Not only the stock market has performed exceptionally well since March of this year. Gold is up 40% and gold-backed Exchange Traded Funds (ETFs) have experienced large inflows. According to the World Gold Council World Gold Council net inflow to gold-backed ETFs in the first seven months of 2020 was 898 tons, resulting in total holdings of 3,785 tons worth USD 239 billion.
Gold-backed ETFs are financial vehicles that pool the money from many investors to buy physical gold. A share in such an ETF represents a fractional share in the assets of the fund, which should not be confused with direct ownership of physical gold. Therefor there has been a lot of controversy about whether the purchase of such shares makes sense.
There are pros and cons regarding the purchase of gold-backed ETFs. Their great advantage is their convenience and low cost. If you have a brokerage account, you can trade gold-backed ETFs during normal trading hours. The process is similar to buying other ETFs and your holdings will appear next to other holdings in the monthly brokerage statement. Transaction fees of gold-backed ETFs are much lower than commissions for the buying/selling of physical gold. In addition, the total expense ratio of such ETFs can be as low as 0.17%, whereas storage costs in a vault or a non-bank safety box can easily amount to 1% or more.
A main argument against gold-backed ETFs is, that they are exposed to multiple counterparty risks. Contrary to what many people think, if you use an online broker, you are often not the true legal owner of the ETF shares, but only have a claim on them or rather an equivalent amount of money (we suggest that you check the terms and conditions of your brokerage account). Additional counterparty risks exist with regards to the ETF management and the actual custodian of the gold. Another disadvantage of gold-backed ETFs is, that redemption of shares against delivery of physical gold is either not possible for the average retail investor, or requires a very large shareholding in the ETF. With most funds, redemption can also be restricted or suspended in times of crisis. Even in normal times, the listed price of a share does not necessarily correspond to the true value of the underlying gold. In times of crisis, this gap can widen substantially.
To get a better understanding of the underlying risks of owning a gold-backed ETF let’s take a closer look at a specific example. The SPDR Gold Trust, which is traded under the ticker GLD, is the largest gold-backed ETF with a net asset value of over USD 84 billion. The following information is based on the U.S. prospectus, that can be downloaded here.
The trust is sponsored by World Gold Trust Services, an indirect wholly-owned subsidiary of the World Gold Council. Players involved in the actual management of the trust are:
- Marketing Agent (assists the Sponsor in marketing shares)
- Trustee (is responsible for the day-to-day administration)
- Authorized Participants (can create and redeem shares in the trust)
- Custodian (is responsible for the safekeeping of the trust’s gold)
- Subcustodians (are appointed by the Custodian to support in gold storage)
All main players are banks. The Trustee is BNY Mellon Asset Servicing, a division of The Bank of New York Mellon. The Authorized Participants are mostly subsidiaries of banks such as Credit Suisse, Goldman Sachs, J.P. Morgan, Merrill Lynch, Morgan Stanley, RBC and UBS. And the Custodian is HSBC Bank. Investing in GLD therefore requires absolute trust in our banking system as well as the fiat currency system, that is the backbone of our financial system. If you consider gold as an insurance against a potential collapse of our banking and fiat system, GLD is probably not the right product to invest in.
Regarding risks, the prospectus contains a lot of revealing information. Below we provide some longer quotes, even though we could have summarized the content. But we think that reading at least part of the original text is certainly worth your time and effort (emphasis in bold has been added by us).
“The Trust creates and redeems the Shares from time to time, but only in one or more Baskets (a Basket equals a block of 100,000 Shares) ….. The initial amount of gold required for deposit with the Trust to create Shares for the period from the formation of the Trust to the first day of trading of the Shares on the NYSE was 10,000 ounces per Basket ….. Baskets may be created or redeemed only by Authorized Participants, who pay a transaction fee for each order to create or redeem Baskets and may sell the Shares included in the Baskets they create to other investors.”
Our comment: Retail investors can’t take physical delivery of gold, only Authorized Participants can. You therefore don’t own any physical gold, you just have a claim to a corresponding amount of money.
