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May 16, 2003

The Gold Equity Share: An Idea Whose Time Has Come
by John Hathaway

The World Gold Council (WGC) launch of a gold exchange traded fund (ETF) promises to revolutionize the gold market. It was filed with the SEC 5/14/03. After reviewing the document and considerable thought, we conclude that the new Gold Equity Share is a highly significant milestone for gold. For the first time in history, investors of all descriptions will be able to invest in physical gold through brokerage firms and other mainstream financial market channels. Previously, investment in gold meant withdrawing money from a brokerage or bank account in order to pay a coin dealer or a bullion dealer. The ETF will eliminate the past inconveniences, uncertainties, and bureaucratic hassles that have long stymied a free flow of capital from retail and institutional investment portfolios into the physical metal.

The WGC Gold ETF will be listed on the NYSE once it has received final SEC approval. Each share will represent 1/10th of one ounce of gold, and at current gold prices, will trade at around $35. More important, each share will be backed by 1/10th of one ounce of physical gold, deposited with Hong Kong Shanghai Bank in London. The gold will be allocated which means that it cannot be lent to bullion dealers and/or used in the gold derivatives trade. The introduction of a gold ETF will finally integrate physical gold with other financial markets and thus end its isolation based on the archaic and creaky conventions subject to which it has historically traded. The gold market's antiquated architecture has much to do with the metal's substantial undervaluation. By creating simple access to physical metal, the WGC ETF will begin to freely tap capital market flows and thereby diminish the heretofore undesirable influence of central banks on the price. Expanding the borders of the gold market beyond the collective mentalities of central bankers, bullion dealers, derivative traders, commodity funds, and jewelry buyers, Middle Eastern souks and Asian bazaars will contribute substantially to its price.

For those who might doubt the potential significance the new Gold Share on the metal price, look no further than the experience of our very own Tocqueville Gold Fund (ticker=TGLDX). One year ago, the fund received authorization to buy and sell physical metal. We did so by soliciting a special vote of the fund trustees and by subsequently establishing complex arrangements with various bullion dealers. Even after having taken these steps, TGLDX is not permitted to hold more than 10% of fund assets in physical metal because of commodity-unfriendly tax regulations. We would be surprised if many gold sector funds have undertaken the same laborious process. For most, the path of least resistance has often been to invest in the shares of gold producers or in structured notes (a.k.a. gold linked derivatives) issued by money center financial institutions.

For individual investors, the historical barriers have been even more daunting. Very recently, an acquaintance of mine described taking a cashier's cheque to a coin dealer in exchange for $50,000 in Krugerrands. These coins were then transported by my friend via the NY subway system (no armed guard by his side) for ultimate deposit in his basement. He has written himself several notes as to the exact subterranean location.

While hard core gold enthusiasts may have been willing on occasion to challenge the impediments to buying the physical metal, main stream investors considered investment in gold to be completely off the reservation. Even if the notion possessed intellectual merit, which of course for most it did not, the preferred route was to invest in the shares of generic, highly liquid gold mining companies.

Although gold mining shares appeal to those seeking their considerable leverage to changes in the gold price, they incorporate business risks that clash with the fundamentally conservative and risk averse reasoning that might attract a wider audience to gold. The business of mining gold is subject to a long list of uncertainties. These include geological, labor, regulatory and environmental, financial, and not least, political risks particular to host countries. In addition, gold shares exhibit all of the volatility and then some of the characteristics of long-dated options, which is in fact what they are. Physical metal entails none of these detractions. In fact, the only risk to physical metal is the possibility of paying excessively. Otherwise, gold bullion is the safest asset in the spectrum of investment alternatives.

The same cannot be said for the gold linked structured notes (derivatives) issued by financial institutions such as money center banks or investment houses. These instruments are backed not by gold but by the credit of the issuing institution. They are easy to buy and next to impossible to sell. The credit of such issuers has been suspect of late.

Will the gold ETF divert capital from the share market and thereby lower valuations of the entire mining sector? On the one hand, those wishing exposure to gold will feel less compelled to configure their entire position in the form of shares. In this regard, the market for gold shares might contract. On the other hand, a gold ETF will broaden the potential population of investors to those who see gold as a portfolio diversifier. For example, large pension funds that must operate with 20 to 30 year time horizons, have to date evidenced only a miniscule presence in the market for physical gold. Surely, the long term financial insurance represented by gold bullion will appeal to many of these fund managers. The speculative aspects of gold investing are less important to these investors than protecting capital during periods of extreme financial market stress. A gold ETF will significantly broaden the eligibility and appeal of physical bullion as an investment class. The resulting revaluation of gold to a permanently higher level will in turn expand the entire market cap of the mining sector.

