GLD vs. Allocated and Segregated Bullion…all that glitters is not gold
The success story of GLD is familiar to institutional investors with an interest in precious metals. Born in November of 2004 in the early stages of the 11-year bull market for gold, the SPDR Gold Trust allows investors to own a derivative proxy for bullion in a convenient ETF package that trades on exchanges like a stock. The value tracks the price of gold to give quick, easy, but inherently indirect access to precious metals, all from the familiarity of their screens at work, at home, or on the road. Freed from the inconvenience of purchasing, storing, and insuring physical bullion, the securitized or paper version of owning gold seemed to be a godsend to investors in search of widening their asset classes for diversification and to ride the bull as prices soared. But in the cold light of experience over recent years, the lure of owning a certificate in place of physical gold has lost some of its luster.
In contrast to that well-known ETF, allocated and segregated bullion provides an innovative alternative to paper gold. This asset enables investors to own fully titled, insured, audited, and deliverable physical gold bullion in the form of securely vaulted bars or coins. Available at competitive cost for storage in a wide choice of global financial centers, the value comes directly from the bullion itself, because gold is the oldest form of money, whether used as a store of value or as a medium of exchange. Latest technology reduces the actual cost, perceived problems, and previously inevitable delays of trading, owning, redeeming, and delivering the gold. This boost in the liquidity and efficiency of trading physical gold modernizes an industry that perennially lags far behind the technological wave. And by bringing the risk-mitigating and portfolio-stabilizing characteristics of physical gold into play for a wide swath of investors and institutions, this tangible bullion makes good sense whether the prices of the precious metals go up, down, or hold constant.
What follows is a comparison in greater depth of these two appealing pathways to paper or physical gold ownership. The discussion begins with GLD:
This idea conceived by State Street of creating a more efficient market for holding and trading gold quickly caught fire with the eager public. Within seven years of inception, GLD became the second largest ETF on the NYSE, peaking at nearly $80 billion in total value when gold hit $1913 per ounce in August of 2011. It has now declined to be a smaller ETF than before, but remains the largest one based on gold. Marketed by State Street Global Markets, the fund has a fine pedigree: It is sponsored by World Gold Trust Services of the World Gold Council, the trustee in charge of servicing the assets is BNY Mellon, and the custodian is HSBC Bank (USA) with the required bullion stored in HSBC’s London vault. The current total value of GLD as of this writing (4/4/2017) for the outstanding shares, each backed by slightly less than 1/10 of an ounce of bullion, has subsided over the past three years to $32.7 billion. That means 809 tonnes of pure gold is backing up the shares, with a metric tonne of gold now worth 40.43 million dollars. To set that figure in context, about 3100 tonnes of gold are mined each year, US official reserves are 8133 tonnes, and roughly 190,000 tonnes have been mined in history. This means that the gold that backs GLD represents less than one half of one percent of all the above-ground gold in existence. Cash also is used to partially back up the fund as well, but more is written about that fact later. Each share, the minimum unit that can be purchased, is now valued at $119.77. Annual fees for maintenance of the account are forty basis points, or 0.40% per annum. Several competing products have expense ratios of exactly 0.39 or less, so GLD is apparently the price-setter in this market with the others ducking just underneath its umbrella. (For illustration, the iShares Gold Trust –IAU on the ticker- is at 0.25%, E-Tracs CMCI Gold Total Return –UBG- is at 0.30%, and both ETFS Securities Physical Swiss Gold Shares and ETF Securities Physical Asian Gold Shares -AGOL- are at 0.39%.) These operating expenses cover the fees charged by the sponsor, trustee, custodian, marketing agent, legal services, stock exchange, and for printing, administration, registration, etc.
There is no question that GLD is convenient: It offers 24 hour accessibility to relevant data through the global OTC market, buying or selling throughout the trading day via brokerage accounts, and as mentioned above, it provides seamless trading like a stock with its own CUSIP on the NYSE. GLD claims to be a liquid, easily accessible, reasonably cost-effective, transparent, flexible and secure solution for the needs of institutional and private investors. This essay now examines each of those six assertions in comparison to the corresponding features of physical gold ownership of allocated and segregated bullion.
