Gold and ETFs

In recent decades, gold has become one of the most misunderstood assets classes.

Today, certain renowned investors deplore it as an archaic relic, scratching their heads as to why anyone would consider owning something with no cash yield. Other economic pundits laud it as the holy grail, the only source of protection from the turmoil in financial markets.

What they both can agree on, however, is that it remains one of the most closely watched assets on the planet – its price is shared on news networks around the world and financial tv shows are alive with often vociferous views on its future direction.

Whilst our analysis and house view on the above dichotomy will be addressed in future articles, this piece seeks to shed light on arguably the most common question we get asked – what’s the difference between physical gold and gold ETF’s?

BUT FIRST, THE BASICS

Gold is a safe haven asset – owning it means that your money will maintain its purchasing power during periods of inflation i.e when your respective national currency is losing its value.

This intrinsic and permanent value of gold is derived from the fact that it is the closest thing we have to an objective store of value.

Literally, the scientific properties of gold make it effectively the rarest, most indestructible element with a finite supply that we know of on earth. For this main reason, human civilisations have historically turned to gold in storing economic value over time.

And unlike paper currency (which we as humans can print more of), only God can ‘print’ more gold (created when a star explodes – supernova), and the act of which would most certainly wipe out all life on our planet.

The prices of other financial assets similar to currency, like stocks, bonds, futures and options, tend to fluctuate in tandem in response to market risks. Gold, due to its natural qualities, usually acts as insurance against such volatility, diversifying an investment portfolio.

Thus, the main reasons touted to invest in gold are: a hedge against inflation, and a portfolio diversifier.

GOLD INVESTMENT VEHICLES

Gaining exposure to gold can either be done by buying ‘paper’ gold, or physical gold.

Paper gold refers to financial assets whose price mimics the movement of the gold price as closely as possible. The asset purchased is not gold itself, but rather a paper asset that reflects the price of gold. Thus, these are ways to gain exposure to gold price movements, without actually owning or taking physical delivery of gold.

Paper gold examples are gold futures, unallocated over the counter (OTC) swaps, exchange-traded funds (ETFs), or through the shares of gold miners. These are all acquired via stockbrokers on a stock exchange.

Paper gold products are also securities traded on exchanges. This convenience and liquidity make it more suitable for short-term and medium-term hedging and speculation – a trading tool. The risks inherent in these products, as described below, make it less suitable for long-term protection.

Physical gold, on the other hand, involves an individual purchasing the physical metal itself.

Holding the physical asset directly will have associated storage and insurance costs, but is attractive as it can usually be held outside the financial system, making it the ultimate insurance policy against market shocks or a colourful dictators’ deep desire for your gold.

Typically, this investment consists of buying refined, investment-grade, gold bars or coins through gold dealers. The most common investment-grade gold products are bullion coins such as the South African Krugerrand, American Gold Eagle, Austrian Philharmonic and bullion bars from LBMA-approved gold refiners in 100g, 1 kg and 400oz weights.

Physical gold investment is, thus, more suited for medium to long-term investment purposes.            

Fig 1: Gold investment Pyramid:

GOLD ETFs

Firstly, a financial institution elects to create a trust – a structure created in law whereby property, in this case gold, is held by one party (a trustee), for the benefit of another party (a beneficiary). The party who elects to establish the trust is called the settlor, thus forming a three-party fiduciary relationship, for the benefit of the beneficiaries.

The financial institution like a bank, initiates the trust as a settlor. Another entity, usually a company established or linked to the settlor, is tasked as the trustee. A trusted vaulting custodian is contracted to safely store the underlying gold.

The trust then wholly owns an issuing company – this company issues the financial instruments that are traded as securities on a stock exchange, in which one can invest.

Predominantly, the issued securities are debt instruments, like a bond, called a debenture. These debentures are structured as non-interest bearing and are secured – backed by the gold held in the trust.

Consequently, as an investor into an ETF, you are purchasing debentures, and become a debenture holder, entitling you to a cash payout equivalent to the gold-equivalent value of the debenture.

These debentures do NOT give the holder any ownership or legal title to any gold held by the company/trust. Depending on the issuing institution, the gold holdings backing the debentures could or could not be disclosed to investors.

The assumption is that the value of these debentures, however, would move in sync with the price of gold, and voila – akin to investing in gold… but not exactly. The risks attached to investing this way are:

  • Counterparty risk – As you do not hold actual title of the gold, your investment risk is the solvency of the company issuing the debenture. You are simply a creditor with a legal claim against the company.
  • Full gold backing – The gold is most often in the form of 400 ounce gold bullion bars held in vaults in London, purchased from bullion banks in London. Unfortunately, this market is renowned for being extremely opaque, and the actual amount of gold held may or may not be disclosed to holders of the securities. Some ETFs aren’t fully backed by physical gold, instead buying gold futures, options, swaps, leases or other derivatives.
  • Redeemability – Requesting physical delivery of the gold may or may not be permitted, but is usually reserved for large debenture holders. The SPDR Gold ETF, for example, will redeem gold to investors holding more than a million dollars worth of gold.

SUMMARY

In short, the benefits of Gold ETF’s lend themselves more to a cost-effective, liquid tool to speculate or trade in gold. It, however, depends on your individual investor. As an investor, seeking long-term protection and insurance against risks to your savings, buying the physical metal is the optimal choice.