New gold bugs making gold investments mainstream
Tudor, Paulson, Greenlight, Hayman bring precious metal in from the fringe
By Alistair Barr, MarketWatch
SAN FRANCISCO (MarketWatch) — Gold has long been favored by a fringe of the investment world, but this year some of the world’s leading hedge-fund managers have loaded up on the precious metal amid concern government efforts to avoid another Great Depression that could undermine major currencies and fuel rampant inflation.
“I have never been a gold bug,” Paul Tudor Jones, chairman of hedge-fund giant Tudor Investment Corp., wrote in an Oct. 15 letter to investors. “It is just an asset that, like everything else in life, has its time and place. And now is that time.”
Tudor has been building positions in gold and other precious metals in recent months and they now represent the firm’s largest commodities exposure, he noted.
John Paulson’s Paulson & Co., one of the world’s largest hedge fund firms that made billions betting against subprime mortgages, is launching a new gold fund Jan. 1 and became the largest holder of the SPDR Gold Trust exchange-traded fund this year.
Greenlight Capital, run by David Einhorn, reversed a long-time aversion to gold, while Kyle Bass’s Hayman Advisors LP held more than 15% of its portfolio in gold and other precious metals earlier this year. Eton Park Capital, headed by former Goldman Sachs trader Eric Mindich, has also got in on the act.
“I can’t remember in 20 years so many respected investors focused on a single strategy,” said Bradley Alford of Alpha Capital Management, which invests in hedge funds. “Some of these people are icons of the industry with at least 15-year track records. It’s a losing proposition to bet against guys like that. They aren’t billionaires because they make bad bets.”
It’s not only hedge funds. Managers of mutual funds and insurance company portfolios are often limited in how much gold they can buy, but these investors have been purchasing the metal for their personal accounts, according to Ed Yardeni, president of Yardeni Research.
“A surprising number of level-headed folks, who I have known over the years, are confessing to me that they’ve become gold bugs,” he said. “They’re starting to give more respect to what was for a long time considered the lunatic fringe.”
On Monday, the most active New York gold contract notched a new high of $1,174 an ounce.
SPDR Gold gained 1.6%, bringing its November advance to 12%.
The original gold bugs have been fans of the metal for decades. They yearn for the past, when the so-called Gold Standard was the central cog of the world’s currency system. A similar system known as the Bretton Woods Agreement tied the U.S. dollar, and all currencies pegged to the dollar, to the price of gold. When the system broke down in 1971, there was no longer a limit on the amount of money that could be printed by governments.
Gold bugs hung on grimly as prices dropped in the ’80s and ’90s amid quelled inflation and roaring stock markets. But gold prices began climbing at the start of this decade, when the Federal Reserve slashed interest rates to revive the U.S. economy in the wake of the dot-com bust.
That helped fuel a housing and credit market boom that came crashing down last year, triggering a global financial crisis and the worst recession since the Great Depression.
The Federal Reserve, headed by Ben Bernanke, responded by slashing interest rates to almost zero and spending more than $1 trillion buying long-term U.S. Treasury bonds and mortgage-backed securities and other debts from collapsed housing giants Fannie Mae and Freddie Mac.
That’s stabilized the economy, but some leading hedge fund managers worry about the long-term consequences of this so-called quantitative easing and are using gold to protect themselves.
‘Grandpa Ben’
“The Fed is making loans collateralized by toxic waste and has now begun a policy called ‘quantitative easing’ — a fancy term for ‘printing money,'” Greenlight’s Einhorn wrote in a January letter to investors.
David Einhorn of Greenlight Capital, Inc.
Printing so much new money will cut the value of the U.S. dollar, which could fuel rapid inflation. In such an environment, the solidity of gold could shine.
“If the chairman of the Fed is determined to debase the currency, he will succeed,” Einhorn added. “Our instinct is that gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself.”
Einhorn initially invested in the Market Vectors Gold Miners ETF, which tracks shares of gold-mining companies. He’d also bought call options on gold, as well as buying the metal directly, according to Greenlight’s January investor letter, a copy of which was obtained by MarketWatch.
Since Einhorn launched Greenlight in 1996, he’s shunned gold and other broad economy-based trades in favor of tracking down under-valued and over-priced stocks.
“We never thought we would ever buy gold or gold stocks,” Einhorn wrote in January, recounting the lesson he learnt from his grandfather’s obsession with the precious metal.
“David’s grandfather Benjamin was a gold bug,” Einhorn recalled. “From the time David was 10, Grandpa Ben took every opportunity to tell David about the problems with fiat currencies and the coming inflation and advised that the only sensible thing to do was to buy gold and gold stocks.”
Einhorn’s grandfather followed his own advice for the last 30 years of his life and lost money.
“Being a patient investor is one thing. Being ‘wrong’ for three decades is quite another,” Einhorn noted.
