For some, buying gold exchange traded funds (ETF) can seem like a good deal. You gain some exposure to gold‘s performance, but without having to arrange for receipt or storage of actual gold. How? A gold ETF trades like a stock, generally tracks the price of gold, and aims to replicate the performance of gold.
Gold ETFs “seek to combine the flexibility and ease of stock-market trading with the benefits of physical gold ownership,” writes the World Gold Council.
Sound like a rosy setup? Make sure you weigh the potential risks before you choose a gold ETF over physical gold.
ETF Risk #1: You’re dealing with unavoidable “counterparty risk”
This is one of the biggest risks associated with gold ETFs, per Business Insider and Forbes. Counterparty risk exists when there’s a chance that another party in an agreement will fail to live up to their side of the deal. With so many institutions involved in the ETF process, there are major counterparty risks to consider.
As an example, let’s say you wanted to buy shares in one of the world’s largest and most popular gold ETFs, the SPDR Gold Trust (GLD). First, you’d have to work through an Authorized Participant, typically a large financial institution. They would buy shares in the fund’s trustee—the SPDR Gold Trust. The trustee turns to their custodian, HSBC in the case of GLD, to source and store their gold.
And there are even more layers to consider beyond the Authorized Participant and the custodian. Custodians, like HSBC, use sub-custodians, reports Forbes, so in addition to carrying custodian risk, you’re also subject to sub-custodian risk.
“You are dependent upon, among other things, management prowess, fund structure, chain of custody, operational integrity, regulatory oversight, and delivery protocols (which are available only to very large shareholders),” notes Forbes. If any of those break down, your holdings could be at risk.
With physical gold, counterparty risk can be minimal since fewer parties are involved. There’s you and your gold company. You can be involved in each stage of the process, from purchase to shipment tracking and receiving. Transparency and trust go a long way toward mitigating counterparty risk and giving you peace of mind concerning your purchase.
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ETF Risk #2: You’re operating within a shaky system
Custodians and sub-custodians, typically banks, are responsible for sourcing and storing the physical gold associated with a gold ETF. The question is, can custodian banks be trusted to 1) last as long as the gold in their vaults and 2) adequately safeguard their holdings?
There have been six bank failures in the U.S. in 2017, according to data from the FDIC, and since October 2000, 553 banks have failed.
Huge international banks, like GLD’s custodian HSBC, must fare better, right? Consider this. HSBC could be on the brink of disaster, says Business Insider. What’s more, Business Insider reports that over the past two years, HSBC (the custodian of the largest gold ETF):
- was fined $1.9 billion for money laundering and sanction violations
- reportedly allowed drug traffickers to launder billions of dollars
- set aside $1.3 billion to settle claims that it manipulated foreign exchange rates
While physical gold can be bought, sold, and stored outside the banking system, gold ETFs and the gold associated with them cannot.
“One primary reason to own gold is for it to be your last line of defense in economic or monetary crisis. But since the banking system is also at risk during periods of stress, so are gold ETFs as they’re part of that very system,” writes Business Insider. “Why sabotage those protections by exposing your gold to an unprincipled and unstable bank?”
ETF Risk #3: You still don’t own any physical gold
Buy a gold-backed ETF and you gain exposure to the price of gold, not actual, physical gold. Owning shares in a gold ETF is not the same thing as owning physical gold, and ETFs can’t replicate the safety and security offered by physical gold.
In theory you can take delivery of gold from your ETF shares, but it isn’t as straightforward as buying physical gold outright. Here’s an example. As Business Insider and MarketWatch note, GLD shareholders have to have a minimum of 100,000 shares in order to request an exchange, which is almost $12 million worth of shares as of August 8, 2017—not a position the average person is likely to have. Gold is then delivered in 400 to 430 oz. gold bars and cannot be broken into smaller pieces. Even after your request, the fund can send you a check instead of bullion for any reason they deem necessary.
In the words of GLD’s founder, George Milling-Stanley, “When you buy GLD shares, you’re buying an ownership in a trust…The individual [buyer] does not own gold that backs the trust, any more than an investor in GM owns a car or an investor in Apple owns an iPhone.” GLD shares represent a paper claim on gold, not gold itself.
Why settle for a paper proxy?
There can be more effective ways to buy and hold gold than a gold ETF—ways that don’t involve great counterparty risk and don’t operate within the confines of the banking system or stock market.
Even central banks buy gold coins and bars—not gold ETFs—to manage risk, promote stability, and hedge against inflation and a sagging dollar. Why buy a paper substitute for gold when you can own the real thing?
Gold has been used as a currency and a store of wealth since the beginning of recorded history. Gold ETFs? The first fund came along in March 2003.
At some point, gold could become difficult to impossible to come by. Unlike exchange-traded funds and their shares, the world’s supply of physical gold is finite.
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