Metals investing: whose gold is it, anyway?
Updated: Oct 16, 2019
Gold's recent move up past $1,350 from the long-term low of around $1,050 established back in December 2015 has renewed interest in the precious metals, and many analysts are predicting that the shiny metal is on track to resume its secular bull after a six year corrective phase. As always, however, gold's ability to polarise the investment community has remained undiminished, with the permabullish gold bugs continually extolling its virtues of wealth preservation in a time of heightened geopolitical stress and currency debasement, while its detractors dismiss it as a yieldless, barbarous relic that owes its survival to tradition and a small number of sentimental investors.
The point of this article is not to argue for or against the merits of gold ownership per se, but rather to show the degree to which 'gold investing' is essentially an umbrella term that is loosely applied to radically different investment types, the proper selection of which is hugely consequential to achieve the desired investment objectives.
Gold investing: what are the benefits?
In the investment mainstream, gold is most commonly referred to as a hedge against inflation, primarily due its ability to act as store of value by protecting investors against short-term inflationary spikes, and longer-term fiat currency debasement.
Despite this, comparative analysis between recent periods of high inflation, and with the current era of prolonged low inflation suggests that it is a poor predictor of the gold price. As can be seen from the chart below, the period of high inflation in the late 1970s and early 1980s which peaked at just over 13%, was indeed accompanied by a trebling of the average annual gold price from $193 in 1978 to $613 in 1980 (with a nominal high of $850 in January 1980). However this pattern did not repeat itself when inflation rose from 1% to 6% from 1986-1991, during which time gold remained largely flat.
Source: McKay Research, usinflationcalculator.com
Therefore, any one-dimensional analysis of the gold price vis-a-vis inflation will typically fail to take into account both other economic factors such as interest rates and stock market performance, and key contextual geopolitical considerations. In the early 1980s for example, rocketing oil prices, a Soviet intervention in Afghanistan, and the impact of the Iranian revolution, all combined to fuel a huge increase in demand for the yellow metal from panicked investors desperate to protect their portfolios from heightened geopolitical and macro-economic stresses.
Similarly, it would be just as easy to take the opposing view when looking at gold's recent bull run from 2000 to 2012 which came during a period of historically low inflation. But again, such a view ignores the fact that a significant driver of the gold price during this period was attributable to the unprecedented expansion of central banks' balance sheets due to quantitative easing (or money printing) programs launched in an attempt to boost liquidity and shore up the banking system in the wake of the 2007-2008 financial crisis.
Perhaps gold's strongest suit, therefore, is its track record of insulating the holder against systemic risk, such as the failure of the banking sector and other financial intermediaries, as well as sovereign defaults and hyperinflationary events, as recently witnessed in Cyprus and Venezuela respectively. Financial crises of this nature often result in the imposition of arbitrary cash withdrawal limits, or worse still, the indefinite freezing or outright theft of account holders' cash deposits (see Cypriot bail-in), and holding gold outside of the baking system is a tried and true method of protecting oneself against such rare but devastating events.
However, therein lies the caveat: to be able to benefit from gold in this way, it must be held in a manner that ensures legal title to the asset. Merely having 'exposure' to the gold price via a financial asset will do little or nothing for the holder in a time of crisis. Put another way, gold investing cannot be equated with gold ownership.
Paper vs. physical gold: a distinction with a difference
Paper gold refers to the purchase of a financial security that essentially amounts to a claim on physical gold through the purchase of shares backed by a particular number of physical gold ounces. This provides the investors with an excellent way to achieve exposure to the percentage price movements of physical gold (see Gold vs. GLD PerfChart below), without having to buy physical gold or futures contracts.
By far the most popular vehicles through which to achieve this are gold exchange-traded funds, or ETFs, such as the SPDR Gold Trust (GLD), which seeks to reflect the price performance of gold bullion by holding gold bars and issuing shares backed by their holdings of physical metal. Each share of GLD is worth just under 1/10 of an ounce of gold, and the bars are held in HSBC’s vault in London, with shares sold in baskets of 100,000.
