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Investor Education and Market Insights – Paper vs. Physical Gold

This piece appeared in Richard Russel’s remarks column yesterday. We think it’s a good synopsis of the pros and cons of investing in paper or physical gold.

by Matthew Kerkhoff
September 26, 2013

Lately we have received many questions from subscribers regarding the difference between “paper gold” and physical gold, and the pros and cons of investing in either. The following aims to shed light on this important question, and explain some lesser known intricacies of investing in gold.

So, what is “paper gold?” Paper gold refers to an asset that acts as a substitute for owning physical gold. It is a claim on physical gold. When you own paper gold, you own a promise to receive a certain amount of physical gold, if so desired, at some time in the future, and if certain conditions are met. Futures contracts and exchange-traded funds are examples of “paper gold.”

Paper gold provides investors with a simple, liquid, and sometimes cheaper method of investing in gold. It allows investors to capitalize on price movements in the yellow metal without the hassle of owning, storing and transporting physical gold. These benefits, however, come with some potentially severe drawbacks.

But first, let’s examine the benefits of paper gold in more detail. The most prominent advantage of paper gold is its liquidity. Anyone with a brokerage account can now purchase or sell paper gold in a matter of seconds, allowing him or her to capitalize more effectively on price movements.

Paper gold can also be less expensive to purchase than physical gold. When purchasing physical gold, investors must pay a premium above the spot price (the current market price set by the futures market), which incorporates the cost of refining the metal to its current form, as well as small margins for the parties involved. These premiums above the spot price vary by vendor, by the level of physical demand, and also in relation to the quantity of gold purchased (volume discounts).

Paper gold, on the other hand, does not generally include a markup above the spot price. Instead, when investors purchase paper gold, they pay a commission to their broker similar to what they would pay to buy shares of stock. With gold ETFs (such as GLD) and all other ETFs, investors will also pay a small management fee.

To examine the potential downsides of investing in paper gold, let’s take a closer look at one of the most popular gold investments, GLD. The primary disadvantage of paper gold is lack-of-ease in converting to physical gold. While investors may own a claim on physical gold, in many cases they will find that actually getting their hands on the metal is much more difficult than they had expected.

Investors may not realize that when they invest in GLD, they do not own physical gold. Yes, in theory GLD is a physical gold-backed ETF, and one share of GLD is supposed to be equivalent to 1/10th ounce of gold. But the actual story is much more complicated, with major restrictions on redemption.

First, to qualify to redeem GLD shares for physical gold, special permission is required from the trustee of GLD. This permission is typically reserved for brokers and major institutional players. Second, shares can only be redeemed in batches of 100,000, which equates to roughly $13 million at today’s prices. Third, according to GLD’s prospectus, the fund retains the right to settle gold requests in cash rather than in the physical metal. So even if you owned 100,000 shares and had permission to redeem them, you still might not receive your physical bullion.

Another nuance to investing in GLD has to do with how its price moves in relation to the spot price of gold on the futures market. While the initial price of GLD was set to represent the price of 1/10th ounce of gold, this relationship has not been maintained, because GLD is subject to its own market forces, as well as reduction in value through management fees. Without getting into too much detail, the price of GLD is highly correlated with the spot price movements of gold, but does not follow those movements exactly. For example, a large purchase or sale of shares in GLD can drive the price up or down, without the spot price of gold changing.

In conclusion, if you are looking for a simple, short-term play on the price movement of gold, then GLD can be a good option. GLD is the largest physical gold-backed ETF in the world, and has many institutional clients, as well as respected investors such as John Paulson and George Soros. GLD claims to have physical gold backing all shares, and posts the serial numbers, fineness (purity) and weight of every bar, on the company’s website. GLD also claims that unallocated gold is not traded, leased or loaned under any circumstance. However, keep in mind that even if all this is true, it does not change the fact that only a handful of GLD’s institutional clients will be able to redeem their shares for physical gold if and when the time comes.

For those of us who are attracted to gold for the safety and protection it offers during times of financial unrest, there is no substitute for owning physical gold. Don’t underestimate the power of governments, banks, and attorneys to block the exchange of paper to physical gold in times of crisis. If such a time comes, those in possession of real gold may do everything in their power to retain it, and block the transfer to those who simply hold “claims.”

In follow-up parts of this series, we will take a look at the divergence in demand for physical vs. paper gold, what’s happening with the inventories of physical gold held by the COMEX and GLD, and how a process dubbed “rehypothecation” is creating multiple claims on each ounce of gold. Stay tuned!