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Recently, we’ve received a number of emails
from readers asking why the primary gold ETF, SPDR Gold Trust (NYSE: GLD),
doesn’t more closely track the price of gold, and other related
questions. For those readers who aren’t already familiar with the
workings of this innovative way to “own gold,” it’s worth
going over a few of the details, because there are some common
misunderstandings regarding the ETF.
The creators of GLD were as savvy as it gets. They
saw a market crying for something like this and turned that need into one of
the most successful new financial products ever introduced. The ETF burst
upon the scene in November of 2004 and was immediately latched onto as a
means of riding the gold bull market without the inconvenience of having to
transport and securely store actual bullion. In the past seven years, its
rise has been meteoric. It has steadily ascended the list of the
world’s leading gold repositories, until today it has the sixth-largest
global stash of the metal, at more than 1,230 tons, or 39.57 million ounces,
worth over $70.7 billion.
First misconception: Contrary to popular opinion,
the SPDR Gold Trust does not buy and sell gold. It creates and redeems paper
shares in the company. These are passed through a group of market makers, who
trade them on the NYSE, then deposit into or withdraw from the HSBC vault in
London the corresponding amount of physical bullion, in the form of 400 oz.
London Good Delivery bars.
And even that description is somewhat misleading.
GLD deals only in “baskets” of 100,000 shares, with the goal
being for the share price to track gold’s market value as closely as
possible. Since each share represents slightly less than a tenth of an ounce
of gold, that means each basket must trade close to 10,000 ounces of gold.
That’d be impractical if the buying and selling had to be done on the
open market.
So how do they pull it off? Well, the company is not
exactly forthcoming about its inner workings, but after extensive
conversations with officials, I was able to determine that what actually
happens is that the gold is moved either into or out of the GLD-allocated
section of HSBC’s vault, to or from another section of that same vault.
When I found that out, I envisioned a guy on a yellow forklift, driving
pallets laden with thousands of ounces of gold back and forth across the
vault floor. Such a job.
Beyond the basics, we don’t know much. You
will not be allowed to see the vault, whether or not you are a GLD
shareholder and no matter how many shares you own. In fact, a high Trust
official in New York told me that even he isn’t allowed inside there.
For the most part, GLD does a pretty good job of
following the spot price of gold. A share will never be priced exactly at the
value of a tenth of an ounce of metal, simply because the Trust deducts
transaction fees and other expenses. But it’s close. During August of
2011, for example, the net asset value (NAV) of a share of GLD varied from
97.3635-97.3867% of the gold price, as fixed each day at 10:30 a.m. New York
time.
However, if you are an investor in GLD, or are
considering becoming one, there are a few things to keep in mind. First of
all, it can’t be stressed enough that this is a paper asset. It is not
a way to buy gold and have someone else store your holdings for you. That can
be done in other ways. There are depositories that specialize in this service, both domestically and in foreign jurisdictions
like Switzerland. But that isn’t what GLD is about.
Now theoretically, it is true that you can convert
your GLD shares to physical gold and take delivery of it. But practically,
you can’t. For one thing, you have to be approved to do so (generally
meaning, you’re either a broker or a market maker), and then you have
to redeem a minimum of 100,000 shares. And even if you meet those
qualifications, buried in the firm’s prospectus – a very tough
read, by the way, but you can get a copy at their website if you want to try your luck – is a provision
stating that they have the option of redeeming such shares in cash equivalent
rather than bullion.
This is to say: If there is a sudden run on physical
gold, GLD is not contractually obligated to provide actual metal, in exchange
for however many shares, to anyone.
Thus our position has always been: Hold as much gold
in coins and bullion as you comfortably can. Use the ETFs to generate profits
if you like, but make sure you realize that all of those profits will be of
the paper variety.
Furthermore, there is the little matter of taxation.
You may well understand that GLD shares are not a substitute for precious
metals, and you may be in it only as a way to make money from a rising gold
price by simply placing an order with your regular stock broker. If so, well
and good. But what you may not know is that GLD shares, although they trade
like stock, are not stocks in the same sense as Apple shares. Not when the
taxman cometh.
If you buy shares of Apple, and hold them long term,
for more than a year, then sell them, you are taxed
at the prevailing capital gains rate, currently 15%. Gold, however, is
considered a “collectible.” If you buy gold coins, for example,
and hold them long term, then sell them, your tax liability is at the rate
for collectibles, presently 28%. If you sell them for a short-term profit,
you’re liable for taxes at the same rate as for ordinary income, which
is determined by whatever bracket you’re in.
Of course, GLD shares are not gold, as I’ve
just taken some pains to point out. Ah, but here’s the rub. GLD is
structured as a grantor trust, not a mutual fund. A grantor trust is ignored
for tax purposes so that the investor is treated as owning a pro-rata share
of the underlying holdings, not the entity as it exists on paper. That
is to say, if GLD were a mutual fund, shares would be taxed at the normal
capital gains rate, but because it is a grantor trust, its long-term gains
are taxed at the applicable rate for the gold it holds… which is 28%.
This situation leads to some rather odd tax
peculiarities. Say your ordinary income is in the 25% tax bracket.
You’re actually better off selling GLD shares short term than you would
be if you held them long term and got pushed into a 28% liability.
None of this is to disparage GLD. For ordinary
investors, the ETF represents a way to (indirectly) participate in gold
“ownership” without the hassle of actually taking physical
delivery and finding a suitable place to vault your metal. Plus, there are no
storage fees, bid/ask spreads, threats of theft, or dealer markups to worry
about. And finally, for those who like to really play the market,
shares are amenable to all the tricks of the securities trade. They can be
optioned, shorted, hedged, bundled, margined, whatever. Little wonder GLD is
so wildly popular.
So use GLD if you are of a mind to. Just be certain
you understand what it is you are dealing with.
[Other
ways of indirectly investing in gold exist; some offer even more upside
potential than the metal itself. Learn what they are and how to make use of
them with a subscription to BIG GOLD. It’s risk-free
for three months.]
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