-- Posted Thursday, 16 December 2004 | Digg This Article
The recent launch of a gold ETF on the NYSE called StreetTRACKS Gold Shares (symbol "GLD") has attracted a lot of attention, some favorable, some not. If you are interested in the detailed commentary, the following links provide a good sample:
Where Is the ETF's Gold? by James Turk:
Behold Gold's ETF by Adam Hamilton:
For those who would like a summary of the above, the primary criticisms of GLD are:
- The key custodian, HSBC, can use sub-custodians and even sub-subcustodians
- HSBC is not liable for the acts or omissions of its sub-custodians
- The locations of the vaults of the sub-custodians are not disclosed
- Neither the Trustee or HSBC monitors the activities of any sub-custodians
- Recent analysis of the allocated bar listing reveals duplicated bar numbers
- Long-term capital gains tax rate on GLD is 28% instead of usual 15%
Some of these criticisms have been dealt with by Mr. David Walker in a December 8 article, but there are still some problems with GLD and its design.
On a more positive note, Adam Hamilton sees gold ETFs as essential to opening up gold investment to traditional stock and bond investors who may not have considered gold. He believes this is necessary if gold is to replicate the rapid rise it achieved in 1980, which would mean a gold price of $3,500 per ounce in today’s terms! As usual, the truth lies somewhere in-between these negative and positive positions.
Where's the gold?
There is no doubt that Mr. Turk's analysis of the GLD prospectus raises some key issues, especially for those investors who are purchasing gold as "insurance". For such investors, the whole point of holding gold is that it will provide protection in the most extreme circumstances, perhaps even rising in value when all other asset classes are falling. In such times, corporations are at greater risk of failure, thus any private company’s promise to pay you money based on the gold price is worthless unless they have the actual gold behind it that they can sell in those times of trouble.
It should be noted that the most secure way of carrying such insurance, of course, is to hold physical gold yourself. However, given the hassle involved in transporting physical gold and the risk that it could get stolen, most investors prefer to leave their metal with someone else. Indeed, this is part of the marketing pitch for GLD. If you're going that way, there are two key questions you need to ask yourself:
1. How many people are involved in storing my gold?
2. Do I trust them?
To the first question, if you have a large number of organizations involved as custodians of your metal, then there exist more counter-party legal agreements (even if there is only one “agreement” between the security and you, there will be additional agreements between the other parties) and if things go sour, there could be a greater likelihood of lawsuits between the custodian and its sub-custodians. This potential would seem to be present with GLD, with the World Gold Council (WGC) as sponsor, a marketing agent, a trustee, a custodian, all those sub-custodians, auditors, etc. Compare this, for example, to the government-backed Perth Mint Certificate Program (PMCP) in which there is only you, the selling agent and the Mint. Furthermore, once your gold, silver or platinum purchase is completed, you hold a Certificate issued directly by the Mint under one agreement - there is no ongoing exposure to the dealer who sold you the product. It’s simple, clean and safe.
The second question is also crucial and I will diverge from Mr. Turk here as I believe that the WGC and HSBC will indeed be buying physical gold and storing it. I just don't believe that if GLD weren’t really buying the gold that with all those parties and employees involved that no one would leak such sensational information. I see no reason not to trust them; my complaint about GLD, however, is that in addition to HSBC and the WGC there are simply too many parties to trust! In addition, while the oft-rumored central bank conspiracy to manipulate the gold price via GLD is remotely possible, I suppose, given they have a da Vinci Code-ish secret society feel about them, I find it very difficult to believe the WGC would be involved in such a conspiracy—not least because the organization is widely considered to leak like a sieve.
While I'm on this point, I'd just like to diverge a bit and make the following comment – either you trust your precious metals depository or you don't. I have heard a few clients say that they prefer allocated storage programs because they don't trust The Perth Mint's unallocated plan (which is backed ounce-for-ounce with physical metal, unlike other "unallocated" products). While Perth, for example, also offers an allocated storage option, this argument doesn't make sense to me— if you don't trust an organization to hold a pile of un-segregated gold against your account, then why would you trust them to hold a segregated pile of gold? The issue is not whether the gold is allocated or unallocated, but whether you trust the organization to fulfill its obligation to you by purchasing your metal in the first place.
Allocated storage indeed has its advantages, primarily being that the gold is pre-fabricated and ready to go. With the Mint's unallocated method, if everyone turned up at the door at the same time, it could take a while to fabricate all the gold into the forms that investors request, but the huge advantage of unallocated is that it has no storage fee. The choice is yours, but you can be confident that a AAA-rated, government-backed Mint that has been refining and fabricating precious metals for over 100 years has the gold.
What will GLD do to the gold price?
Mr. Hamilton (whose work I think very highly of, by the way… his Zeal Research website remains under-appreciated, in my opinion), is upbeat on the potential for GLD and other gold ETFs to help push the gold price much higher than it is today. I am not so bullish on the notion that GLD will have so large an impact. Why? Let’s look at GLD from the point of view of three of its key target markets:
1. Gold Bugs - existing holders of gold or those who are first-time investors in gold but don't need convincing as to why they should.
2. Stock & Bond Investors - people who have never considered gold and need convincing.
3. Institutions - pension funds and the like who have found it too difficult to buy physical gold.
The complex legal structure of GLD, which results in the investor being totally divorced from the physical gold, means many gold bugs simply are not going to buy it. Most of these will do their own research on where to buy gold and won't have any problem dealing with organizations such as the Perth Mint, especially as it gives them access to gold at 0% storage fee under the PMCP, compared to GLD's 0.40% (the security’s annual expense ratio).
