Physical gold and silver are great to look at, you know exactly what it is and what it represents, and you can hold it in your hand and have direct ownership of it. Pretty straight forward. Exchange traded funds (ETFs) involve contracts and counterparties. For example, the GLD ETF prospectus consists of 36 pages of fine print and clauses. Let’s look more closely at why someone would own an ETF.
Advantages of gold ETFs and silver ETFs
- Leverage is possible
- No premiums
- trading fee applicable
- No storage fee
- Management fee applicable
ETFs do have their advantages. They offer great convenience because you can trade them quickly and easily from the comfort of your own home with just a click of a mouse. ETFs are very liquid and back in March 2020, when physical silver was tough to get hold of, you could still buy SLV shares. It is possible to leverage your trade through options on ETFs. ETFs do not charge the premiums over spot that you would pay when you buy physical gold, but remember that depending on the platform you use you will still be paying a trading fee. Storage fees are also not applicable to ETFs but there is a management fee of just under half a percent per annum.
Considerations when buying gold and silver ETFs
Only redeemable in cash
When buying an ETF, one of the common misconceptions is that people often think that they can redeem their shares for physical gold or physical silver. For retail investors, that is not the case. If we read the fine print in the GLD prospectus, it states that “the shares are not neither interests in nor obligations of the sponsor the trustee or the marketing agent and may only be redeemed by or through an authorized participant and only in baskets”. A basket is one hundred thousand GLD shares and retail investors are not considered to be authorized participants. Indeed, even authorized participants could be refused delivery of the physical metal and instead settled in cash. ETFs are therefore not a substitute for physical gold.
Foreign currency denomination and risk
The largest and most liquid ETFs for precious metals are usually listed on the American stock exchanges and are therefore denominated in US dollars. The equivalents on exchanges in other countries that are denominated in other currencies don’t have the same level of liquidity. For those who live outside USA and are considering buying US dollar denominated precious metals ETFs, an important issue is that as well as being exposed to the gold or silver price, you are also adding currency risk to your trade. For example, Someone from UK would need to exchange British pounds for US dollars and then buy a US dollar denominated gold ETF. When the time comes to sell and cash in the ETF, the US dollars will be converted into British pounds. If the US dollar gets stronger, they will benefit but if the US dollar is weaker, then that’s going to reduce any gains from the exposure to the gold price. Foreign currency ETFs therefore add an extra layer of risk. On the other hand, physical gold is basically universal and there are ways of selling physical gold for your currency of choice.
When it comes to ETFs versus physical, there are important tax implications to consider and these will differ by country. Some countries might have capital gains tax on ETFs but not on physical gold whereas other countries might have wealth taxes on physical gold but not on precious metals ETFs.
Risks of ETFs
- Paper proxy for gold and silver
- Counterparty risk
- Insurance risk
- Type of physical backing
- Decoupling of spot price from physical price
All forms of investment carry risks and ETFs are no exception. One risk is that gold and silver ETFs are a paper proxy for precious metals and are effectively fiat currency with exposure to the metals prices. That is very different from holding the physical metal itself.
Counterparty risk should also be considered. Who are these counterparties? Firstly you have the trustees. The trustee for the GLD ETF is the SPDR gold trust. Then there is the custodian who sources and arranges storage for the gold. In the case of GLD, the custodian is HSBC meaning that your investment is part of the banking system. There are also sub-custodians which might be other banks or even central banks. Notably, there are no written contracts between these three entities and so any legal action between them is going to be limited. Overall you have at least three counterparties and if something goes wrong who are you going to call?
Isn’t all of this covered by insurance? The ETF is not insured by the trustee and the level of coverage by the custodian can vary but is likely to be of minimal benefit to retail investors.
Another common misconception is that each share of the ETF is backed by physical gold. Some of the backing may be in the form of leased gold, which is far from ideal. The preferred form of backing is in the form of allocated (and even better segregated) gold. This is something that’s really important to look for when you’re investigating the different precious metals ETFs that are available to you. The GLD and SLV ETFs are thought to use a significant amount of leased gold. The Sprott ETFs report that their metals are fully allocated.
If something happens that results in the spot price of gold or silver decoupling significantly from the physical price, then owning the ETF would be a disadvantage compared to owning physical gold or silver.
Of course it’s entirely possible that an individual ETF could go bankrupt and your investment could go to zero. In contrast, the only way that physical gold would be valued at zero would be if there were no humans left on the planet!
Reasons to own a precious metals ETFs
- No choice (e.g. retirement fund)
- Short term trading
There are some valid reasons for owning precious metals ETFs. It might be that you don’t have a choice. For example some retirement funds don’t offer physical gold options but they might allow investment in gold ETFs which would allow you to have some exposure to the gold price. In that case, it’s going to be up to you to look through all the different ETF options and select the best one while also accepting the pitfalls mentioned above.
ETFs are much better than physical gold if you are trading on short time scales (weeks/months). This is because by using the ETFs you’re avoiding having to pay the premiums and storage fees associated with physical metals.
ETFs are also useful if you want leverage and they can be useful if you want to hedge your physical position.
Overall precious metals ETFs are not a trap as long as you know exactly what it is that you are getting into and why. That does mean going through the prospectus and being clear about what your expectations are. If your aim is to invest outside of the banking system then ETFs aren’t for you. Let’s face it, these contracts are never drawn up to benefit you and they include multiple pages of indecipherable lawyers language. With physical gold you don’t have such a contract. It does exactly what it says on the bottle.