Wednesday, July 14, 2010

All that glitters is not GLD


It's not only now acceptable to invest in gold, it's fashionable. It's not only fashionable, it's necessary in the view of many financial commentators (not to mention marketers and pitchmen whose income derives from hyping the metal).

Gold investing got a rocket booster with the advent of gold exchange-traded funds, or ETFs, the most popular of which is the SPDR Gold Trust, ticker symbol GLD. The ETF says that it holds actual gold bars in HSBC bank vaults, on which GLD ownership represents a claim. At the end of last year, GLD's assets were worth more than US$40 billion.


It seems like a godsend for the small investor (under 5 feet 7 inches) who finds it inconvenient and expensive to keep gold coins and bars around the hacienda. Buy shares in GLD and the fund managers take care of the practical side, and you just rake in the profits as world economies blow up or inflate madly, and the price of gold reaches for the sky.

As in most investing, however, risks that seem negligible take center stage and do a fan dance once your money is on the table.

For months now, there have been rumors about GLD, principally variations on the possibility that with so much gold bullion being owned by the ETF, it has been necessary to stow some with sub-custodians who are not too bothered with the niceties of inventory management. Stories have made it into print that gold bars have been discovered (not under GLD management) that comprised tungsten ($10 an ounce) with a gold veneer, tungsten having the same molecular weight as gold, so that if you weighed a tungsten "gold" bar it would seem authentic.


I dismissed these rumors and anecdotes at first as just the kind of stories people like to tell. When they didn't fade away and seemed to grow in volume, I started to take them more seriously. My reasoning was this: while the odds are that GLD is and does exactly what it says, if some fiddling were going on and it became public, the value of GLD shares would sell off instantly to near zero, even if gold bullion kept zooming up. Worth the risk? I decided to sell my GLD holdings for a reasonable profit while I could.

Last week, a reputable source — — published a story titled "7 Reasons Not to Buy GLD." The writer, a lawyer named Jeff Nielson, is affiliated with something called Bullion Bulls Canada, which suggests he might have a vested interest in trashing the ETF. But that would run the piece makes me think it's at least reasonably credible. Nielson makes interesting points, sometimes amusingly. Here are a few excerpts:
… If this fund were really the simple "trust" that it pretends to be, it would have been very easy for the sponsor to say that the objective of the Trust was to provide "a cost-effective investment in gold" for unit-holders, but the fund deliberately avoids any such language. Instead, it defines the Trust's investment objective as merely to "reflect the performance of the price of gold bullion."

It then immediately goes on to say:

"The Sponsor believes [emphasis mine] that, for many investors, the Shares represent a cost-effective investment in gold."

The choice of wording here is enormously important, given that in a preceding page of the prospectus, the word "believe" is expressly designated as a "forward-looking statement."It then says that with respect to all such "forward-looking statements" that: "They are only predictions. Actual events or results may differ materially."
What's wrong with saying that the sponsor only believes that the shares are a cost-effective way to invest in gold? Especially when further hedged by "for many investors"? All prospectuses are full of lawyer-minted weasel wording. But Nielson continues:
The only "warranty" that the sponsor has chosen to provide (i.e., the "investment objective") is that the fund will "reflect the performance of the price of gold bullion." Whether or not there is (actually) any gold in this fund is merely a "belief" of the sponsor and thus may not be relied upon by unit-holders.

To provide a hypothetical example, suppose that the "custodian" for the fund (HSBC) has done extensive research and found that the price of chickens tends to be almost precisely correlated with the price of gold (i.e., they closely track each other). Given that HSBC has other things it would like to do with its gold (such as dumping bullion onto the market, or backing its massive short position), it decides that instead of going to all the bother of acquiring and storing such a massive quantity of gold that it will buy and hold chickens instead.

While much bulkier than gold, the "storage costs" associated with stationing a sleepy, security guard outside the freezers of a few meat-packers certainly cannot compare with the overhead of managing a bullion-vault capable of storing billions of dollars worth of bullion, not to mention the logistical costs associated with transporting (and insuring) all the bullion being bought and sold by this massive fund.
Although he acknowledges that the example sounds absurd, Nielson gives his lawyer's view of another aspect of the prospectus: "I have warned unit-holders that if there were some fraud or default associated with the fund, that all that unit-holders would ever be able to recover from the fund is paper. In other words, they could sue to get their (paper) money back, but they could never sue to force the sponsor (and/or 'custodian') to provide them with the gold they thought they had bought." If I understand him, he is saying that if, after a fraud was discovered, the GLD share price fell to 5 cents, you could only get back the number of shares you own times 5 cents.
Not only does the document seek the normal waiver with respect to acts of God, war, or terrorism, but it also seeks to indemnify both the sponsor and custodian from fraud, negligence, or willful default.

