Occasionally, ETF Strategy publishes articles from respected external contributors. Here, Russ Koesterich, Managing Director and Chief Investment Strategist at iShares (www.ishares.com), one of the world’s largest ETF providers, considers the case for gold. Alongside the article, we highlight a number of exchange-traded products appropriate for UK-based investors seeking exposure to gold.

By Russ Koesterich, Global Chief Investment Strategist, iShares

Given the scope of recent market volatility, the definition of what constitutes a defensive stance has shifted. Though commodities have traditionally been viewed as a volatile asset class, given a backdrop of low or negative real rates and ongoing anxiety over developed market sovereign debt, defensive investors may now consider maintaining a strategic allocation to commodities, and in particular, gold.

Gold ETPs: Is the rush to gold rational?

The current environment offers support for an investment in gold, even despite the metal’s rise over the past few weeks and over the past decade.

Low real interest rates: First and foremost, we would emphasize the importance of real interest rates (the nominal interest rate minus the inflation rate) for the price of gold. Over the past 20 years, roughly 60% of the variation in the annual return of gold can be attributed to the level of real interest rates.

Why is this the case?  Low real rates mean the opportunity cost of owning gold is low.  When rates are high, investors tend to prefer assets that have the potential to produce income (stocks and bonds do; gold does not).  Conversely, when rates are low, the opportunity cost of owning gold is low.

Real interest rates have been low over the past decade and have thus buttressed gold prices.  What’s more, recent market volatility and weak economic data have strengthened the case for the maintenance of a low interest rate, and provided additional buoyancy for gold prices. At its most recent meeting on August 9, 2011, the Federal Reserve (Fed) announced that conditions “would likely warrant exceptionally low levels for the federal funds rate at least through mid-2013.” Sustained low interest rates over the next two years may continue to support the price of gold.

Erosion of the dollar: Gold tends to do best when the dollar is eroding for two reasons: 1) because gold is valued in dollars, a declining dollar by definition leads to higher gold prices; and 2) when investors are uncomfortable with any fiat currency, gold is the natural beneficiary.  Recent signs from Washington and the Fed point to a continued erosion of the dollar relative to foreign currencies.

Longer-term inflation fears: Deficit spending traditionally gives investors pause as they believe that governments will deal with large deficits by increasing money supply.  Today, despite the absence of any near-term inflationary pressures, the US fiscal situation remains precarious and may continue to support gold prices.

Given the current economic and political landscape, commodities in general, and gold specifically, appear to be attractive for defensive investors.