The Risk of GLD and Gold ETFs

The recent Ukraine crisis and rise of the gold price bring the risk of gold ETFs to my attention. Investing in gold ETFs such as GLD, IAU, and SGOL is obviously more convenient and cheaper than buying and selling physical gold bullion. A newbie investor like me might think such paper gold investment is safe. After all, ETFs such as GLDM claim that they put their physical gold bars in an England vault. What could go wrong when the ETF is backed by assets in physical gold bullion?

However, after some research, I realized that things are more tricky than I previously thought. Here, I try to summarize the major risk of gold ETFs. I would also refer readers to the report “The Illusion of Owning Gold” by Nick Barisheff for further readings.

Counterparty Risk

Counterparty risk refers to the likelihood that the other end of a transaction cannot pay what he promised. People are used to counterparty risk in leveraged financial products. For example, let’s say you have a long position on a crude oil contract and for some reason, the price of oil skyrockets. Unfortunately, your opponent who holds a short position might bankrupt due to the event, and thus cannot pay you the money as promised.

It sounds strange that gold ETFs also have counterparty risk, as there should be no leverage involved in transaction. Unfortunately, this is not true. To see this, it is important to understand how gold ETF shares are created. The Authorized Participants (APs) of the gold ETF, which are banks like Goldman Sachs or J.P. Morgan, can contribute gold to the ETF trust while creating new ETF shares for sale. The caveat here is that the ETF does not hold the title of the contributed gold, and worse, the title might not even belong to the AP. It is perfectly legal and likely a common practice for an AP to borrow gold from central banks and contribute it to the ETF for share creation.

Now you probably can see why this is problematic. In an event of the skyrocketing gold price, central banks can recall its leased gold from the APs. Some APs can go bankrupt in such an event if they do not have enough cash to buy back ETF shares and return the leased gold to central banks. In that case, the ETF investors will suffer the loss as it is unlikely they could win the lawsuit against the central bank over the ownership of gold in the ETF’s vault.

One might question why APs want to contribute leased gold for ETF share creation. My answer here is that one scenario APs will do this is when the interest rate of leased gold plus the cost of hedging by longing gold futures on COMEX are less than the cash interest rate. Such strategy, however, essentially transfers the counterparty risk from the gold future market into the gold ETF market.

In summary, although paper gold might work well during the normal time, it has a non-negligible chance to break when catastrophe strikes. This somehow defeats the purpose of owning gold.

Lacking of Insurance

On the FAQ page of GLDM, they claim:

Therefore, Shareholders cannot be assured that the Custodian maintains adequate insurance or any insurance with respect to the gold bullion held by the Custodian on behalf of GLDM… Consequently, a loss may be suffered with respect to GLDM’s gold which is not covered by insurance and for which no person is liable in damages.

This means that if something bad happens to the gold stored in the vault, the ETF investors will be responsible for the damages, even though the ETF does not own the gold. That said, this risk is probably smaller than the counterparty risk in my opinion.

My Recommendation

If the goal of owning gold is a long-term investment against inflation rather than short-term speculation, I would recommend investing in gold bullion coins such as American Eagle and Canadian Maple. These coins are standardized with quality assured by government mints. They sell at about a hundred dollars over the spot price (i.e., paper gold price) now. The liquidity might also be better than you think: The bid-ask spread is only around 5% among major online gold dealers in the United States.