1. Liquidity:
The SPDR Gold Trust (GLD) writes on its website, “Structure allows for baskets to be created and redeemed according to market demand, creating liquidity.” However, the basket must contain 100,000 shares, the equivalent of $11.98 million USD. This makes redemption of the GLD shares for physical metal extremely difficult or impossible for the ordinary HNW investors or modest-sized institutions. For example, only 87 of 747 institutions that held GLD in 2015 would have met that threshold of ownership. But it is far more restrictive than that, for the special permission for redemption of GLD shares is primarily reserved for only the largest brokers and major institutions that can assemble a batch of that magnitude. These select few are called “Authorized Participants”. Predictably, these AP’s include bullion banks such as Goldman, Citi, Morgan Stanley, JP Morgan Chase, Bank of America, Barclays, Deutsche Bank, Credit Suisse, and a few others. GLD writes, “Authorized Participants are the only persons that may place orders to create and redeem Baskets; the Trust does not deal directly with individual investors… Authorized Participants must be (1) registered broker-dealers or other securities market participants, such as banks and other financial institutions, which are not required to register as broker-dealers to engage in securities transactions and (2) Depository Trust Company, or DTC, participants.”
For the ordinary institution and especially for the individual, redemption is a remote possibility, and this redeemer would be the last in line to receive payment if there were a breakdown of any kind. This introduces counter-party risk to the equation for the investor, something that does not exist for those who own allocated and segregated bullion in its physical, tangible, fully-titled form. Anyone with even modest holdings can redeem all the owned gold in his or her account on short notice, for delivery to any destination in its physical form, or if preferred, in currency. In comparison, GLD holds the option to redeem its shares in cash but not necessarily in gold. Here is how GLD phrases this important caveat: “The Gold Shares represent fractional, undivided interests in the Trust, the sole assets of which are physical gold bullion and, from time to time, cash.” In stark contrast, although owners of allocated and segregated bullion can redeem their gold in any major currency for convenience, they always have sufficient liquidity for redeeming their gold in its physical form.
In addition, the easy trading of shares that GLD offers its buyers and sellers works quite well in ordinary times, but when markets are shocked by sudden events in the gold marketplace and GLD prices plunge, the nature of the underlying markets may render GLD far less liquid and therefore unexpectedly volatile. Like all ETFs, GLD offers investors liquidity on demand, but in extreme cases, the assets are not going to cooperate to make a reality of that claim. The price of gold is historically less volatile than stock indexes, for the international gold market is deep and liquid. Tracking the fluctuations of the price of GLD shares against the more stable spot price of gold shows a widening gap between the two, leading to arbitrage opportunities for banks to profit from that differential. No analogous gap appears in the relatively more disciplined market for physical gold.
Easy Accessibility:
It is true that the owner of GLD can very quickly gain access to account information and the current market value of their holdings. SEC regulatory protocols and frequent auditing maintain the integrity of the securitized asset at a high standard. But owner access to the actual underlying metal backing of the shares is problematic and rarely sought after. Requests are infrequent to validate the holdings in the HSBC vaults, whereas the Allocated And Segregated Bullion on deposit with Loomis or the Brink’s Company for clients holding physical gold in secured vaults is continually confirmed by outside auditors and available for physical examination by the owners on special request. Additionally, the fact that buyers can use leverage to get hold of large amounts of GLD makes its value more uncertain than physical gold, where leverage from buying on margin is not permitted. Bullion must be paid for in full up front, in order for the new owner to take unambiguous title to the precious metal. Holders of physical gold with their longer-term reasons for investing are far less affected by a sudden movement away from gold than would those who are timing the market on margin in hopes of a tactical gain.
Relative Cost Effectiveness:
The annual costs of GLD are in most cases below the costs of holding, storing, and insuring physical bullion. This is because the physical metal will always sell at some premium above the spot price, a variable amount dependent on the nature and location of the bars or coins in question. In the case of a typical stock of allocated and segregated bullion, annual expense ratios start at forty basis points (0.40%) and reach somewhat higher levels depending on what valuable ancillary services the client desires beyond the basic vaulting, auditing, reports and other essential services. For example, client access to optional sophisticated portfolio allocation tools or currency conversion capabilities would justify an additional fee. However, the 0.40% quoted by GLD leaves out the commissions paid by investors for buying and selling an ETF. Active traders will find these charges can accumulate rapidly, rising from $10 up to $25 for each active trade assisted by brokers, or in other special circumstances. So the effective expense ratio paid by the owner of the SPDR Gold Trust can be in fact considerably more than the stated 40 basis points.
