All that is gold still glisters as jewellery drives market

Gold may have had a strong run, but fans of metal remain bullish, says David Prosser

Mark Twain had a warning for investors in gold. "A gold mine is a hole in the ground with a liar on top," he once wrote. But despite the shady characters that have been associated with the precious metal, its allure to collectors and investors has rarely been tarnished.

Gold has long been seen as a hedge against inflation and a refuge. But while gold is one of few investments to have an intrinsic value, the metal has until recently been out of favour.

It is more than 25 years since the gold price peaked at $850 a troy ounce in 1980 (then around £380). Gold's reputation as a safe haven was hit hard during the Nineties - after a long bear market, the price had fallen as low as $252 by 1999 (then around £150).

Since then, and particularly from early 2001, gold has staged a remarkable recovery. The price is now around $530, the highest since 1983, with further gains early in the new year.

Gold investors have gained through an increasing imbalance between demand and supply. During the Nineties, as the price fell, few mining companies explored new reserves, so there is little chance of any significant increase in supply.

Demand has been outstripping supply for at least 10 years and is steadily increasing. Some shortfall is made up by sales of gold by the world's central banks, but these have slowed.

In uncertain times, such as the three-year decline of world stock markets from 2000, gold has more appeal as a safe investment. It has a very low correlation with other types of asset - it does not tend to fall in price at the same time as shares or bonds, which makes it a good way to diversify.

Demand for gold jewellery, particulary in developing nations such as India and China, has soared, further buoying the price.

But investing in gold carries its own risk. It has often proved a volatile asset - not least because so many mines are in emerging markets rather than developed economies. And the risk of buying into any asset after a long period of gains is that you are getting in just before prices plummet.

Nevertheless, gold bugs are quietly confident that gold's strong run has further to go. "Favourable supply and demand fundamentals will support the gold price in all currencies," argues Graham Birch, the manager of Merrill Lynch's Gold & General Fund.

Third-quarter 2005 figures from the World Gold Council show that investment demand has increased by 56 per cent year on year, while jewellery demand remains strong, Birch says. "Though total mine supply increased, South African production declined by 15 per cent. Such an environment should support the gold price going forward."

Darius McDermott, managing director of independent financial adviser Chelsea Financial Services, says rising demand for jewellery could be the key factor driving the gold price onwards. "Demand from developing countries will continue to grow because the middle classes are growing," McDermott says. "In China, there are expected to be 200 million people joining the middle classes. Gold jewellery will be one of the things they buy."

The bullish outlook is not to say investors should get out of property and shares. Even those who think gold is in the middle of a "super-cycle" of growth suggest the metal should only be a small part of your portfolio.

The World Gold Council has argued that gold should make up 8 per cent of the typical investor's assets. More independent experts suggest 5 per cent might be a more reasonable figure.

There is also the question of how to get that exposure. One option is to buy gold - purchases for investment purposes are not subject to VAT. The alternative is to find conventional investments that offer gold exposure, such as shares in gold-mining companies.

GOLD COINS

Launched in 1970, Krugerrands are synonomous with gold investment. The coins are available in large quantities, and are very cost effective for small investors. It's easy to compare prices because each Krugerrand contains an ounce of gold.

Countries including Canada, the US, Singapore and Britain have launched their own coins. But don't confuse these bullion coins with commemorative coins, where the value depends on rarity, design and finish. Bullion coins are priced on the value of the gold they contain, though prices vary.

There's a spread between the buying and selling price. About 7 per cent is typical, so you'll need prices to rise this far to be in the money.

The World Gold Council (020-7826 4700; www.gold. org) and British Numismatic Trade Association (01797 229988, www.numis.co.uk/bnta.html) list details of reputable dealers.

GOLD BARS

Gold bars can represent better value than coins. They are cheaper to make and dealers take a smaller cut on sales. Buying a gold bar can be cheaper than buying the same weight of gold coin.

Small bars - of interest to most investors - are defined as those weighing 1,000g or less. Around 50 manufacturers offer more than 300 bars of different weights (see the World Gold Council for where to buy).

Whether you buy bars or coins, you need to consider storage carefully. Some dealers will store your investments - for a fee - but if you're keeping gold at home, you may need a safe. And you will pay more in home insurance.

MINING SHARES

There's a strong link between the price of shares in gold-mining companies and the value of gold. But this may be a riskier way to bet on the price of gold rising.

Mining firms often sell future production years in advance to protect themselves against fluctuations in price. Shares may not move as you expect when the gold price rises.

Gold shares have often been more volatile than the underlying asset. The value of gold miners has fallen more quickly when the gold price has dropped, exposing investors to potentially serious losses.

GOLD FUNDS

Stock market investors may therefore prefer to stick to a well-diversified fund that is run by a professional manager and invests in a portfolio of companies. Darius McDermott recommends two specialist funds that have performed well over the past year.

"We like Merrill Lynch's Gold & General Fund, which is primarily exposed to larger mining companies," McDermott says. "Alternatively, the CF Ruffer Baker Steel fund has holdings in more medium-sized and smaller companies."

The alternative is a commodities fund that has some exposure. McDermott suggests JP Morgan Fleming's Natural Resources fund.

GOLD SECURITIES

Finally, some investors may like gold bullion securities, the brainchild of the World Gold Council, which has been trying to develop ways of making gold more accessible to investors.

The securities are listed on the London Stock Exchange - each is valued at about one-tenth of an ounce of gold. You invest as with any share, but in addition to the broker's fees you'll pay an annual management fee of 0.3 per cent, which covers storage, insurance and administration.