learning the basics of gold.

The Use of Gold as Money or Currency Standard

Until recent times, gold has been used throughout history as money and has also been used as a standard for currencies. The gold standard is when the value of a country’s money is tied to the amount of gold the country possesses. An individual holding a particular country’s paper money could present it to the government and receive an agreed upon value (par value) from that country’s gold reserves.

Gold as a currency standard has some advantages and disadvantages. The basic advantages derive from the fact that gold is a fixed asset: When a country’s currency is fixed to the asset, it is not possible to print more currency than the country has in gold. This discourages and reduces government debt and the nations that are able to produce more exports can attract more gold.

However, the nations with less gold as a natural resource are typically the poorest unless they are able to compensate with more exports of goods and services. But the desire to obtain or hold on to gold can also potentially distract from the desire and energy to produce better goods and services.

The Use of Gold as an Investment or Hedge Strategy

In recent times, investors have concerns about the devaluation of the US dollar. Due to large government deficits, the federal government pumps more money into the economy as stimulation. However, the more money that is created, the lower its value. As concerns over dollar devaluation increases, more investors invest in gold as a perceived safer alternative.

This adds to the effect of self-fulfilling prophecy: As the demand for gold increases, so does its price. For related reasons, gold is considered a safe haven; investors feel more comfortable with real assets in times of economic uncertainty. Therefore gold can be used as a hedge against inflation but also as a hedge against hard economic times.

Investing in Gold Mutual Funds and ETFs

The most common means of buying gold is either in bullion gold coins or through a bullion Exchange Traded Fund (ETF) such as the SPDR Gold Shares (GLD). Mutual funds invest little to no assets in physical gold. Usually categorized as Precious Metals, gold mutual funds typically hold stocks of mining companies. A few of the best gold mutual funds, in terms of long-term performance, long manager tenure and average to low expense ratios include Tocqueville Gold (TGLDX) and Gabelli Gold Load-Waived (GLDAX.LW) .

Which is best, gold mutual funds or gold ETFs?

A Wall Street Journal article, Gold Mutual Funds vs Gold ETFs. makes a few good points. Use the ETF as the traditional hedge against inflation or extreme economic downturns when investors typically flee to perceived safety of physical assets like gold. However WSJ makes this valid point for gold mutual funds:

If it costs a company $800 to mine an ounce of gold, and gold is $1,000 an ounce, the profit for the company is $200. If gold rises to $1,100, the profit becomes $300. That’s a 50% rise in profits off a 10% rise in the price of gold.

Caution About Investing in Gold

It is important to remember that gold should never be used as a market timing tool or as the sole vehicle for all of your savings. The price of gold can have dramatic turns and the long-term average return for gold as an investment trends around 3.00%, which is significantly less than that of an average S&P 500 stock fund. Gold can be a good diversification tool and an appropriate amount for most investor portfolios is around 5%.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.