Beware of Gold Exchange Trade Funds (ETFs)

By: Mark_OByrne

Gold Bullion Unique as No Counter Party Risk
Gold is unique among asset classes as it is the only asset class not dependent on the performance of auditors, management, corporations, financial institutions, banks, politicians and governments. Nor should physical gold be dependent on the performance of trustees, custodians and or sub custodians.

Gold does not depend on the performance and health of the wider economy and as importantly when you buy gold in its physical form there is no third party liability or credit risk. Or at least there should not be. Gold has an intrinsic value in and of itself that is not contingent on someone else’s or some entities performance or mere promise to pay.

Thus, gold in its physical form is still the ultimate form of financial insurance. This is why every major central bank in the world still maintains a significant portion of their reserves in gold bullion and many, such as the Chinese, are now increasing their gold bullion reserves.

Exchange-traded fund (or ETF)
An exchange-traded fund (or ETF) is an investment vehicle or a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. A gold exchange-traded fund is an exchange-traded fund that tracks the price of gold. It is akin to a derivative that derives its value from the value of the underlying asset. Gold exchange-traded funds are traded on the major stock exchanges including Zurich, Mumbai, Sydney, London, Paris and New York. One can sell short, buy on margin and purchase as little as one share.

In November, 2004 the first gold exchange-traded fund in the United States started trading.  Known as GLD, this exchange traded fund allowed stock investors to buy a stock-like asset designed as per the GLD website to “track the price of gold”. Thus it was beneficial in allowing speculators to gain exposure to the gold price and go long or short gold.

Risks Posed by ETFs
From the outset many respected analysts have questioned the precious metal ETFs and their precious metal backing and have warned of risks in these ETFs and warned that they should not be confused with owning physical gold and actual physical bullion.

When one buys an ETF or exchange traded fund, one is buying a derivative or a financial instrument which derives its value from or whose price is dependent on the underlying equity, indices, commodity or precious metal. One does not directly own the underlying asset and one does not have an automatic right to take possession of the underlying product.

This defeats the purpose of buying a hard tangible asset and finite currency like gold. This is because the fundamental point of investing in gold bullion is that it is the safe haven asset which investors turn to in times of geopolitical, financial and systemic uncertainty – the asset of last resort.

Gold’s primary investment purpose is as a long term or permanent defensive portfolio holding which can be used during one’s retirement, passed to children, grand children and great grand children. It is used to diversify one's investments, as a hedge against macroeconomic factors such as inflation and systemic risk and most importantly as financial insurance.

ETFs Good for Speculating but not for Safe Haven Investing
 ETFs are paper vehicles or derivatives that track the price of gold or silver. With ETF's a speculator is hoping to profit from short term fluctuations in the price of or value of the derivative instrument. Thus ETFs are not assets in the traditional sense of that word. An asset is an item of property or an item of monetary value owned by an individual or institution.

ETFs are a form of debenture. Unlike physical gold bullion which is held in personally allocated storage, if an ETF provider went into liquidation the investor will only become a general creditor. In the event of a 1929 style stock market crash or a systemic crash, banks and financial markets may be closed for a period of time and financial markets including ETFs would become illiquid (as recently happened to some Exchange Traded Commodities (ETCs). Immediately after his inauguration as president in 1933, Franklin Roosevelt instituted a four-day bank holiday and Italian Prime Minister Silvio Berlusconi recently said that political leaders are discussing the idea of closing the world’s financial markets while they “rewrite the rules of international finance.”

Unlike gold, an ETF confers a possible future financial benefit on the owner. But when one possesses real gold bullion one owns in the present a real tangible asset which one can see and touch and can sell at anytime – especially in a financial crisis when demand soars and prices soar.

Derivatives are derivatives and are nor hard, tangible assets. Derivatives can become illiquid and impossible to sell. If an investor wants to invest in property, they do not buy a derivative. One can speculate on property prices through spread bets, contracts for difference (CFDs) and covered warrants on the Halifax house price index and on indices in the US. But property like land and gold is a hard tangible asset and most investors rightfully prefer the security of directly owning their own home, investment apartments, houses, offices, land or gold. It is the physical and tangible dimension of property or ‘bricks and mortar’, land and gold that is rightfully attractive to investors internationally.

Paper derivative property vehicles are better used in order to hedge. If one already has a large portfolio exposure to property one could use these instruments to 'short' the property market and hedge one’s investment. Similarly some investors who have large gold bullion holdings might use the ETF to hedge themselves against pull backs in the gold price.

Other Possible ETF Risks
Some of the other issues facing these recently created financial instruments include valuations, annual fees and expenses, counter-party risks as well as liabilities and responsibilities of the market participants such as the auditors and custodians. Also, only very large investors with a holding of over 100,000 shares (worth some $9 million at today’s prices) can take delivery of the exchange traded fund gold.

