Recently the mainstream media has reported that several billionaires are
concerned about global financial markets and have purchased significant
amounts of gold to protect their portfolios.
Take Stan Druckenmiller, the famed hedge fund manager who managed money
for George Soros as
the lead portfolio manager for Quantum Fund. He and Soros famously 'broke the
Bank of England'
when they shorted the British pound sterling in
1992, reputedly making more than $1 billion in profits. He has reportedly
used over $323 million of his own money to invest in gold. This is
approximately a 30% allocation in his $1-billion family fund. His belief in
gold can be attributed to his criticism of the Federal Reserve's massive
money printing and near-zero interest rates. Ongoing low rates will drive
both central banks and investors into gold.
Then there's John Paulson, the CEO of Paulson & Co., which manages
over $18 billion in assets invested in credits default swaps. The company has
made about $15 billion in profits by betting against subprime mortgages. In
2015 Paulson invested about $900 million in gold at close to what now appears
to have been the bottom of the three-year correction. He believes gold has a
place in portfolios as insurance against the unexpected. "We view
gold as a currency, not a commodity," Paulson said recently. "Its
importance as a currency will continue to increase as the major central banks
around the world continue to print money."
Typically the billionaires are ahead of the curve, making their
investments before the market recognizes the trend, and increasing their
wealth while everyone else wonders what happened. High net worth individuals
and other savvy investors realize that owning gold is one of the best ways to
manage systemic risk. However, in this case both Druckenmiller and Paulson
have the right idea but the wrong execution. Instead of acquiring physical
bullion stored on an allocated basis, these billionaires chose proxies of
gold in the form of ETFs. Their investments in ETFs may ultimately negate the
very reason for investing in gold in the first place. Only physical gold
provides true diversification outside of the financial system. Physical gold
is immune from counterparty risk or liquidity constraints. Investing in gold
proxies may work under normal conditions for short-term trades and hedging
strategies, but will be subject to the same systemic risks that financial
assets will incur. The time when you need the protection of gold the most is
the time when these proxies are most likely to fail and not provide the
portfolio protection of bullion owned directly.
Gold ETFs are an investment choice that many investors and their advisors
make. They are seduced by the ease of purchasing shares and the low
management fees. However, as with all investments, it is critical to look
under the covers and do your due diligence in order to fully understand how
ETFs work and what the risks are. A paper by the Bank of International
Settlements (http://www.bis.org/publ/work343.pdf)
concluded:
"Crisis experience has shown that as the intermediation chain
lengthens, it becomes complicated to assess the risks of financial products
due to lack of transparency as to how risks are managed at different levels
of the intermediation chains. Exchange-traded funds, which have become
popular among investors seeking exposure to a diversified portfolio of
assets, share this characteristic, especially when returns are replicated
using derivative products. As the volume of such products grows, such
replication strategies can lead to a build up systemic ricks in the financial
system."
In an Investor Bulletin on exchange-traded funds (https://www.sec.gov/investor/alerts/etfs.pdf),
the SEC recommended that:
"Before investing in an ETF, you should read both its summary
prospectus and its full prospectus, which provide detailed information on the
ETF's investment objective, principal investment strategies, risks, costs and
historical performance (if any). The SEC warned 'Do not invest in something
that you do not understand. If you cannot explain the investment opportunity
in a few words and in an understandable way, you may need to reconsider the
investment.'"
Unfortunately, most investors and/or their financial advisors have not
read the prospectus or the underlying documents, such as the Authorized
Participant Agreements. As a result they do not understand the underlying
risks of ETFs. In the case of the gold ETFs a careful read, paying particular
attention to the wording, is critically important. I have participated in the
process of creating prospectuses dozens of times with some of the major law
firms in Canada. In these drafting sessions, the lawyers for each side spent
an enormous amount of time arguing about the subtleties of the wording that
is carefully chosen for its precise legal meaning.
Most investors and many financial advisors assume that an ETF is similar
to an open-end mutual fund with low management fees. The low management fees
are the motivating factor, and they tend to overlook the fundamental
structure of ETFs versus open-end mutual funds. In open-end mutual funds:
- Investors send their subscriptions to the fund manager;
- The fund manager purchases assets according to the
fund's stated mandate;
- Investors are issued units that represent an undivided
interest in the mutual fund.
In properly structured mutual funds, the only people that have any claim
on the fund's assets are the unitholders. Fees are typically in the order of
1.25%, plus trailer fees and expenses.
ETFs are structured in a completely different manner. To start with, the
GLD prospectus states:
"The investment objective of the Trust is for the Shares to reflect
the performance of the price of gold bullion, less the Trust's
expenses."
