ST. LOUIS (MineFund.com) -- Hedge funds are generally secretive and shy away from discussing their strategies, never mind slices of their portfolios. That makes it all the more curious that hedgies are making such a public spectacle of their gold investments. With tax rates set to change dramatically at the start of next year, retail gold investors need to stay on their toes to avoid getting pounded.
While it is difficult to keep information from the market for very long when you're taking outsize positions in things like exchange traded commodity funds, notably SPDR Gold Shares [GLD], it's quite another thing to deliberately pull the spotlight onto them.
There's David Einhorn, president of Greenlight Capital, making perfectly sound arguments about the value of owning gold. But in theNew York Times? Granted, he did not actually mention the metal by name although the allusion to hard assets in the headline is obvious. One hardly needs an anvil on the head to realize what he was really driving at.
The Times is a very useful vehicle to talk up your book.
So is the Wall Street Journal which recently ran a lavish profile on Tom Kaplan of Tigris Financial. Kaplan let on about an exclusive club of gold bulls that happily swaps trading ideas at high society soirees.
Meanwhile John Paulson's eponymous firm has been shopping quite aggressively for metal and mining analysts and market shapers.
There's a flotilla of funds offering gold denominated investments including Chris Kuchanny's Osmium Capital Management, Paulson & Co, and Christian Baha's Superfund.
And who can forget George Soros taking to the stage in Davos this year to proclaim gold the "ultimate asset bubble". But he also didn't miss a beat that it was a rational investment to chase, and which he backs up with a reported $600 million parked in gold funds.
The contrarian -- and don't gold bugs love contrarians -- has been Seth Klarman of Boston based Baupost Group. He has warned that commodities are over priced, and he especially dislikes gold "near it's all time high". That was an odd inflation-unadjusted perspective for someone who's deathly afraid of currencies giving up their purchasing power. Nevertheless, he is very far out of field compared with his peers.
All the public noises on gold from the hedgies has conformed with what hard asset investors have been on the bandwagon about for years before the funs came on the scene. Indeed, let's not forget that the big hedgies are actually very late to the game and only started to show a serious face in 2007 - when gold had nearly tripled from its cycle lows.
Which is not to say their presence hasn't had an impact. They have been moving and supporting the gold price very substantially. However, they need it to rise much further from here to fully realize their ambitions.
Consequently, investors need to pay careful attention to the strategies and tactics the hedge funds are likely to use. Hedge funds made a killing scalping the likes of Ford [F], General Motors and Chrysler in the early part of last decade as they outmaneuvered the car makers' house metal buyers. The hedge funds squeezed thinly traded markets and eventually cashed out after a patient, but deliberate, spiking play in palladium.
The run on palladium is said to have cost Ford alone $1 billion as the company undertook panic stockpiling of PGMs for its catalytic converters.
Platinum and palladium markets are far easier to corner than gold, which enjoys far more liquidity and avenues of trade. However, it is rather obvious that the same temptations exist as unfolded in the palladium gambit (which was followed by a ramp in rhodium and platinum). The difference this time is that hedge funds will not be targeting industrial consumers, but retail consumers and governments.
There are already signs of herding behavior: Coin sales are going through the roof (even at jaw dropping spreads); money is pouring into gold funds; tinpot dictators reverse course on currency reserves; sovereign wealth funds are investing in gold indirectly and even directly; central banks have redeveloped a taste for gold after scorning it; gold pawn networks; and gold bank accounts for Joe Citizen.
And, as we have warned for many years, there is a rising temptation to tax gold. That temptation increases exponentially the more successful hedge funds are with the metal; and the threat has gotten its most public airing to date.
There is clearly momentum behind gold. It's just a question of who's exerting the most influence and who will know when to leave the party first.
One of the more interesting conundrums for gold investors is the differential taxation treatment. Since the revenuers deem gold a collectible, American domiciled investors are subject to a 28 percent capital gains rate if they hold and sell after a year.
Right now that is excessive compared with the regular long-term capital gains rate of 15 percent on equities. Taxes at the state level can help though. For example, Washington State does not tax the sale of precious metals. However, come Jan. 1, 2011, the capital gains rate jumps to 20 percent while dividends will be hammered with a 39.6 percent take at the highest level (equal to an investor's highest marginal income tax rate).
A slew of other taxes are also set to rise sharply, not least a crushing 0-55 percent percent change in the estate tax, and they must inevitably dampen equity returns while squeezing the life out of capital formation.
The cumulative impact is going to hurt. A lot.
With a huge chunk of money invested in gold recently, the near-term threat is mass selling for tax reasons, especially the closer we get to the end of the year.
That said, it's also not hard to see why hedge funds might be more inclined to physical gold ahead of the 2011 rollover. The taxation differential then becomes a matter of performance rather than punishment. The obvious trade is to bring unrelated earnings forward from 2011 and divert them into an asset like physical gold with the added bonus of not having to deal with equity premium risk in a weak economy. Of course, you could just liquidate wholesale and pay 15 percent this year with the balance going to hard assets. But that's not a sound or safe option unless you're confident you can time gold's peak perfectly.
The other temptation is for funds to drive gold bullion as high as possible in targeted currencies, and then cash out in a variation on a traditional carry trade. And let's be clear, the funds are holding gold in the expectation of monetizing it at some point. They are not wedded to it for any longer than they think opposing investors will stand.
Similar dynamics are at play in gold equities, but the strategy is more nuanced. Right now participating in gold cash flow via dividends is very attractive; how much more effective if you own a big slug of stock and can influence the board's dividend decisions. But that will change again in January 2011 when dividends will be penalized compared with capital gains.
So the long term gold play would be best aligned with owning interests in gold coming out of the ground in a rising price environment that pushes equity multiples to euphoric heights. At the right moment, you offload those holdings to pension funds and retail investors. A 20 percent cap gains rate won't be too hard to swallow in the circumstance. Of course, that's not factoring in the impact of proposed taxation on carried interests in investment partnerships.
Another option is to swap (or redistribute a portion of) ETF holdings for a passive foreign investment fund like the relatively sleepy Central Fund of Canada. PFICs receive preferential cap gains treatment that can lower the rate to the regular rate which would shave a tax bill substantially.
There's no telling how the hedgies will ultimately realize their profits. You can only be sure that they have the resources, patience, and ability to manage gold much higher if they want to. And we know that they talk with each other regularly.
Don't be to gold what Ford was to palladium in 2000-1.
(c) 2010, MineFund.com