‘Grandma Cookie’
However, Greenlight Capital lost more than 15% last year — its first ever annual loss — as the global financial crisis rocked the hedge fund industry. Einhorn had rightly warned of the demise of Lehman Brothers before it happened, but he underestimated the broader impact of such an event.
“The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture,” he said during an Oct. 19 speech at the Value Investing Congress in New York.
At the same conference four years earlier, Einhorn advocated his Grandma Cookie’s approach of investing in stocks like Nike, IBM, McDonald’s and Walgreens, over his Grandpa’s holdings of bullion and gold stocks.
“I explained how Grandma Cookie had been right for the last 30 years and would probably be right for the next thirty,” Einhorn said. “However, the recent crisis has changed my view.”
Gold should do “fine” until policymakers and politicians show more monetary and fiscal restraint. The metal will likely do “very well” if there’s a sovereign debt default or currency crisis, he added.
Einhorn said last month that he moved all his positions into physical gold because it’s a cheaper, more-certain and more-liquid way of investing in the metal.
Physical delivery
Hayman Advisors, a Dallas, Tex.-based hedge fund firm run by Kyle Bass, became another proponent of holding physical gold this year.
Most precious-metal investing has historically been done via paper futures contracts on COMEX, part of the New York Mercantile Exchange, owned by CME Group.
However, Hayman expects more demand for physical delivery of precious metals. That could cause problems because there are only enough inventories in COMEX warehouses to supply 15% to 30% of open interest on futures and options contracts, the firm explained in a presentation to investors earlier this year.
“It is prudent to focus efforts on obtaining physical delivery of metals backing paper contracts ‘while supplies last,'” Hayman wrote in its presentation, a copy of which was obtained by MarketWatch.
Faster Monopoly
Bass, Einhorn and others are holding gold because they’re concerned that a damaging bout of inflation will be triggered by the efforts of several central banks to stabilize economies by pumping lots of new money into the global financial system.
“In God-like fashion (with a little ecclesiastical white-out), the central banker decides to add two more banks of money to the game that are distributed to the participants,” Bass wrote. “Under this scenario, did the real value of anything change? Does the bartering for property increase or decrease prices? Did each unit of money become worth more or less?”
Reserve multiplier
Quantitative easing by the Fed has pumped roughly $1.2 trillion into the U.S. financial system this year. But M1 money supply, the most liquid measure of money outside of tangible currency, has only increased a seasonally adjusted $73.2 billion, Hayman said, citing Fed data.
This hides the potential for a massive increase in money supply that could be unleashed from bank reserves, the firm added.
The foundation of money supply is the monetary base of an economy, which consists of tangible currency and reserves that banks are required to hold against customer deposits.
The reserve requirement is usually about 10%. This means banks can lend out 90 cents for every dollar they get in deposits. That money often ends up in another bank account, and 81 cents of this is re-lent, and so on, Hayman explained.
Banks usually lend as much as possible, but since the collapse of Lehman last year they’ve been hoarding excess cash. As the Fed’s quantitative easing picked up steam this year, the extra money has piled up in bank reserves, rather than flowing out into the economy.
Excess reserves in the U.S. banking system stood at an unprecedented $855 billion recently, up from $2 billion a year earlier, according to Hayman.
If banks decide they’re comfortable enough to lend out these extra reserves, “it would not increase the money supply by $855 billion; rather it would increase the money supply by some multiple of that,” as the money is deposited again and re-lent over and over, Hayman wrote.
This so-called banking reserve multiplier has historically been at least seven times, which suggests that the money supply could balloon by about $6 trillion, Hayman estimated.
“Do you trust the Federal Reserve et al. to select the precise timing of when to withdraw the money from the system, such that a recovery is sustained and inflation does not take hold?” Hayman wrote. “We believe the market, in its forward-looking nature, does not.”
20% under-valued
But what if gold prices already reflect concern about future inflation?
The precious metal is storable and portable and has been universally accepted as a medium of exchange for over 5,000 years, outlasting governments, fiat money systems and the rise of other metals and minerals, according to Paul Tudor Jones of Tudor Investment Corp.
“These somewhat esoteric descriptions of gold’s value do not help in evaluating if gold is cheap or expensive,” Jones added in letter to investors last month.
Compared to the long-term average of M2 money supply in the G-20 countries, gold is cheap. It should also increase in value as it becomes scarcer relative to a growing supply of printed currencies, Jones explained.
If gold prices are adjusted for inflation, the price is still a long way below records hit 25 years ago. Depending on which inflation measure is used, the peak is between $1,600 and $2,400 per ounce, he wrote.
Tudor’s proprietary model, which takes into account inflation, M2 growth and real rates, suggests gold is 20% under-valued over the next 24 months, Jones concluded.
Supply and demand
Jones also reckons old-fashioned supply and demand could drive gold prices higher too.
Despite a three-fold jump in spending on metal exploration in the past decade, new gold mine production has stagnated at 80 million troy ounces, he noted.
“They just aren’t making that much of it anymore,” Jones wrote. “Any incremental demand for gold must be met through sales from current owners.”
