Why gold-backed ETFs 'have created an illusion'

Bullion expert says funds have distracted investors from the benefits of owning physical gold

Why gold-backed ETFs 'have created an illusion'

Gold-backed ETFs have created an illusion, tricking investors away from examining the benefits of owning physical gold.

That’s the view of Nick Barisheff, of BMG Group Inc, who compared these funds to a magician that has focused investors’ minds on a distraction while performing an act. He warned that many investors and financial advisors might be surprised to learn that owning shares in a gold ETF is not the same as actually owning physical gold but rather track the price.

Barisheff used the purchase of a physical asset, such as real estate, a car or a boat, to illustrate his point. These purchases typically involve a specific description of the asset – the make, model, serial number, for example – to ensure there are no encumbrances and that the seller “has the legal right to convey title to the buyer”.

He added: “Surprisingly, when it comes to acquiring gold, investors tend to ignore these basic fundamentals and instead focus on the storage costs and management fees; they don’t give a second thought to actual legal ownership. What good is it to save money on the storage costs if you don’t have legal title to the gold?

“Many gold transactions, such as futures contracts, certificates, and ETFs, are nothing more than paper proxies or derivatives of gold. They do not represent legal ownership of gold. These proxies may work as planned during normal market conditions but may fail under stress, when investors need the safe haven of bullion the most. I have always said that if you aren’t paying reasonable insured storage fees for allocated bullion, then in all likelihood you don’t own any gold at all.”

According to the World Gold Council, global gold-backed ETFs added 298 tonnes, or US$23 billion, across all regions in the first quarter of 2020, while total ETF holdings amounted to 3,296 tonnes, representing US$179 billion. The largest ETF is SPDR Gold Shares (GLD) with 1,048 tonnes.

But Barisheff insisted that the structure of gold ETF “tracking vehicles” defeats one of the most important attributes of allocated bullion – no counterparty risk. He explained: “If we were to place a bet on tomorrow’s gold price, and we agreed to settle in currency, then we wouldn’t need any actual gold as long as each of us had the ability to pay if he/she lost the bet. However, this isn’t an investment, and is totally dependent on the credit worthiness of the counterparty.”

He added: “Unlike physical gold, ETFs have counterparty risk, because there’s a possibility that the other parties, such as the Authorized Participant (AP), the trustee or others, may default or fail to uphold their part of the agreement.”

Barisheff argued that, with the recent increased popularity of ETFs, many investors assume they are like open-end mutual funds, but with much lower management fees, and that “Wall Street has become generous”. Investors need to understand the difference, he said, to realise the benefits of an open-end mutual fund trust, such as the BMG mutual funds.

Similar to a stock transaction, the custodian - Scotiabank, in BMG’s case - issues a Trade Record Sheet, specifying the bar being transferred to the fund by refiner, serial number, exact weight and purity to three decimal places. This monthly document is signed by an officer of the bank and audited annually by the BMG Funds’ independent auditors (RSM Canada LLP). Barisheff believes that while open-end funds have to incur a number of expenses, as mandated by regulatory authorities, the investors will benefit from the economies of scale in both purchasing and storing the bullion on a fully insured basis, as well as the reduced legal and accounting costs.

He highlighted the fact that ETFs, on the other hand, are not subject to conventional securities laws. They use a “Registration Statement” instead of a “Prospectus” and, as a result, are not subject to the same regulations as open-end mutual fund trusts.

He said: “Both hedge funds and ETFs, at least under current law, are investment vehicles created for the express purpose of avoiding some or all of the regulation under securities laws that apply to investment companies and traditional stocks. ETF investors have limited voting power, including the ability to remove management.

“The Trustee’s and Custodian’s limited responsibilities are set out at the creation of the trust and execution of the custodial agreement, with no mechanism to change those responsibilities in the event of change, and no direct accountability to investors.”

This can affect the chain of integrity and, therefore, if gold is removed from this chain, there can be no assurance that it is pure gold or that it meets “Good Delivery Standards”. In the past, investors have been swindled into buying gold-plated tungsten bars when no chain of integrity was in place.

Critically, though, ETF investors don’t own any bullion, Barisheff said, adding that as long as the APs are solvent, the system works. He said: “If an AP became insolvent, the lawyers would get rich arguing whether the ETF or the actual beneficial owners would be deemed to be the rightful owners. Although we came close to the ETF market blowing up in 2008 when Lehman Brothers, an AP, defaulted, the system and Lehman was bailed out.”

He explained that while this poses a serious problem with traditional securities ETFs, it is a much bigger problem when it comes to bullion. In the case of precious metals, as would be the case with the GLD and SLV ETFs, the bullion is leased from central banks by bullion banks acting as APs.

When a central bank leases gold, it still shows the asset on its balance sheet, even though it has been leased to a bullion bank, and it no longer has physical possession of the bullion. Again, everything works relatively smoothly during normal market conditions. However, Barisheff argued that if a bullion bank becomes insolvent, the central bank lessor would demand the return of its bullion from the ETF.  

“The result could be a total loss for the ETF investors at a time when they would need the wealth preservation attributes of bullion the most. For the sake of saving about 1% on annual management fees, they risk a 100% loss of their capital.”

Despite his criticism, Barisheff believes there is a good use for ETFs in investment portfolios because, unlike open-end mutual funds, ETFs offer put and call options. The best use of ETFs in his opinion is to hedge a portfolio of assets that you have legal title to and own outright by using ETF options.

“When it comes to bullion, you could acquire ETF puts to hedge your physical precious metal holdings. In addition, you could buy calls to enhance the performance of your bullion holdings.”