Further complicating the cost situation, there are some so-called “tracking errors” that enter in over time. Because the gold itself that backs GLD is a commodity that does not generate a stream of income, the managers of the Gold Trust must sell off some of the backing gold each year to cover the costs of operation. GLD phrases it this way: The Trustee sells a small quantity of gold every month in order to pay the Trust’s expenses. This eventually erodes the value at the margin of the gold that stands behind the ETF, causing the tracking error. This is different from the way the physical gold stored as allocated and segregated bullion is kept intact and safe from such erosion, with separate billing of the owners for the expenses on a monthly basis.
The volatility of GLD share prices is further evidenced by the widening and variable spread between the share price of GLD and the spot price of one-tenth of an ounce of gold, a differential that will trigger a round of arbitrage at the big banks. This kind of secondary effect does not occur in the physical market, where premiums are exactly up to the moment with the underlying supply and demand factors.
And there is the matter of the tax authorities. As a grantor trust and not a mutual fund, if an investor buys shares of GLD and holds them for more than a year, they are taxed at the rate for a collectible at 28% and not as a long-term capital gain at a marginal rate of 15%. If held shorter than a year, the gains are taxed like ordinary income. The costs are the same with physical gold bullion that is also taxed as a collectible whenever it appreciates in value. So there is no tax advantage to ownership of GLD over owning bullion, at least as far as the US Tax Code is concerned.
Transparency:
GLD boasts correctly about the easy access to gold bullion market data around the clock and the updated value of the shares themselves. But transparency appears to be a lower priority in other phases of the GLD business model. For example, the cost structure is a bit opaque and heavily qualified in the prospectus. Here is an example of the way costs are presented conditionally on the GLD prospectus: “Additionally, if the Trust incurs unforeseen expenses that cause the total ordinary expenses of the Trust to exceed 0.70% per year of the daily ANAV of the Trust, the ordinary expenses will accrue at a rate greater than 0.40% per year of the daily ANAV of the Trust, even after the Sponsor and the Marketing Agent have completely waived their combined fees of 0.30% per year of the daily ANAV of the Trust.” This means the fee may end up more than the 0.40% that the investor expected to pay.
And the matter of privacy is somewhat compromised by having one’s gold holdings securitized, as compared to the strict anonymity that is accorded to owners of physical gold. Furthermore, owners of allocated and segregated bullion benefit from the transparency of the global process that invariably provides frequent audits of all their fully insured physical precious metals, not just gold, at the many secure vaulting sites around the world. Each client’s holdings of gold, silver, platinum or palladium are fully allocated and never compromised, held by sub-custodians, or loaned out in any way. They are there in the vault in physical form. (This statement does not imply that GLD or HSBC are complicit in any such activities.) And all fees are clearly stated and confirmed from the beginning of the relationship between and the institution or ultra-high net worth individual. There are no surprises. Such responsible vaulting companies believe that the size of the holding in ounces is a more critical factor in assuring long-term stability and effective wealth management than the currency in which the precious metal is redeemed. And the physical gold itself can function well as a medium of exchange, for gold is the oldest and most durable form of money in existence.
Flexibility:
GLD takes pride in this desirable feature of their ETF when they write, “Gold Shares are listed on the New York Stock Exchange Arca and trade the same way ordinary stocks do. It is possible to buy or sell Gold Shares continuously throughout the trading day on the exchange at prices established by the market. Additionally, it is possible to place market, limit and stop-loss orders of Gold Shares.” There is no doubt that investors have responded favorably to having immediate access to their holdings of GLD. And for better or worse, the shares of GLD can be hedged, bought on margin, optioned out, sold short, placed into bundles, and otherwise repackaged using practices of the skilled securities traders.
In comparison, the technologies behind the bullion ownership process have opened a different avenue for investors: For these firms accelerate the manifold ways that gold can be utilized more flexibly and powerfully as a medium of exchange. The old pathways to owning physical gold were far too slow, indivisible, clunky, impractical, and mysterious to function with versatility in a dynamic portfolio of assets. In modernizing the process of ownership and by making it faster, more liquid, and more efficient, with precise identification codes on each unit of metal, the newer approach to owning allocated and segregated bullion takes its rightful place at the table alongside other asset classes. These physical holdings can fulfill gold’s traditional role as a strategic asset with all the benefits of risk mitigation, portfolio stability, long-term consistency, and potential profits as motivators. But with the advent of far more accessible platform on which to purchase, trade, redeem, hold internationally and deliver physical gold, this real investment can function as a tactical asset as well as a medium of exchange.
