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Gold Not Really Golden

The current value of gold is driven by the demand & supply of paper gold in the financial markets, writes Dhirendra Kumar

The recent surge in gold prices has once again turned the spotlight to gold as an investment. The presence of Gold Exchange Traded Funds (ETFs) and gold stock funds makes fund investors acutely aware of the performance of gold vis-à-vis funds that invest in equity or debt. When an investor looks at fund performance data on valueresearchonline.com or any other mutual funds portal, he can't help noticing how equity funds look like poor cousins of gold funds.

Currently, Gold ETFs lie at the top of the heap on just about every performance table. Over the last three months, Gold ETFs gained about 30 per cent while even the best equity funds have barely gained anything at all. Over longer periods, investors find the difference all the more stark. Over one year, gold has gained about 30 per cent while equity funds have lost a hefty 50 per cent. Even out to five years or so, gold leaves equity in the dust.

However, this stark contrast between equity and gold returns is a peculiarity of the point of time where we are right now. I believe that gold as an investment has changed characteristics over the last few years. It is now yet another hyper-volatile paper asset whose value will yo-yo as violently as that of any other. Just look at the numbers I've quoted above. Over the last three months gold ETFs are up about 30 per cent, which is exactly what they are up over a year. And that's because gold too has had a few very volatile months. International gold prices last peaked in March 2008. From that time to the end of October, gold fell about 25 per cent. During that time, stocks were falling sharply and so was gold. Back during the panic of October, gold wasn't looking like such a great hedge against falling stock prices. Remember, when the global financial panic was at its peak in October, gold prices were at their recent low.

Historically, gold's cover as the asset to hold during bad times was of a very different kind. That reputation was not of a paper asset that would fall less than stocks, but that of being physical wealth that would continue to hold value even if society was in a state of collapse. If you were a Jewish family still in Paris in 1942, you would have tried to buy your way to Spain with gold coins. Those are the scale of crises that gold is a good hedge against, provided it is real physical gold in your physical possession. Gold ETF units or dematerialised gold options on a commodity exchange are unlikely to be of much use. Here's a joke someone SMSed me on the 23rd of October. First guy: "The financial crisis is making me really pessimistic. I'm starting to buy gold". Second guy: "You're an optimist. I'm buying rice."

Today, the value of gold is increasingly driven by the demand and supply of paper gold on financial markets. It is a financial asset and is clearly subject to the same volatility as other financial assets as investor interest flows in or out. We could well be in a gold bubble which is just as ephemeral as the stock or oil or real estate bubbles were. Waking up to gold today could be like waking up to stocks or real estate in 2007.