Precious metals—particularly gold—have been a part of many investors’ portfolios for decades, but, for some people, how the metals were bought and held looked very different 20 years ago than how they look today.
Prior to the first gold exchange-traded fund (ETF) in 2003, investors had two main options: owning physical gold or buying shares in a gold miner. We’ve already shown how physical gold can be a better long-term investment than gold mining stocks, but what about this newer ETF option?
ETFs emerged in the 2000s as an alternative way to invest in gold, but they also pose certain inherent risks that physical gold never faces.
Paper Gold: Exchange-Traded Funds
What is an exchange-traded fund (ETF)?
An ETF is an investment fund comprised of shares sold on an exchange, much like stocks. But because ETFs actually hold a wide range of investments, they operate more like mutual funds. ETFs involve a group of trusts, funds, or similar entities that hold gold in a vault and issue out fractional ownership to investors.
Theoretically, gold ETFs are supposed to always have enough gold on hand to back each penny of their share price. Many investors buy into ETFs expecting a straightforward situation, but there is actually a fairly wide range of issues that are posed by this asset type.
- Gold ETFs aren’t required to pay out in gold even if something happens to that company and they are forced to close. SPDR Gold Trust’s own prospectus language makes this clear about its ETF (GLD): “GLD represents fractional, undivided interest in the Trust.” Note, “in the Trust,” not “in gold.”In fact, ETF holders cannot access the gold that backs their shares. Investors certainly cannot physically hold this gold, but they may be surprised to learn they can’t even access or visit the vaults where this gold is said to be stored.
- The quantity of gold owned in an ETF share is not constant. In fact, some argue that the value of a single share declines because the Trusts behind the ETF need to sell gold in order to pay for expenses.
- Counterparty risk is another issues with gold ETFs. Their paperwork as well as the organizations behind them are designed to be extremely complex and involve lots of different entities. All of the parties involved and red tape that’s set up means that it would be easy for any theoretical payouts to investors get blocked.
- Insurance likely wouldn’t help. The actual gold owned by GLD is only covered by limited general insurance, and that insurance isn’t enough to cover all the gold in the vaults. Trusts make their custodians provide insurance, but those custodians choose limited general insurance which doesn’t cover the entire value of the gold held in the vaults.ETF paperwork generally notes this by saying something along the lines of: since the trust is not a beneficiary of this insurance, it has no say in the coverage and therefore can’t make any promises or demands with regards to the insurance chosen by the custodian.
- Insolvency is a risk with ETFs. If anything were to happen to the ETF, its custodian, or anyone else involved in the structures underlying the ETF that were to cause it to fail, there may be a default on the promise contained in the ETF—rendering the ETF worthless. This is not a small risk for the investor, particularly because loss of the ETF is without recourse given the lack of adequate insurance and other potential fail safes.
So while ETFs do give investors some exposure to gold, it’s indirect exposure. Business trends and company problems could outweigh even the best gold performance and set an ETF in decline, or even shut it down, with no actual gold transactions involved for the investors.
Those looking to add gold for its protective value against poor economic times might find the fact that gold ETFs offer neither gold nor protection to be alarming. The limited insurance offered by the bank is not comforting either, as the 2008-2009 financial crisis remains fresh in the memory of most investors as a time when they faced much loss with little chance for recuperation.
The evolution of investor interest in ETFs
A fund developed by ETF Securities, ETFS Physical Gold (GOLD) debuted on the Australian Stock Exchange on March 28, 2003. One and a half years later, the much larger and still dominant SPDR Gold Trust ETF launched in the U.S.
From its first $1 billion in assets at launch, GLD has grown to control $63 billion by mid-2020. The price of gold hasn’t increased sixty-three-fold, so what is driving this growth? It shows the massive interest for investing in gold even by the majority of the population, which likely hasn’t learned of physical gold’s benefits—and the potential pitfalls of ETFs.
Prior to this ETF era, investing in gold typically meant physically owning and storing it. Mining companies were options with stocks to invest in, but at their core they were companies with their own expenses and corporate problems to deal with—and these investments didn’t necessarily play out that differently from other company stocks. Pure gold plays were few and far between.
Besides physical gold, you could buy gold certificates, the original paper gold; but because of demand and competition, unallocated gold certificates became the norm. As Forbes pointed out a decade ago, “for every 100 ounces of ‘paper gold’ sold in the world, there is only one ounce of physical gold.” While allocated gold makes you an owner of gold, unallocated gold is the property of the bank and you are effectively its creditor—with all the liability that could entail.
The inadequacies of mining stocks and gold certificates is what really left room for ETFs. The latter offered the paper aspect certificates did, in that they were easy to buy and sell and didn’t require home safes or (direct) storage fees.
Physical Gold: Coins, Bars, and IRAs
Although an ETF may be purchased in minutes, we’ve seen that what you’re actually buying is highly questionable and potentially very risky. While physical gold does come with considerations about storage and sometimes about transportation, owning physical gold is the best way to get the most out of your investment. And depending on whom you work with, storage and transportation can be no-brainers.
Diversifying your savings into gold comes with a wide range of potential benefits. Gold is known to act as a direct hedge against market uncertainty and economic downturns. Gold has shown its potential as a perfect hedge when things turn sour elsewhere.
And if you are looking for steady protection long-term, physical gold can offer that in spades. While there have been spikes in the price of gold, it has held its value better than nearly everything else, including major currencies.
The World Gold Council has concluded that “gold has maintained its real purchasing power in terms of commodities and intermediate products since the early days of the United States of America, since the reign of Queen Elizabeth I, and since shortly after the end of the First Republic in France.”
Not long before the first gold ETF hit the market, physical gold gained a new market itself. In the Taxpayer Relief Act of 1997, gold officially was allowed inside of IRAs. Only certain types and purities are allowed, but gold—alongside precious metals like silver, platinum, and palladium—is officially a retirement account asset class of its own.
To hold precious metals like gold and silver in a retirement account, you will need a self-directed IRA. You’ll be able to leverage the tax deferment benefits of an individual retirement account—or pay taxes upfront, if you choose to open a Roth SDIRA—while diversifying your savings and adding a potential hedge against inflation or economic downturn.
You own the physical gold when you buy it in an IRA, but you hold it in a depository and work through a custodian to manage transactions. With this method, you get the convenience that comes with paper gold like an ETF, but the security of actual ownership of physical gold.
Physical vs Paper Gold: Which Should I Choose?
Physical gold—whether purchased directly or within an IRA—comes with a history of performance even when the dollar is down, making it a strong potential hedge against inflation or protection from economic downturns. You actually own gold when you buy it; it is not a promise or a piece of paper, which is what other potential investments like stocks or ETFs can be reduced to.
Buying physical gold is one way to truly diversify your assets, and many investors rely on it.