The Case for Direct Ownership of Gold

By Neland D. Nobel

As in the case with many things in life, sometimes the simple way to do something, is often the best way to do something.  But there is a proclivity in the human mind towards sophistication and complexity.  If we can manage complexity, we seem to feel we are more talented.

We are big fans of the gold mining stocks, but it is worthwhile pointing out that while they are sort of a call option on the future of the gold price, they are not gold.  They are companies that mine gold.  As such they have all the problems that owning a public company must face.  Among these are geographical and political risk, regulatory risk, risk with credit, labor unions, geology, and environmental liability.  In addition, orderly exchanges and execution is not always possible.

For example, after 911, the stock market was closed for a few days. And as for orderly markets, leveraged ETFs seem to have misfired of late, causing gold mining shares to trade wildly with swings of 15% or more during a trading session.

Now for traders, this may be an advantage of the shares.  They trade well, if your timing is good.  Bullion coins have too wide of a spread to be used for trading.  But should one be “trading” at all, the thing you bought as insurance against bad times?

Today, there is an added risk; the risk of pandemic.  It is certainly possible that the work force in a given mine could be disrupted by infection.  And it is not only possible, home office activities have actually been disrupted at IAMGOLD and Glencore, two large mining companies.  Newmont and Agnico Eagle are also putting various mining operations on “maintenance.” The entire country of South Africa is closing down.   That one country produces about 12% of global production of gold, 72% of platinum, and 37% of palladium.

Like all equities, gold mining shares represent counterparty risk.  The shares have value based largely upon the ability of management to deliver results.  This is equally true of gold mining ETFs and mutual funds.

This is also true of Exchange Traded Funds that buy and hold bullion.  The gold they say they have must be there for the shares to have value.  How do you know at all times they have the bullion they say they do?  We believe all these companies are ethical and that their duties are clearly explained in their prospectus.  How many people actually read the prospectus?  How would you know if the terms are being violated and how, and at what expense, could you sue if violations occurred?  Because of this, you have counterparty risk.  The ETF maker and the regulatory bodies must do their job properly.

Bullion coins or small bars in the possession of the holder, do not have these sets of risks.  They do have some risk, such as the risk of theft.  And you take risk in the fluctuation of the gold price.  But the value of bullion coins does not have counterparty risk.  There is nobody on the other side of a contract to perform.

Additionally, the added risk of the mining shares should provide added compensation in the form of additional return.  But it does not appear to be true in a liquidity panic such as we have been experiencing quite recently.

In the past two months, gold bullion has retreated about 5%.  GDX, the leading ETF that represents the senior gold mining shares is down 25%, and GDXJ representing the junior shares, is down 37%.  In short, during this stage of the financial crisis, they have offered little protection from the rout occurring in the equity markets.  The holder of the shares took additional risk and did not get additional returns.  In fact, you got substantially lower returns.

gold chart

If you think this is an isolated problem, look again.  We have set up a ratio between the bullion price and the price of the longest running gold stock mutual fund.  When the line goes up, bullion is outperforming the shares. When it goes down, shares are doing better.  There are numerous periods such as between 1994 and 2000, and 2011 to 2016, where the shares lag bullion.  In short, gold mining shares and gold don’t move together.  Often, you simply don’t get an added return for the additional risk.

Understand, we are not against gold mining shares.  What we are against is the advice of some stock brokers that suggests that one has gotten the protection of gold by buying mining equities.

Each play a role in your portfolio.

What you think is your “safe” money, must be safe, or it fails to do its job.

The first thing to acquire is the safety of owning bullion coins and bars directly.  Once that need has been satisfied, then ownership of the shares is a choice worth considering.

–Neland D. Nobel is a retired money manager and Certified Financial Planner with 45 years’ experience in financial markets. With a Master’s Degree in Economic History he has been a long-time observer of gold and financial markets from both the practical and theoretical perspective.

Charts courtesy of StockCharts.com.  All information is derived from sources believed reliable but investment results cannot be guaranteed.