It does not say that the objective is to own gold. The ETF works well for
investors who are frequent traders, and for investors who use ETF options to
hedge their physical gold holdings or improve performance. However, they are not
the best choice for investors who want to have all the benefits of owning
gold. The SPDR website explains how ETFs operate:
"Authorized Participants create fund shares in large increments --
known as creation units -- by assembling the underlying securities of
the fund in their appropriate weightings to reach creation unit size and then
deliver those securities to the fund in-kind. In return, the AP receives Fund
shares which are then introduced to the secondary market where they
are traded between buyers and sellers through the exchange.
APs also have the ability to redeem the fund shares through the same
process in reverse. Large increments of fund shares -- known as redemption
units -- are collected in the secondary markets and then delivered to
the fund in-kind exchange for the underlying securities in the appropriate
weightings equalling that redemption unit."
Given that very high-priced lawyers reviewed the above wording, it is
interesting to note the unusual word choices: assembling instead of
acquiring or purchasing; introduced instead of sold; collected
instead of purchased. Based on my experience with lawyers, there is nothing
unintentional about this vocabulary. On the contrary, a great deal of thought
went into it.
A thorough report on the differences between mutual funds and ETFs was
prepared by Deloitte (http://www.runtogold.com/images/Deloitte-ETF-report.pdf).
The explanation there offers more clarity:
"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 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 AP sells the ETF shares on the open market like any other publicly
traded share."
I have clarified the way ETFs operate in two previous interviews with
David Ranson of Wainwright Economics (http://bmgbullion.com/wp-content/uploads/2016...eatals-ETFs.pdf)
target="_blank"(http://bmgbullion.com/wp-content/uploads/2...s-metal-ETF.pdf).
Since Wall Street is all about making money, it is important to follow the
money. What motivation is there for Wall Street to purchase bullion at spot
price, contribute the gold to the ETF at Net Asset Value (NAV), get ETF
shares at NAV and then sell the shares at NAV to market participants? In
simple terms, the AP borrows the assets at little or no cost, exchanges these
assets for ETF creation units, then sells these creation units in the market
and keeps the entire proceeds. It should be clear to everyone that
this is not about management fees at all, but about Authorized Participants
getting 100% of the proceeds from the sale of ETF creation units. They then
use the proceeds to invest in investments that pay higher returns than their
cost of borrowing, and add a liability to their balance sheet. For financial
assets, Authorized Participants, who are primarily the major banks and brokerage
houses, have always been able to borrow the assets from their client margin
accounts at no interest cost, and from hedge funds when they are the prime
broker. In the case of gold, it is typically leased from central banks.
However, in an IMF Issue Paper dated April 2006, Paragraph 99 of the
Guidelines mentions that the monetary authority make gold deposits:
"...to have their bullion physically deposited with a bullion
bank, which may use the gold for trading purposes in world gold markets"
and "the ownership of the gold effectively remains with the monetary
authorities, which earn interest on the deposits, and the gold is returned to
the monetary authorities on the maturity of the deposits."
As a result, the monetary authorities still show the leased gold as their
asset -- that is why it is called "leasing." While the gold
ETF does in fact have gold in its vaults, the ultimate ownership may be with
a central bank. At some point, an AP somewhere in the world, on some ETF,
will become insolvent and then the lawyers will get rich arguing who is the
rightful owner of the underlying asset -- the ETF, or the original lender of
the assets? While the litigation drags on, investors' assets will be frozen
to the NAV calculated at the time of the default of the AP. Even if the true
ETF owners are successful in recovering their capital, this could be a
significant lost opportunity cost in a rising gold market. If they are not
successful, and it is more likely that the true owner -- the central bank
lender -- will be successful, the 'gold' investment that they made to
protect their portfolio would be worthless.
With this in mind some billionaires, as well as investors and financial
advisors, have the right concept of portfolio diversification but the wrong
execution. ETF shares, certificates, and futures contracts are all proxies or
derivatives of physical gold. What good is insurance if the insurance company
is insolvent when your house burns down? In order to receive the benefits
that gold has offered for thousands of years, investors need to own physical
gold, not a financial asset, derivative, or gold proxy. Bullion Management
Group Inc. has created a checklist to help investors with their due diligence
to ensure that they actually own go target="_blank"ld (http://bmgbullionbars.com/bullion-checklist/).
Once you have acquired gold in the form of London Good Delivery Ba target="_blank"rs (http://bmgbullionbars.com/products-serv...s/good-delivery)
or bullion coins produced by the major government mints, you need to store
the bullion in an LBMA-member vault on a fully allocated, insured basis.
Allocated, insured storage will cost investors up to 1% depending on volumes.
Any program that offers low-cost storage or a leveraged purchase program is
not likely to provide true allocated, insured storage. Instead, investors may
only own a liability of the bank or bullion dealer. Since gold could
potentially be your asset of last resort, you do not want to save money on
seemingly bargain storage fees and end up with no gold when you need it the
most.
Don't be wrong like some of the billionaires who have the right concept
but the wrong execution in their gold investment -- be sure to acquire
physical bullion and store it on an allocated, insured basis.