For the second group, your average investors, you would need to convince them to buy gold using portfolio diversification/asset allocation arguments since, unlike gold bugs, they won’t be quick to appreciate gold's powerful "insurance" capability in times of financial crisis. However, there is a problem with this approach as these investors may assess GLD the way they do any other investment. A hypothetical conversation:
Investor: So what is GLD’s yield?
Broker: Negative 0.40%.
Investor: Hmmm, OK… what about its capital gain growth?
Broker: Well, it is not a wealth producing asset like a company, just a commodity reliant upon supply/demand, but the fundamentals look good.
Investor: OK, and I assume any of those long term capital gains are taxed at 15% like other assets, right?
Broker: Ah, no. They are taxed at 28%.
Investor: I think I'll buy some gold mining shares instead.
The third class of investor is, in my estimation, more likely to go for GLD. Indeed, it appears that this is actually who GLD has been designed for. It is interesting to note that there has been a shift by the WGC in how it has designed and marketed its various ETF products. The first one off the rack was in Australia in April, 2003, and was actually a collaborative product between the WGC and an independent operator. The Australian ETF (technically it is not an ETF, but operates in the same way) has completely different features to it U.S. sister, such as:
- A "see-through" trust structure so that investors have a beneficial interest in the gold.
- Ability to take delivery of the gold instead of having to sell the shares.
Now, these two features were put in, in my opinion, because the designers of the product realized that direct ownership and convertibility of the gold were valued by gold bugs and also because it had to compete against The Perth Mint on its home turf, which was offering a zero storage fee, government-backed depository facility.
These two features are great and there were undoubtedly high hopes when it was launched. So, what happened? First, it has only attracted around 240,000oz (approximately US $110 million)— by comparison, the Perth Mint currently holds over US $400 million worth of precious metals. Second, in November 2003, a representative of the Aussie ETF said that 75% of the shares were held by foreign investors and about 85% of the shares were in the hands of institutional investors.
Thus, the WGC realized at this early stage that this ETF idea appeals more to institutional investors than retail buyers. Therefore, when the WGC got around to doing a UK gold ETF, it was sensitive to the needs of institutional investors. In the UK, there are some regulatory restrictions on British funds owning gold so the WGC changed the UK product so that only market makers would be able to redeem shares for physical gold, which it felt would overcome this problem. It then launched the product in December 2003, but by March 2004 feedback from institutions revealed that the legal structure was not compliant with the regulations. The WGC then had to launch a "new" ETF in April and close the old one so that these funds could invest. However embarrassing, it shows how the focus was on meeting the needs of institutions.
The way the US product has been designed, then, makes it clear that the WGC is no longer sensitive to the needs of gold bugs and retail investors and is really aiming this product at the big fund managers instead.
I can hear you saying, "Well, while GLD doesn't appeal to two of the three target markets, isn't it still positive because fund managers control a substantial amount of money?" Let’s look at the history of the WGC's other ETFs as it provides some insight into what might happen:
The chart above shows the amount of gold held by the custodians (not stock exchange trading volumes, which can reflect the same ounce of gold traded many times during the day—a key point to understand). I have put the Australian version on the right hand scale because the Australian market is much smaller. As you can see, both the Aussie and UK ETFs initially had good inflows but have subsequently stalled. At this early stage, GLD shows the same worrying trend, with a few days of good inflows, then flat and actually then posting an outflow of 500,000oz on December 7th.
If GLD replicates the performance of its two other sister ETFs, then it is likely to end up holding only 6 million ounces of gold. While this is $2.7 billion worth at current prices, it is insignificant in terms of the gold market, which has a daily average clearing turnover in London of 15 million ounces. It is also small in terms of the size of the US stock market, which tops $15 Trillion. As a result, I don't see much chance that GLD will have a huge impact on the gold price in the near future.
Indeed, it has been speculated that one of the factors behind the recent strength in the gold price has been investors going long gold on the expectation that the launch of the ETF would open up new demand for gold, pushing the price much higher. There is a case, therefore, to argue that once the market fully realizes that GLD isn't going to send gold prices flying, those short-term speculators might leave, presenting a good opportunity to hold off now and consolidate your gold position later when prices are lower. I believe that in the long run gold is set for $500 an ounce and higher, but precisely none of my opinion is based on GLD shouldering that load.
However, I do agree with Mr. Hamilton that gold ETFs are supportive of a bull market in gold, I just happen to believe an issue like GLD constitutes just one more small ingredient in the gold bull market picture, not the savior some have been waiting for. Indeed, GLD may provide its biggest support to gold prices late in a precious metals bull market as it provides an excellent vehicle for "dot com" style hot money, which will likely be brought by the same investors who are late to every party and won’t care about the security’s fees or counterparty risks.
So, in summary, don't expect GLD to make a heavy impact on the gold price in the near future. If you want a safe and cost effective way to invest in physical gold, a vehicle such as the Perth Mint Certificate Program remains a simpler, lower risk, lower cost option for the serious precious metals investor.
Chip Hanlon
C.O.O./Chief Domestic Strategist
Euro Pacific Capital, Inc.
Newport Beach, CA
Chanlon@europac.net
-- Posted Thursday, 16 December 2004 | Digg This Article
