By Nick Barisheff

Special to the Financial Independence Hub

Gold-backed exchange-traded funds (ETFs) and similar products account for a significant part of the gold market, with institutional and individual investors using them to implement many of their investment strategies without considering the true risk associated with many aspects of holding non-tangible assets.

Gold ETFs are units representing physical gold in paper or dematerialized form, which is very different from owning physical gold. According to the World Gold Council, global gold-backed ETFs added 298 tonnes, or US$23 billion, across all regions in the first quarter of 2020[1]. Total ETF holdings amounted to 3,296 tonnes, representing US$179 billion. The largest ETF is SPDR Gold Shares (GLD) with 1,048 tonnes.

Many investors and financial advisors may be surprised to learn that owning shares in a gold ETF is not the same as owning physical gold. As one of the largest ETFs, GLD states in its prospectus: “ … designed to track the price of gold.” Is it wise to choose convenience over holding physical gold?

Since their introduction in 2003, gold-backed ETFs have transformed the gold investment market into an illusion, diverting attention from ownership of physical gold. This is like a magician that has you focused on a distraction while they perform a trick.

When you buy a physical asset, such as real estate, a car or a boat, a great deal of effort is made to ensure that legal title to the asset is transferred to the buyer. This generally involves a specific description of the asset – the make, model, colour and serial number, in the case of a car. In addition, the seller typically warrants that they have free and clear title, that there are no encumbrances and that they have the legal right to convey title to the buyer.

Surprisingly, when it comes to acquiring gold, investors tend to ignore these basic fundamentals and instead focus on the storage costs and management fees; they don’t give a second thought to actual legal ownership. What good is it to save money on the storage costs if you don’t have legal title to the gold? Many gold transactions, such as futures contracts, certificates, and ETFs, are nothing more than paper proxies or derivatives of gold. They do not represent legal ownership of gold. These proxies may work as planned during normal market conditions but may fail under stress, when investors need the safe haven of bullion the most. I have always said that if you aren’t paying reasonable insured storage fees for allocated bullion, then in all likelihood you don’t own any gold at all.

For example, if we were to place a bet on tomorrow’s gold price, and we agreed to settle in currency, then we wouldn’t need any actual gold as long as each of us had the ability to pay if he/she lost the bet. However, this isn’t an investment, and is totally dependent on the credit worthiness of the counterparty. It defeats one of the most important attributes of allocated bullion: NO COUNTERPARTY RISK.

ETFs have significant counterparty risk on many levels

In the marketing materials of the GLD ETF, the first thing to note is that it is referred to as a “Tracking Vehicle.” There is nothing mentioned about owning gold. On the GLD website, it clearly sets out the objective of the Trust. Unlike physical gold, ETFs have counterparty risk, because there’s a possibility that the other parties, such as the Authorized Participant (AP), the trustee or others, may default or fail to uphold their part of the agreement.

I have spent many years with lawyers, drafting prospectuses and legal agreements. As everyone can appreciate, lawyers are always careful and precise with the specific language in all legal documents. As a result, it is important for each investor to carefully read all the documents associated with a transaction in order to understand the objectives of the ETF.

Pay strict attention to the wording in the Regulatory Documents

With the recent increased popularity of ETFs, many investors assume they are like open-end mutual funds, but with much lower management fees. They never question why the fees are lower; they simply assume that Wall Street has become generous and wants to provide cost savings to public investors.

In an open-end mutual fund trust, such as the BMG mutual funds, the fund manager receives the investor’s contributions and then purchases the appropriate bullion according to the mandate of the fund. Similar to a stock transaction, the Custodian (Scotiabank, in BMG’s case) issues a Trade Record Sheet, specifying the bar being transferred to the fund by refiner, serial number, exact weight and purity to three decimal places. Every month, the Custodian provides a list of bars held in custody for each fund by refiner, serial number, exact weight and purity. This monthly document is signed by an officer of the bank and is posted on the BMG Group Inc. website.

The holdings are audited annually by the BMG Funds’ independent auditors (RSM Canada LLP).

While open-end funds have to incur a number of expenses, as mandated by regulatory authorities, the investors will benefit from the economies of scale in both purchasing the bullion and storing the bullion on a fully insured basis, as well as the reduced legal and accounting costs. Continue Reading…