Furthermore, the precious metals enabled through these more agile vaulting companies provide a direct method to all owners for purchasing or selling at specified limit prices. Physical gold ownership is certainly not an obsolete artifact of the past, for the technology now exists to bring this unique, durable, timeless, and extraordinary asset into the faster pace and global playing field that are hallmarks of this second decade of the new millennium.
Security:
The track record of GLD is spotless in terms of its integrity as an exchange traded security. Backed by SEC regulation and the reputations of the prestigious trade association and banks that sponsor, market, serve as custodian, and provide vaulting, it has delivered on its promise of a flexible securitized asset that faithfully tracks reasonably close to the spot price. Owners of shares do indeed feel they can sell their shares for cash in a liquid market whenever they wish to redeem them. There has been no objective proof of any highly suspect and self-serving rumors involving the existence of the physical backing, or of multiple claims on the gold in their vaults, or any other rehypothecation schemes.
The only legitimate security concerns revolve around the impossibility of all but a select few to redeem the shares in physical bullion, a shortcoming discussed in detail in point #1. Unlike physical gold ownership, “paper gold” carries the burden of counter-party risk for the owners to shoulder. Should there be a serious shock to the financial system, or one of the key players in the GLD world suffers a cataclysmic failure tantamount to the collapse observed in 2007, the owners of GLD shares would be the last ones on the queue to receive restitution. They would have to accept the plummeting market value of their shares as they liquidate. GLD writes this in their FAQs about insurance: “The Custodian, HSBC Bank USA, NA, maintains such insurance for its bullion and custody business that it deems appropriate. The Custodian is responsible for the safekeeping of the gold held on behalf of the Trust in accordance with the terms of the Trust’s custody agreements and is required to exercise reasonable care in the performance of its obligations. The Custodian is responsible for loss or damage suffered by the Trust as a direct result of any negligence, fraud or willful default in the performance of its duties.”
In contrast to this policy, holdings of allocated and segregated bullion enabled through the best new platform are totally insured at full market value. There is no counterparty risk, for neither the firms nor the vaulting partners hold any claim to the gold. The owners of bullion possess full, absolute, irrevocable title to the physical gold; and even in the extremely improbable event of a failure of a vaulting company or the dissolution, the precious metals holdings cannot be used to settle other debts. The owners of the precious metals always come first. The physical gold, silver, platinum and/or palladium are the exclusive private property of each owner of the metal, fully insured by Lloyd’s of London and their global web of thoroughly redundant and extraordinary security systems. Long-term security is assured.
In addition to the control of insurance risk and the absence of counter-party risk, a number of other investment risks are mitigated by holding bullion as an alternative to paper gold from GLD: Most importantly, because gold itself is a currency, the pure fact of ownership of physical allocations of the yellow metal reduces currency risk. Systemic risks are significantly reduced as the owners of the gold can vault it as they choose in a considerable number of major financial centers around the world. As a further advantage, there is minimal sovereign risk, for the vaulted bullion is segregated and does not sit as a liability of the vault, nor does it sit as a liability of the custodian, trustee, or third party. And it is domiciled a comfortable distance from the vulnerabilities of the traditional banking system. Derivative risk is entirely eliminated from the situation by the very nature of physical gold ownership. Portfolio risk is reduced because the nature of gold with its remarkable negative correlations with many other asset classes makes it an ideal diversifier of holdings. As with GLD, there is no appreciable credit risk associated with physical bullion, especially when fully allocated and segregated. Liquidity risk is reduced by in creating an efficient market in this practical approach to holding physical gold that assures an active pool of buyers and sellers.
In conclusion, these two innovative approaches to adding the presence of gold to a portfolio of assets, whether in paper or physical form, measure up well on the six important dimensions that are detailed in this comparison. There are some differences of consequence that make GLD more appealing as a tactical investment vehicle that can be bought and sold as an ordinary security. But coded identifiers on each unit of the bullion make them more liquid than collectibles have ever been. And there are substantial qualities that make this investment vehicle more appealing as the enabler of either tactical positions or strategic investments in tangible physical gold. For institutions seeking to integrate the considerable advantages of physical gold and other precious metals to their investment universe, and to those who appreciate the exceptional role of gold as a medium of exchange, a significant holding of physical gold would be a worthwhile pathway to take toward prudent diversification.
Roy Van Til, Ph.D.
Vienna Me USA
royvantil@mac.com
207-500-9604
Voyages of a Flying Dutchman...................... blog by Roy Van Til of Vienna, Maine 