“The value of the gold held by the Trust is determined using the LBMA Gold Price PM. Potential discrepancies in the calculation of the LBMA Gold Price PM, as well as any future changes to the LBMA Gold Price PM, could impact the value of the gold held by the Trust and could have an adverse effect on the value of an investment in the Shares ….. the calculation of the LBMA Gold Price PM is not an exact process ….. The LBMA Gold Price PM does not therefore purport to reflect each buyer or seller of gold in the market, nor does it purport to set a definitive price for gold at which all orders for sale or purchase will take place on that particular day or time.”
Our comment: The quality and reliability of the London Bullion Market Association (LBMA) gold price fixing is not undisputed, to put it nicely. The price is based on an auction process among just 16 participants, most of them banks. Many of the banks have in the past been investigated for price fixing and some of them had to pay fines. The most recent case case occurred in September 2019, when the U.S. Department of Justice charged among others Michael Nowak, JPMorgan’s head of precious metals trading and Board member of the LBMA, “for their alleged participation in a racketeering conspiracy and other federal crimes in connection with the manipulation of the markets for precious metals futures contracts, which spanned over eight years and involved thousands of unlawful trading sequences.”For gold, that is truly traded physically, there is usually a small premium to the LBMA Gold Price. In times of crisis this premium is likely to rise significantly. Authorized Participants can use this opportunity to redeem GLD shares for physical gold and sell the gold in the physical market for a huge profit. The average retail investor does not have this option, as he/she is not allowed to trade in shares for physical gold.
“Although Shares are listed for trading on NYSE Arca, it cannot be assumed that an active trading market for the Shares will be maintained. If an investor needs to sell Shares at a time when no active market for Shares exists, or there is a halt in trading of securities generally or of the Shares, this will most likely adversely affect the price the investor receives for the Shares (assuming the investor is able to sell them).”
Our comment: Convenience comes with a price. In normal times there should be no issue. But in times of crisis it is likely, that trading is suspended and it might therefore not be possible to sell shares for an extended period.
“Redemption orders are subject to postponement, suspension or rejection by the Trustee under certain circumstances. The Trustee may, in its discretion, and will when directed by the Sponsor, suspend the right of redemption or postpone the redemption settlement date, (1) for any period during which NYSE Arca is closed other than customary weekend or holiday closings, or trading on NYSE Arca is suspended or restricted, (2) for any period during which an emergency exists as a result of which the delivery, disposal or evaluation of gold is not reasonably practicable, or (3) for such other period as the Sponsor determines to be necessary for the protection of Shareholders ….. Under the Trust Indenture, the Sponsor and the Trustee disclaim any liability for any loss or damage that may result from any such suspension or postponement.”
Our comment: Great. If a crisis occurs you might not have access to your funds for a day, a week, a month or even longer. The Trustee and the Sponsor decide, and you can’t do anything against it.
“Shares have none of the statutory rights normally associated with the ownership of shares of a corporation (including, for example, the right to bring “oppression” or “derivative” actions). In addition, the Shares have limited voting and distribution rights (for example, Shareholders do not have the right to elect directors and will not receive dividends).”
Our comment: Wonderful. You provide the money, but you have no rights. Reminds us of some stocks.
“The Trust does not insure its gold. The Custodian maintains insurance with regard to its business on such terms and conditions as it considers appropriate which does not cover the full amount of gold. The Trust is not a beneficiary of any such insurance and does not have the ability to dictate the existence, nature or amount of coverage ….. In addition, the Custodian and the Trustee do not require any direct or indirect subcustodians to be insured.”
Our comment: We are not the biggest friends of insurance. If our financial system breaks down, many insurance companies may become insolvent and will therefore not be able to fulfill their obligations. Nevertheless, losses can also occur, when markets are still fully functional. Contrary to most gold storage providers, GLD does not offer any insurance. This is unsatisfactory.