The market capitalization of the gold mining sector is a relatively tiny $50-60 billion. The "market cap" of the amount of physical gold available for investment, excluding central bank holdings, is very approximately $ 1 trillion. Even after making the extreme assumption that all central bank gold is in play, the investment gold market cap is only $1.4 trillion. World financial wealth in the form of bonds and equities exceeds $50 trillion. An allocation of only 1/10th of 1%, (by the way, a much smaller allocation than we are recommending) would equate to 5000 tonnes of physical metal, the equivalent of two years' supply of newly mined gold. Such an allocation would in time cause gold to trade comfortably in excess of 4 digits in terms of US dollars, Euros and just about any other currency as well.

Ample research testifies to the fact that gold is either non-correlated or inversely correlated to all other asset classes including equities, bonds, and currencies. Research also shows that gold tends to perform well during periods of financial market stress. During stressful periods, the correlation between major asset classes other than gold becomes more positive. Portfolios designed for plain vanilla risk might not survive less frequent but more serious risk. Efficient frontier analysis suggests that a small (5%) allocation to gold stabilizes portfolio returns. As stated in a recent research paper published by Nik Bienkowski of Gold Bullion Limited, "a portfolio designed for the long-term may not survive to generate long term performance unless it can withstand all market conditions."

No academic studies are needed to demonstrate the superiority of gold relative to paper in terms of maintaining value throughout generations and even centuries. Given the sorry record of paper assets in this regard, why should derivatives fare any better? Derivatives of all kinds now total $141.7 trillion, according to the Bank for International Settlements, and are by far the most rapidly expanding asset class. They are fatally skewed in that they came into prominence during the historical oasis of the last two decades. They were conceived in a yankee-centric fantasy world of a permanently strong dollar, low inflation, falling interest rates, and high equity valuations. When stress tested, even in this best of all possible worlds, derivatives have failed abysmally to provide liquidity.

Despite the fact that the gold mining industry hedge book has been reduced by 504 tonnes (or 15%) over the past two years, the notional amount of world gold derivatives have increased by 50% since 2001, according to the BIS, to $315 billion. The netted amount or gross market value has increased by 25% to $28 billion, the equivalent of one year's supply of newly mined gold. In our view, the global derivatives book continues to be offside in a world of shrinking gold production, declining hedge activity, and rising gold prices. While not central to the case for a substantial rise in the gold price, the continuing reduction of hedge books by the mining industry along with the increasing paper claims for physical gold represented by derivatives reinforce the prospect for volatility and instability in a rising price trend.

Derivatives, designed to disseminate risk, have in fact become a source of systemic risk. Interest rates, currencies, share prices, credit risks and commodity prices are now intermediated by complex financial products which Warren Buffet described as financial weapons of mass destruction and time bombs that threaten the financial system. The financial markets and their central institutions have become mega betting machines that are indecipherable to outsiders and to participants alike. Designed to perform in what their architects presumed to be "normal" circumstances, derivatives will fall apart in a climate of sinking confidence. Gold, a bystander to the intellectual foolishness at the core of derivatives, will be welcomed by the financial markets as a premier financial asset incorruptible by such nonsense. It will be sought after vigorously by investment managers for whom long term outcomes and the well being of their investment constituents truly matter.

John Hathaway
© Tocqueville Asset Management L.P.

This commentary is not an advertisement or solicitation to subscribe to The Tocqueville Gold Fund, which may only be made by prospectus.

The Gold Fund is subject to the special risks associated with investing in gold and other precious metals, including: the price of gold/precious metals may be subject to wide fluctuation; the market for gold /precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. In addition, there are special risks associated with investing in foreign securities, including: the value of foreign currencies may decline relative to the US dollar; a foreign government may expropriate the Fund's assets; and political, social or economic instability in a foreign county in which the Fund invests may cause the value of the Fund's investments to decline.

Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication.

Performance data on this page represents past performance and does not guarantee future performance. The investment return and principal value of an investment will fluctuate and the investor's shares, when redeemed, may be worth more or less than their original cost.

For more complete information on any fund including management fees and other expenses, please order a free prospectus by downloading a copy, by contacting one of the approved broker-dealers or by calling 1-800-697-3863. Read the prospectus carefully before you invest or send money.

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