Gold provided 18.9% return for 2019, while silver is up around 15.3% since the end of 2018. Based on trade in most-active futures contracts, that would be the strongest performance for the yellow metal since 2010, when gold rose 29.7%. For silver, that metal notched its best annual gain since 2016 when it rose 15.8%, according to FactSet.
With inflows showing continued strength in 2020, why should investors avoid gold ETFs?
Counterparty Risk on All Levels
Unlike physical gold bullion—which is a tangible asset—ETFs are a financial product that have counterparty risk. Counterparty risk is present when there’s a possibility the other party in an agreement will default or fail to live up to their obligations.
As you may already know, one of gold’s primary benefits is being the only financial asset that is not simultaneously somebody else’s liability. Therefore, these ETFs are a poor substitute.
When we look at how these ETFs function, the problems quickly become apparent.
Let’s analyze the operations of the world’s largest gold ETF—the SPDR Gold Trust (GLD). To gain exposure to the price of gold, investors buy GLD shares through an Authorized Participant. An Authorized Participant is usually a large financial institution, like a market maker, which is responsible for obtaining the underlying assets necessary to create ETF shares.
When they do so, they are buying shares in the funds trustee—the SPDR Gold Trust. The trustee then uses a custodian, in this case HSBC, to source and store the gold for them. As the custodian is tasked with sourcing and storing the gold on behalf of the trustee, they are a major counterparty.
Herein lies the first problem. Many investors buy gold as portfolio insurance against a systemic failure in the financial system. As GLD is intertwined with one of the world’s largest banks, it doesn’t fit this purpose. If HSBC became impaired, GLD shares could be negatively impacted.
But the problems go deeper. Custodians like HSBC use sub-custodians, such as the Bank of England, to source and store gold. So, in addition to carrying custodian risk, investors also have sub-custodian risk.
Sounds like a lot of counterparty risk. But there has to be rules in place to protect investors if something goes awry—right?
Based on old LBMA rules, there are no written contractual agreements between sub-custodians and the trustees or the custodians. As a result, the ability of trustees and custodians to take legal action against sub-custodians is limited. Therefore, the trustee is on the hook for any negligence. But trustees are insured against such events—correct?
It turns out that trustees don’t insure their gold holdings. They leave the responsibility of insurance to the custodian… And the plot thickens. Custodians only insure the contents of the vaults for limited general insurance cover. Such coverage falls greatly short of the value of the gold held inside the vaults.
Putting it all together, if anything happens to any of the counterparties, the investor has zero recourse. Besides carrying major risks, there is another issue with gold ETFs.
No Exposure to Gold
You may be surprised to learn gold ETFs don’t give you exposure to gold—but, it’s true. The GLD prospectus states “GLD represents fractional, undivided interest in the Trust.” When you invest in a gold ETF, you are buying shares of the Trustee. Basically, you are a shareholder of the trust, not a gold holder.
As such, GLD shares represent a paper claim on gold, not gold itself. This negates a major reason for owning it—protection during crises. If the economy collapsed and brought down a part of the financial system with it, the Trustee will settle your claim in cash, not gold.
The real irony is the price of gold could be skyrocketing and the ETFs could be going bankrupt at the same time.
Given these issues, long-term investors would be wise to avoid gold ETFs. Luckily, for those wanting to buy physical gold, things have never been better.
The Best of Both Worlds
Unlike ETFs, physical bullion is divorced from “price tracking promises” and exonerating 40+ page prospectuses. It’s an asset you can store outside of the banking system with a private company. It also helps preserve wealth during times of financial turmoil.
While there continues to be strong inflows in gold ETFs, long-term investors would be wise to abstain from them. They may be a good tool for traders, but are no place for those looking to hedge against a crisis.
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