Some of the many “Risk Factors” detailed in the prospectus for GLD and replicated largely by other precious metal ETFs are:
-“ The Trust’s gold may be subject to loss, damage, theft or restriction on access. “
- “The Trust may not have adequate sources of recovery if its gold is lost, damaged, stolen or destroyed and recovery may be limited, even in the event of fraud, to the market value of the gold at the time the fraud is discovered.”
- “The ability of the Trustee and the Custodian to take legal action against subcustodians may be limited, which increases the possibility that the Trust may suffer a loss if a subcustodian does not use due care in the safekeeping of the Trust’s gold.”

While all of these conditions are reasonable and standard in typical ETFs, they show the risk of owning these financial instruments rather than owning physical bullion in one’s possession or in a personal allocated account.

Another important and very worrying indemnification is with regard to the very important matter of the standard and the purity of the gold meant to be held in the exchange traded fund:
- “Gold bullion allocated to the Trust in connection with the creation of a Basket may not meet the London Good Delivery Standards and, if a Basket is issued against such gold, the Trust may suffer a loss.
 Neither the Trustee nor the Custodian independently confirms the fineness of the gold allocated to the Trust in connection with the creation of a Basket. The gold bullion allocated to the Trust by the Custodian may be different from the reported fineness or weight required by the LBMA’s standards for gold bars delivered in settlement of a gold trade, or the London Good Delivery Standards, the standards required by the Trust. If the Trustee nevertheless issues a Basket against such gold, and if the Custodian fails to satisfy its obligation to credit the Trust the amount of any deficiency, the Trust may suffer a loss.”

These many important indemnifications mean that the these ETFs carry additional risks and are not the same as owning actual physical gold.

There are too many parties, intermediaries such as trustees, custodians and sub custodians between you and the gold in the ETF. Worryingly, doubts have been raised by respected individuals in the gold industry regarding the auditing of the gold. This should be automatically done in order to confirm the fund is fully backed by gold bullion and to verify that all the gold is of the right purity. Also, an audit is necessary  to confirm that the gold is fully accounted for and not swapped and leased which has been common practice in recent years.

 This is the only type of fund that the SEC has ever approved for the retail level that isn't required to audit the assets that are meant to back the fund. Many precious metal ETFs have loose custodial controls which conflict with longstanding SEC and other jurisdictional requirements. Given the SEC’s and other regulatory bodies complete failure to properly regulate and protect investors in recent months, it would be best to err on the side of caution when dealing with these new financial instruments.

Thus ETFs are a great way to speculate on gold's spot price, just as futures contracts are a great way to speculate on gold's future price. But neither should be viewed as an alternative to owning the physical metal either in your personal possession or in bullion accounts in safe and secure vaults.
 
Summary

Thus, the key issues facing these emerging financial instruments include the fact that

-             they are derivatives backed by gold and not outright or titled ownership of physical bullion
-             the ongoing annual fees and expenses
-             poor level of governance and custodial control
-             auditor risk – the bullion holdings are not independently audited and verified
-             indemnification from many substantial risks
-             intermediation, counter-party risk and systemic risk involving the sponsor (World Gold Trust Services), the trustee (The Bank of New York), the custodian (HSBC) and the many sub custodians who include the Bank of Nova Scotia (BNS), ScotiaMocatta, Deutsche Bank AG (DB), JPMorgan Chase Bank (JPM), and UBS AG and the Bank of England

These are the primary reason why we do not recommend investors buy the ETF. We believe that ETFs are a good way to speculate on gold's spot price or to speculate or invest for the short term. But we do not believe that the ETF should be viewed as an alternative to owning the physical metal either in your personal possession or stored with secure and trusted third parties.

A fundamental consideration for investors and savers in these extraordinary  times is counterparty risk and thus proximity to one’s gold.

Gold is the only asset class that is not someone else’s liability and thus it is important when owning gold to not be exposed to counterparties in the form of brokerages, banks, auditors, insurance companies, trustees, custodians and sub custodians. Intermediation is to be avoided and this is why many investors are increasingly favoring taking delivery of gold bullion (storing in safety deposit boxes, home safes or elsewhere in the one’s home with home insurance), owning  gold certificates where bullion can be taken delivery of, if need be and safe allocated accounts with secure and trusted third parties in safer jurisdiction (such as Switzerland).

There is a risk that many hapless and badly advised investors will realize too late that precious metal ETFs are akin to derivatives, investment vehicles or securities that track the price of gold and not the financial insurance of real physical bullion.

Gold remains the ultimate safe haven asset and investors should be certain that they own actual physical bullion in order to protect themselves from very significant macroeconomic, systemic and monetary risk.

By Mark O'Byrne, Executive Director

Gold and Silver Investments Ltd. have been awarded the MoneyMate and Investor Magazine Financial Analyst of 2006.

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