Gold vs. GLD Performance Chart
Source: Stockcharts.com, McKay Research
Investors attracted to these ETFs are enticed by the ease at which they can own gold shares 'backed' by physical gold as well the superior liquidity over buying and selling physical gold coins or bars. Indeed, according to Word Gold Council data, global gold-backed ETF holdings rose 8.4% in 2017, underlining their popularity in the current climate.
Where most investors get it wrong about GLD, though, is about redemption. Taking a look at the fine print reveals that despite the physical backing, it is virtually impossible for investors to redeem shares of GLD and take physical delivery of the metal. Instead, and as stated on the SPDR website:
"Investors have no right to request the Sponsor to redeem their Shares while the Shares are listed. It is intended that the holders of the Shares may only deal in their Shares through trading on the Singapore Exchange Securities Trading Limited ("SGX"). Redemption of Shares can only be executed in substantial size through authorized participants."
Crucially, the "authorised participants," referred to above, are the banks and financial institutions that have sponsorship and custodial relationships with the trust such as Citi, Goldman Sachs, Morgan Stanley, JPMorgan Chase, and Merrill Lynch-Bank of America, among others. So although GLD may own all the physical bullion necessary to back all shares issued, a complex system of custodians and sub-custodians, and limiting withdrawal mechanisms to authorised participants means that the investor does not have legal title to the underlying physical commodity, regardless of the physical backing of the shares.
Physical gold: is a certificate really enough?
This brings us to physical gold ownership. Typically, companies will market physical gold storage services to investors who have concerns over the aforementioned structural complexities of ETFs, and who wish to secure actual legal, unencumbered title to the metal. But, here again, a certificate of physical gold ownership does not always mean the investor legally owns the metal. This is because many bullion banks/companies promise physical gold ownership in the form of unallocated accounts, which means they sell inexclusive, 'virtual' ounces of gold that are split between investors and for which no storage fees are charged (get the catch?).
Although an itemised certificate of gold holdings is issued, this amounts to little more than an IOU and merely serves as proof of the gold owed to the account holder. It in no way implies legal ownership, and is just a different form of paper gold ownership with a 'physical' label.
How are they able to do this? Well, just as commercial banks operate under a fractional reserve system that legally obliges them to have only 10% of cash on deposit, bullion banks are also not required to have all gold needed to back all cash deposits on account. Instead, they store enough gold to satisfy whatever redemption demand they think is likely. If too many creditors insist on receiving their physical gold and the bank is unable to deliver, there will typically be an insurance clause covering for such an event which enables outstanding orders to be settled in the cash.
How 'Good' is your gold?
If the objective is to hold physical gold to hedge against systemic risk, there are therefore really only two acceptable options to guarantee actual gold ownership through full legal title. The first option is to purchase physical coins or bars from a reputable dealer and take responsibility for the storage either at home or in a third-party safety deposit box or secured vault. While taking personal responsibility for storage introduces an element of risk, there is the advantage of having direct access to one's investment; a desirable option given the potentially unpredictable circumstances in a time of systemic crisis.
The second method to achieve legal title is via a fully allocated storage account through specialist bullion vaulting companies, that, unlike their unallocated counterparts, generally always charge storage fees to account holders and are not owned by any third-party bank. As well as being independently audited on a regular basis, such companies also offer a selection of different options for the secure withdrawal of gold from their vaults.
Crucially, any such company will deal exclusively in bars certified by the London Bullion Market Association (LBMA), a trade association of big banks that engage in buying and selling gold bullion through the London interbank OTC market. The LBMA benchmarks and regulates the acceptable requirements for large gold and silver bars through its regularly updated publication of the London Good Delivery Lists. These are universally recognised standards that ensure that accredited refiners maintain the high assaying and bar quality criteria standards necessary for listing and accreditation. Investors must ensure their bullion meets the LBMA Good Delivery standard and that certificates are issued with all serial numbers for each individual bar.
In conclusion, different forms of gold investing offer different advantages and disadvantages, and investors must be clear on their objectives in order to determine the best option, be that for gold price exposure, diversification, or wealth preservation. If full physical ownership is what one is after, knowing how to achieve legal title and avoiding fool’s gold is the first step to achieving this.
The information contained within is for educational and informational purposes only. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. McKay Research/James McKay is neither being compensated for this article, nor has any positions in the stocks/funds mentioned. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.