“Gold bars may be held by one or more subcustodians appointed by the Custodian ….. until it is transported to the Custodian’s London vault premises. Under the Allocated Bullion Account Agreement, ….. the Custodian is not liable for the acts or omissions of its subcustodians unless the selection of such subcustodians was made negligently or in bad faith. There are expected to be no written contractual arrangements between subcustodians that hold the Trust’s gold bars and the Trustee or the Custodian, because traditionally such arrangements are based on the LBMA’s rules and on the customs and practices of the London bullion market. In the event of a legal dispute with respect to or arising from such arrangements, it may be difficult to define such customs and practices. The LBMA’s rules may be subject to change outside the control of the Trust. Under English law, neither the Trustee, nor the Custodian would have a supportable breach of contract claim against a subcustodian for losses relating to the safekeeping of gold. If the Trust’s gold bars are lost or damaged while in the custody of a subcustodian, the Trust may not be able to recover damages from the Custodian or the subcustodian.”
Our comment: This passage is truly horrifying. GLD is not a mom and pop store but a trust, that conducts transactions worth tens of millions of dollars. But they have no contracts in place, applicable customs and practices are obviously not well-defined and LBMA’s rules can be changed. Managers in normal enterprises would get fired, if they run their business in such a way.
“There may be periods of time when some portion of the Trust’s gold bars may be held by one or more subcustodians …. These subcustodians may in turn appoint further subcustodians, but the Custodian is not responsible for the appointment of these further subcustodians. The Custodian does not undertake to monitor the performance by subcustodians of their custody functions or their selection of further subcustodians. The Trustee does not undertake to monitor the performance of any subcustodian. Furthermore, the Trustee may have no right to visit the premises of any subcustodian for the purposes of examining the Trust’s gold bars or any records maintained by the subcustodian, and no subcustodian will be obligated to cooperate in any review the Trustee may wish to conduct of the facilities, procedures, records or creditworthiness of such subcustodian.”
Our comment: No monitoring of service providers and potentially not even the right to visit the premises of subcustodians. For a multi-billion-dollar business this constitutes, at least in our view, gross negligence and we really wonder, how this can be stated so clearly in a prospectus.
“The gold bullion custody operations of the Custodian are not subject to specific governmental regulatory supervision ….. the Trust is dependent on the Custodian to comply with the best practices of the LBMA and to implement satisfactory internal controls for its gold bullion custody operations in order to keep the Trust’s gold secure.”
Our comment: Ouch. Usually there is government regulation for almost everything. But in this billion USD industry we have to rely on “best practice”.
The whole document reads like a big disclaimer. It basically tells potential buyers of the shares, that they have no rights and that the management of the trust is responsible for nothing. How is it possible, that such an ETF got approved by the U.S. Securities and Exchange Commission (SEC) for public listing? Considering that the SEC has declined all applications for Bitcoin ETFs, there appears to be a double standard. We all know why.
The prospectuses of the other big gold-backed ETFs are similar. Most involve banks as trustee and custodian. If you want to buy gold as an insurance against the collapse of the financial and fiat currency system, they are obviously not a good choice.
One fund that does not include banks in its management is the Sprott Physical Gold Trust, that is established under the laws of the Province of Ontario in Canada. According to the prospectus, custodian of the trust is The Royal Canadian Mint, a “Canadian Crown corporation, which acts as an agent of the Canadian Government, and its obligations generally constitute unconditional obligations of the Canadian government”. Doesn’t that sound good? Well, not really. Canada does not only boast a remarkable real estate bubble, but also has one of the highest household debt-to-GDP ratios in the world. But it gets even worse. The Bank of Canada sold its last gold in 2015 and now doesn’t own a single ounce of the precious metal. What do you think is going to happen, if there is a true global crisis? We have our own thoughts about it and therefore stay away from the trust.
In summary, gold-backed ETFs are a convenient and cost-efficient investment, that more or less properly tracks the price of gold, when everything is fine. Once a global crisis is underway, share prices in such ETFs will likely deviate from the underlying price of physical gold, which will go higher. In addition, trading of shares on the stock exchange might be suspended and redemption of shares might be halted. As there are better ways to invest in gold, we have decided to stay away from gold-backed ETFs.