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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.
The process for ETFs is entirely different. The first important distinction is that ETFs are not subject to conventional securities laws. They use a “Registration Statement” instead of a “Prospectus” and, as a result, are not subject to the same regulations as open-end mutual fund trusts. According to a Solari Special Report by Catherine Austin Fitts, president of Solari, Inc., the publisher of The Solari Report and managing member of Solari Investment Advisory Services, LLC, on the GLD and SLV[2], the term “exchange-traded fund” is not a precise legal term defined by statute, as is an “Investment Company,” of which mutual funds are a subcategory. Both hedge funds and ETFs, at least under current law, are investment vehicles created for the express purpose of avoiding some or all of the regulation under securities laws that apply to investment companies and traditional stocks. ETF investors have limited voting power, including the ability to remove management. The Trustee’s and Custodian’s limited responsibilities are set out at the creation of the trust and execution of the custodial agreement, with no mechanism to change those responsibilities in the event of change, and no direct accountability to investors.
CUSTODIANS OF THE GOLD AND SILVER IN AN ETF
Concerns have been raised by numerous analysts over the Custodians in the GLD and SLV ETFs – HSBC Bank (HSBC) and JPMorgan Chase (JPM). Both HSBC and JPM, while holding 1,080 tonnes in gold and almost 9,500 tonnes in silver (December 2009), held significant over-the-counter derivatives in both gold and silver, and significant short positions in both gold and silver, on the COMEX. According to the Commitment of Traders Report (CFTC), between them, HSBC and JPM are short more than 30% of the entire COMEX silver market on a net basis, with JPM holding the vast majority of these short positions. Moreover, both banks have been fined by regulators and have class action lawsuits pending against them for manipulating the gold and silver markets, bond rigging, LIBOR rigging, rigging commodity markets and mortgage securities fraud[3].
Both banks have been fined various times by multiple institutions such as the Federal Trade Commission (FTC) for manipulating these markets, for fraud, for money laundering, and for helping Americans evade taxes. (HSBC ‘s Rising Legal Liability and JPMorgan Faces Potential Class Action Lawsuit)
In addition to the ethical concerns about the Custodians for the GLD and SLV ETFs, neither the Trustee, Manager or Custodian assumes any responsibility for the quality of gold and silver delivered to the ETF in question. There is no requirement for the sub-custodians to be London Bullion Market Association (LBMA) members. There is no assurance that the bullion is legally mined and meets Responsible Investment Association (RIA) standards. The importance of this is that gold normally held by LBMA members in LBMA member- vaults will maintain its Chain of Integrity. This means that every Good Delivery bar is tracked from the mine, the transportation company, the refiner and the vault. If gold is removed from this chain of integrity, there can be no assurance that it is pure gold or that it meets Good Delivery Standards. In the past, investors have been swindled into buying gold-plated tungsten bars when no chain of integrity was in place.
Elemental Gold was initially rated as an LBMA-qualified refiner but lost that status when a money-laundering investigation was launched by the Financial Crimes Enforcement Network (FinCEN). Elemental Gold was accused of selling illegally mined gold that did not meet LBMA standards[4].
Instead of “Buying” or “Acquiring” assets, ETFs use Authorized Participants to “contribute” “baskets” of securities, as defined in the Registration Statement. Authorized Participants are typically the largest brokerage houses and must be members of the Depository Trust Corporation (DTC). As a result, even institutions or pension funds cannot redeem in physical if they are ETF shareholders unless they are also members of the DTC and have entered into an Authorized Participant Agreement. According to the prospectus, APs “assemble” the securities to form the baskets.
Why do they use the word “assemble” instead of “purchase” or “acquire”?
How do they “assemble” the baskets?
According to Catherine Austin Fitts, “Underlying documents may permit Authorized Participants to contribute (or at least not expressly prohibit them from contributing) to the ETFs’ gold and silver leased from central banksinstead of precious metals to which Authorized Participants hold absolute legal title.”
In addition, a report written by Deloitte & Touche LLP entitled “Exchange Traded Funds – Challenging the Dominance of Mutual Funds” described how baskets are created and redeemed.
‘The “creation of units” is the daily operational process that is utilized by APs to create ETF units. A portfolio composition file, created by the sponsor, lists the composition and weights of the underlying securities or commodities that mirror the target index. APs then buy or borrow relatively large amounts of the underlying stocks from the capital markets that would mirror the index. If the proposed ETF tracks a commodity, it buys or borrows certificates of ownership of that commodity. The basket of securities is delivered to the custodian who verifies that it is an approximate mirror of the index. The AP (if they are the sponsor) then subsequently receives a “creation unit” delivered to their account at the Depository Trust Corporation. The creation unit is broken up into ETF shares, which represent a fraction of the creation unit. The number of ETF shares depends on the NAV of the creation unit — a function of the weights assigned to the underlying securities. In the case of commodities, the sponsor will usually have a formula to calculate the NAV. Because this is “in-kind” barter and no cash changes hands, there are no tax implications.’
[1] https://www.gold.org/goldhub/data/global-gold-backed-etf-holdings-and-flows
[2]https://home.solari.com/wp-content/uploads/2010/Disclosure_in_the_Precious_Metals_Puzzle_Palace.pdf
[3] https://www.forbes.com/sites/francescoppola/2016/02/28/hsbcs-catalog-of-lawsuits/#1151570657fc
[4] https://www.silverdoctors.com/gold/gold-news/what-does-the-elemetal-gold-scandal-say-about-gold-prices/
For the rest of this blog, please click on this link to the original (long!) version that ran on the BMG site.
Nick Barisheff is the founder, president and CEO of BMG Group Inc., a company dedicated to providing investors with a secure, cost-effective, transparent way to purchase and hold physical bullion. BMG is an Associate Member of the London Bullion Market Association (LBMA) as well signatory to the Six Principles of Responsible Investments (United Nations endorsed Principles for Responsible Investment – PRI).
Widely recognized as international bullion expert, Nick has written numerous articles on bullion and current market trends that have been published on various news and business websites. Nick has appeared on BNN, CBC, CNBC and Sun Media, and has been interviewed for countless articles by leading business publications across North America, Europe and Asia. His first book, $10,000 Gold: Why Gold’s Inevitable Rise Is the Investor’s Safe Haven, was published in the spring of 2013. Every investor who seeks the safety of sound money will benefit from Nick’s insights into the portfolio-preserving power of gold. www.bmg-group.com
