The many traps of paper gold

As the historic bull market is approaching its end, with volatility increasing and investor anxiety climbing, interest in gold is sure to be soon renewed. After stock markets revert to an uncertain, bearish stage, a seismic shift towards safety and capital preservation is bound to take place. Nervous investors looking for shelter in a time-tested safe haven will inescapably try to build up a defensive precious metals position. However, investing in gold can be a complicated affair for those who tend to overlook the small print. In a market full of “gold-backed” ETF products and pseudo-physical gold solutions, there are several traps to look out for.


A closer look at gold ETFs

Gold ETFs are often promoted as convenient and efficient ways to invest in gold, freeing the investor of all the trouble of storage and the corresponding fees. However, for all the ease and convenience they may provide, they also bear significant risks. Assuming one chooses to buy gold as a hedge against market turmoil and to isolate themselves for systemic risks, the inherent flaws of the ETF solutions practically defeat the very purpose of investing in gold in the first place. To make matters worse, all these risks will only be exacerbated in the event of a severe crisis.

All ETFs carry counterparty risk, placing the investor at a disadvantage as he is forced to rely on another party to keep their side of the deal. Their investment heavily depends on the managerial, operational and structural integrity of the fund. Also, the very structure of a gold ETF involves additional parties, and most worryingly, those are often big banks. Thus, if the aim of the gold investment was to create a defensive position against the risks and vulnerabilities of banking system during a crisis, buying into such an ETF achieves the exact opposite. A good example is the SPDR Gold Trust (GLD), the world’s largest and most popular gold ETF. GLD uses a custodian to store its gold bars, HSBC, which is arguably one of the first to take a hit in the next market downturn. As for a harsh crisis scenario, where the banking sector would most likely be once again in the eye of the storm, one can easily see how counterparty risk would explode.

Another very important, but often overlooked, caveat of gold ETF investments is the the question of gold ownership itself. It is hard to believe, but many ETF investors are still not aware that they don’t actually own any gold whatsoever. In many cases, they are not allowed to ask for delivery, but even if they are, the conditions are so strict and the costs so exorbitant that this option is practically impossible for the average investor. Nevertheless, even if an investor could and would chose to redeem their money in gold, ETFs have cash settlement clauses in place that allow them to pay out the amount in cash instead of gold bars.

In the plain and clear words of the George Milling-Stanley himself, head of gold strategy at State Street and key member of the team that launched GLD:

“When you buy GLD shares, you’re buying an ownership interest in a trust, and the sole asset of that trust is physical allocated gold bullion bars. The individual investor does not own the gold that backs the trust, any more than an investor in GM owns a car or an investor in Apple owns an iPhone.”


More paper disguised as gold: Certificates and unallocated accounts

Even if an investor seeking to invest in gold manages to avoid ETF solutions, there are plenty of other traps in the pseudo-physical gold market too. Bank products, gold certificates and similar offerings will often be advertised as an efficient way to own physical gold, glossing over the specific nature and conditions of this ownership. However, it is on these details and small print that the careful investor should focus.

Unallocated gold the most widely traded form of the metal, sold especially by banks. As opposed to an allocated account, where the gold is attributed to the account holder and the bank is prohibited from lending it out, unallocated accounts essentially turn investors into creditors of the bank. In this case, they do not own the gold, it is merely owed to them by the bank, which remains its legal owner. In return for their money, they get a certificate that proves their claim.

However, it is useful to remember that your unallocated gold, much like any other deposit, is fair game for a bank to use and to lend out, a practice that is fully legal and commonplace. Also, much like regular deposits, banks are required to keep only a portion of the gold they owe to customers of unallocated accounts as reserves. Thus, in a harsh crisis scenario, there simply wouldn’t be enough physical gold to cover your claim. In other words, with unallocated accounts, the bank or other service provider, apart from the cash for your gold investment, they also get to profit from lending it out, while the gold remains their legal property. Incredibly enough, most also charge rather significant storage fees as well.

“In the event of a major crisis or systematic failure, when the dust settles, paper gold will be little more than a piece of paper. A bar of gold will always be a bar of gold.”


The only way to really own gold

Direct and unencumbered ownership of physical gold in an allocated storage account is not only the safest, but also the only option for anyone that wishes to invest in gold for the right reasons. Speculators and those who seek short-term gains from gambling on the day-to-day price fluctuations would indeed be better served with an ETF or other paper gold solution. However, any investor who seeks to actually own the metal and sees a physical gold investment as long-term hedge against market fragility and systemic risks will find no value in these products. If anything, they largely achieve the exact opposite, as they tie one’s investments even closer to the banking sector and open it up to dangerous exposure to the next crisis.

A physical gold investment, securely stored outside the banking system, is the only reliable way to isolate one’s savings from a market downturn and from bank bail-ins, as well as from inflation and from central bank manipulation of the currency, while also eliminating counterparty risk. Gold owned in this way, especially when stored in safe jurisdiction like Switzerland, can serve as a solid shield against potential turbulence down the road, be it economic or political.

Claudio Grass, Hünenberg See, Switzerland

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