Europeans raise gold stakes

August 17, 2017

Pat Heller

I have previously stated that European gold demand has been strong. The World Gold Council Gold Demand Trends for the second quarter of 2017 provides some hard data to confirm just how much it has grown.

While a comparatively small percentage, possibly only one percent, of people worldwide actually own bullion-priced physical gold, a much larger number think they own gold by trading paper forms that are more convenient.

As one paper form, people are able to purchase shares of gold exchange traded funds. Typically, such a fund is established with an initial share value equal to 1/10th of a troy ounce of gold that, theoretically, is represented by physical metal in the custody of the fund. As the ETF sells more shares, it has to acquire more physical gold to cover that obligation. Or, if shares are redeemed, the ETF needs to reduce its physical gold holdings. This appears to many investors to offer a more convenient way to theoretically own the physical metal without the bother to themselves of taking physical possession. Over time, though, the expenses of operating the fund gradually make each share worth less, so that they represent less than 1/10th of an ounce of gold.

There are several reasons why I have concerns over the practicality of owning gold ETF shares instead of the physical metal. First, if you read a gold ETF prospectus, you are likely to learn that the entity does not verify the physical existence of all the gold it supposedly owns. Instead, it relies on statements received from sub-depositories that they are really holding the metal on behalf of the ETF, but the main depository does not audit the accuracy of the statement.

Second, the prospectus is also likely to include a statement that the ETF is authorized to lease out some of its holdings. To the extent that it does, it may not have the physical metal to back up its outstanding shares, and it also has some risk of default that gold may not be returned at the end of a lease.

Third, ETFs can have complicated tax structures. This may result in those who own such shares having to pay personal income taxes on the basis of the trading activity of the ETF even if the shareholders themselves did not buy or sell any shares during a tax year.

Fourth, while the ETF may offer the theoretical ability to demand delivery of the underlying physical gold, it is only available if conducted in extremely large quantities that almost no investors can afford. So, the practical result for most investors is that it is not possible to obtain the physical gold directly from an ETF.

For these and other reasons, I consider the ownership of a gold ETF to be somewhat risky and not all that appealing as a substitute for directly owning the physical metal. At most, I would consider it a useful trading tool for very short-term purposes.