Specifically, even under the worst acts of malfeasance, investors could never recover anything other than the market value of their holdings (i.e. paper money) as of the day the fraud was discovered, or default occurred. While (to some extent) language like this is common in such legal documents, we must attach considerable importance to the deliberate choice of the words "willful default," rather than just the generic term "default" -- which most reasonable readers would assume would imply some involuntary event.

Instead, if HSBC defaults on its custodian agreement, and even if it actually did have enough gold currently in its possession to cover its obligation, it could simply refuse to turn over the gold it held. Suddenly, my example of the hypothetical chickens doesn't sound quite so preposterous. In the event of a willful default, it could liquidate its chickens to cover its custodian agreement, keep all its gold -- and unit-holders could do nothing.

Those are only the first two of Nielson's seven reasons to stay away from GLD. I am not qualified either to endorse or refute his arguments. However, if you own or are considering owning a significant position in the ETF, I recommend you read the article and perform your own due diligence.


Should you decide that you are better off owning what the gold bugs call "the physical" — i.e., the actual stuff you can see and touch, chez vous and not in a bank vault — what do you do with it? Hide gold bricks behind a wall in your basement? Bury them in the backyard? Not very practical if you're a renter. Perhaps you'd be better off owning gold in a useful form. Examples follow.


Gold pills: take as directed.


Gold Mac PowerBook.


And of course you'll want a couple of gold flash drives.


You may or may not want to park a gold Mercedes in your driveway,
depending on your neighborhood.


"Face" it, ladies. You've dreamed of this …



Anonymous said...

Reputable precious metals traders (i.e. not those who advertise on talk radio)generally offer storage options for an extremely reasonable price. Thus you can own the real deal without hiding it under your bed (or in specially-built hiding places in your home that not even your widow will know of without your architect's advice - a real situation I know of). Sorry, reasons of professional courtesy and family security necessitate that this be an anonymous posting, Rick.

Rick Darby said...


Understood. Of course, you have the doomsdayers, survivalists, and conspiracy theorists who say unless the metal is in your actual possession, you may not have access when you need it; or the government can seize it with a few keystrokes; or it can send Gestapo units to torture your gold trader till he gives them the combination to the safe …

I'm all for reasonable prudence in this (or any) asset class, but there is no such thing as absolute security.

Anonymous said...

My thoughts about buying gold are pretty medieval. Buy gold, then hire a small private army to defend it. And then pray that your small private army stays loyal to you.

That was basically the strategy of Lord Bigacres in 1135. Of course,then you'll need even more gold to pay off that private army. . .

Really, there are no good solutions.

--Mary J.

Marcus said...

I'm a little surprised you dismiss those who advocate taking possession of gold and precious metals as conspiracy theorists and doomsdayers given the history of (attempted) gold confiscation in this country. Take the Obama Medical Scam Bill (please, take it!). It was revealed yesterday that it includes a provision to tax and track gold purchases from OTC merchants.

For decades they have tried to make buying gold in cash illegal here. Understand that gold represents a genuine threat to fiat currencies, and with the dollar in long-term spiral, any movement to an international special drawing rights regime (as has been discussed repeatedly by very mainstream, insider types like Jim Rickards, Mark Faber and Jim Rogers) will include gold as part of the basket of currencies.

Given that backdrop (not to mention the GLD and other ETF's prospectuses), it seems to me that storing gold or silver in one's home is a relatively painless precaution, one I'd hardly associate with survivalists. I live one block north of Wall St, worked at Deutsche Bank, Liberty Financial and a major finance law firm, and I keep gold and silver (and palladium) in physical form. Nothing conspiratorial about it.

Gold is in a long-term, secular bull market, like other commodities. We are nowhere near a top or hysteria moment. Gold at $1200 or so will look like a bargain after this Congress, President and Fed are through with us.

And I'm no "goldbug," just a student of financial history.

All the best,