The Gold Rush: Don't Get Burned

With the yellow metal near $1,000 per ounce, investors are clamoring for coins and bullion. But buying gold in its physical form can be tricky

If you had any doubt that the prime motivation for investors has shifted from greed to fear, look at the price of gold. The spot price for the yellow metal reached $992.43 an ounce on Feb. 20, its highest level since hitting $1,002.70 on Mar. 17, 2008, the day that Bear Stearns collapsed. The spot price has climbed more than 39% from a near-term low of $712.30 on Nov. 12, 2008.

Demand for physical gold has exploded as the deepening financial crisis and ongoing slide in stock prices has pushed nervous investors into safe-haven investments. But new investors need to be careful about who they buy from, since inexperienced people seeking to take advantage of opportunities in the market are opening coin dealerships without being aware of the financial risks or legal compliance issues involved.

How to Choose a Dealer

"These days, with everything going on with the [Bernard] Madoff scandal and now the [Allen] Stanford scandal, you have to know exactly who you're dealing with," says David Beahm, vice-president at Blanchard & Co., a leading retail dealer of gold coins and other precious-metals products based in New Orleans. The best way to ensure the quality of what you're buying is to do your due diligence when choosing a dealer, he says. The Better Business Bureau is a good place to start, at least to be able to see whether a certain dealer's clients are satisfied or not. And the Internet makes due diligence that much easier. For instance, you can check whether a dealer belongs to the Professional Numismatists Guild (PNG), a nationwide association based in Fallbrook, Calif., on the PNG Web site.

Be wary of incoming cold calls from dealers unless it's someone with whom you have a long-standing relationship, advises Diane Piret, industry affairs director at the Industry Council for Tangible Assets (ICTA), the national trade association for rare coin and precious-metals dealers. Investors are better off seeking out dealers on their own. It's a good idea to look for companies whose dealers are members of the PNG, which requires dealers to have five years of experience as numismatists, have a net financial worth of at least $250,000, and be elected to the guild by a majority of the present members. PNG members must abide by guild rules, which include an arbitration process to resolve any dispute over product quality between buyers and sellers.

It's treacherous to enter the bullion market with no understanding of how tight the margins are and how rapidly investors can lose their shirts, given the volatility in gold prices, says Piret. Although she has received five or six inquiries recently from people asking which laws they need to comply with in order to establish a dealership, she doubts many of them have subsequently opened a business. "A dealer who buys and sells over $50,000 with all [his] customers of bullion-related products…needs to be compliant with section 352 of the Patriot Act and have a compliance officer," she says. "Cash reporting laws and money laundering laws are very serious."

Keep Close to the Spot Price

New investors in the yellow metal also need to keep an eye on the spot price of gold to ensure they're not being charged too high a premium for gold coins. It's common these days for dealers to sell gold coins at 8% or 9% above the spot price, and that's not necessarily bad, given the supply constraints for the retail product due to higher demand, says Dave Meger, managing director of metals services at Alaron Trading in Chicago. His firm has had to turn away orders occasionally in recent months when it hasn't received fresh product from the U.S. Mint.

During the fourth quarter of 2008, U.S. consumer demand for gold coins and bars jumped to nearly five times the amount from a year earlier, to 34.8 metric tons, according to the World Gold Council. Between Sept. 15 and early December, Blanchard sold more gold than it had in the prior three years, despite the Mint's 45-day suspension of sales of one-ounce American gold eagle coins after the collapse of Lehman Brothers. Blanchard had to sell "whatever product we could get our hands on"—Canadian maples or South African krugerrands—until supply of American eagles resumed, says Beahm. "At that particular time, nobody really cared what they had as long as they had gold."

To keep the premium they pay over the spot price to a minimum, Meger at Alaron recommends investors buy from one of the four authorized distributors that buy directly from the U.S. Mint. The Mint charges premiums of 3% on one-ounce gold coins, 5% on half-ounce coins, and 7% on quarter-ounce coins when it sells to authorized purchasers, which in turn mark up prices to dealers and individual investors. While Alaron can't buy directly from the Mint, it benefits from having a partnership with a firm that is an authorized purchaser.

Hedging Gold Purchases

Meger also suggests buying from a dealer who is linked to a brokerage firm with a reputable name in the commodities industry and who sells only exchange-approved brands, hallmarked bars, and reputable mint coins.

"We can offer clients the ability to hedge their purchases with options or futures contracts," he says. A buy-and-hold investor who expects to see gold prices pull back in the short term isn't likely to go to the trouble of taking gold out of the warehouse to sell it, but might think it advantageous to hedge his position by selling a futures contract. "It's nice to be able to deal with a brokerage firm that offers you that ability," he says.

Only a few of the 30 or so refiners whose brands are listed on the New York Mercantile Exchange's Web site sell gold bars in retail sizes of one, five, and 10 ounces. Until about a month ago, those smaller retail forms of gold were in short supply, but now that refiners realize they can get significantly higher premiums for them, they are starting to shift resources from jewelry and other industrial fabrication to increase production of the smaller retail forms, says Meger.

When ordering coins from a dealer, it's best to send your money in as quickly as possible, since dealers will only lock in prices once they've received "good funds" in the form of a bank wire transfer or cash. "The price could change from the time you contact us until the funds are good," says Beahm.

Alternatives to Bullion

From a cost perspective, there are far more efficient ways to buy gold than coins or bars, where uncertainty about the size of markups is compounded by shipping costs, says Leonard Kaplan, president of Prospector Asset Management in Evanston, Ill. "The alternatives are so much better and so much safer. You can either buy futures or ETFs. Then you're dealing with regulated industries, known quantities, not Joe Schmo coin dealer who's been around for two weeks," he says.

Gold investors have to pay shipping and storage costs on top of the hefty premiums they're already paying above the spot price. "Is it worth $6,000 to $8,000 on 100 ounces of gold to have it in your hand, and to lose liquidity, and to pay storage? I don't think so," Kaplan says.

Some strategists suggest waiting for a pullback in gold prices, to around $950, before buying more. But $992 may prove to be cheap a few months from now if things break the gold bulls' way. Beahm at Blanchard believes spot gold is poised to reach at least $1,500 by the end of this year, in view of all the liquidity the government is putting into the economy, which will eventually boost inflation.

Right now, the fundamentals look good for gold. But remember that the yellow metal has tripped up smart investors in years past, and will likely do so in the current boom.

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