Some of that extra demand may come from investors in ETFs. These securities have flourished in recent years by giving investors who previously struggled to invest in gold an easier way of getting into the precious metal, Jones said.
By the end of 2009, ETFs will hold 3% of available supplies, making them the sixth-largest holder of gold in the world. That may only be the start, according to Tudor.
“With only $50 billion in total assets of listed, physically-backed ETFs as of October 14th, there is huge scope for increased flow,” Jones wrote. “The private-wealth universe of trillions of dollars is under-exposed to gold and now can readily get exposure.”
G-13
Tudor also expects central banks, which have been net sellers of gold for many years, to become net buyers during the second half of 2009, a “remarkable” turnaround for a market that’s used to absorbing big sales from this official sector.
The large, developed countries of the G-7 already have roughly 35% of their reserves in gold, but the remaining members of the G-20 only have 3.5% of reserves in the precious metal, Tudor estimated.
These 13 countries, which include China and India, have seen a $2.2 trillion surge in reserves in the past five years, making up well over half of the increase in global reserves during that period, Tudor said.
Almost that entire surge has been in paper currency or debt backed by paper currencies, the hedge fund firm noted.
If non-G-7 countries in the G-20 lifted gold holdings to 10% of their reserves, they would need to buy 370 million troy ounces, or 20% of current above-ground supplies. If they lifted holdings to 35% of reserves, they could need to buy 1.3 billion troy ounces, or 35% of above-ground supplies, Tudor estimated.
“There is huge potential for more buy-side interest to emerge from central banks,” Jones wrote in his Oct. 15 letter to investors.
Indeed, India’s central bank bought 200 tons of gold bullion from the International Monetary Fund in the final two weeks of October.
“The scope for increased investment demand over the coming years is much stronger than the potential from new supply,” Jones wrote. “As a result, incremental new demand must buy gold from current holders… We doubt the transfer of gold from current holders to its new owners will occur at, or near, current prices.”
Gold M&A
Paulson & Co., which made billions of dollars betting against mortgage-related securities before the housing bust, is starting a new fund Jan. 1 that will invest in gold stocks and gold-related derivatives. John Paulson, who heads the firm, will invest a chunk of his own money in the vehicle, according to a person familiar with the matter.
Paulson told investors recently that the rally in gold has only just begun, according to The Wall Street Journal, which noted that Paulson is putting $250 million of his own money in the new fund.
Paulson has already been building gold positions in the firm’s current funds. The firm, which oversees more than $25 billion, recently held 31.5 million shares in the SPDR Gold Trust /quotes/comstock/13*!gld/quotes/nls/gld (GLD 114.56, +0.27, +0.24%) , the largest ETF backed by bullion. The stake was worth $3.1 billion on Sept. 30, according to a recent regulatory filing.
Paulson has his roots in merger arbitrage — a strategy in which traders bet on the outcomes of mergers and acquisitions. So he may also be betting on more deals in the gold-mining industry.
Paulson’s firm held a $1.75 billion stake in AngloGold Ashanti at the end of September, a position it initially bought from diversified miner Anglo American in March.
The firm also owned shares of Kinross Gold Corp. worth $668 million and stock in Gold Fields Ltd. /quotesworth $317 million as of Sept. 30, regulatory filings show.
Rather than allowing such gold positions to become a larger and larger part of Paulson’s main hedge funds, the firm decided to create a new vehicle to focus on the strategy, the person familiar with the matter said on condition of anonymity.
Paulson took a similar approach as the firm’s subprime trades grew earlier this decade. The Paulson Credit Opportunities fund was launched to focus on the strategy. It generated returns of almost 600% in 2007 as the housing market began to crash and mortgage-related securities collapsed.
Eric Mindich’s Eton Park hedge fund firm has also taken stakes this year in gold-mining companies including AngloGold Ashanti, Gold Fields and Harmony Gold /quotes/comstock/13*!hmy/quotes/nls/hmy (HMY 10.59, -0.16, -1.49%) . Eton Park also held shares and call options on the SPDR Gold Trust at the end of June, according to regulatory filings.
Gold share classes
Paulson has also offered a share class denominated in gold, tapping into investor concern about holding paper currencies.
Other hedge fund firms, including Christian Baha’s Superfund and Osmium Capital Management Ltd., run by former ABN Amro trader Chris Kuchanny, also launched new share classes denominated in gold this year. See full story.
The idea is that investors get the same returns generated by the underlying hedge fund, but those returns are denominated in troy ounces of gold, rather than in U.S. dollars, euros or pounds. If such currencies lose value, the hedge fund gains may be preserved.
Excluding Japan, the world’s major currencies have experienced money supply growth of 15% to 55% in the past three years, Bass estimated in an Oct. 2 letter to investors.
The Hayman managing partner compared the efforts to a game of Monopoly in which the banker decides money is too tight, the “velocity” of the game is slowing down, or a few players are about to go broke.
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