«-- Letter Re: Innovations in the Treatment of Obesity and Diabetes | Main | Note from JWR: --»
Letter Re: Physical Gold Versus Synthetic Gold, a View Redux
Dear Mr. Rawles:
You don’t seem to be the type of guy who enjoys saying “I told
you so” when you are proven to be right, but I thought I’d at least
give you that opportunity. Back
in May, I wrote to you singing the praises of synthetic gold ownership via Exchange Traded Funds (ETFs), and opined that “physical
gold combines the worst of all worlds.”
I’ve since started building my long position in gold (and silver), and
I surprised myself by deciding quite early on to hold physical metals rather
than to express my long position synthetically. This was particularly surprising,
because I am just barely of the view that an extreme economic collapse could
be coming, and by both profession and education, our household is very knowledgeable
about capital markets. We’re more or less optimistic about the future;
I mean, we live in New York City, of all places!
Still, when I really thought about it, I concluded that physical gold was a
superior asset for somebody looking to hedge a downside risk over the long-term
(as opposed to actively trade a position). I thought your readers might benefit
from hearing my logic.
First, the single biggest benefit of synthetic/ETF gold is that it can be bought
and sold at low transaction costs. But when I thought about it, I realized
that I was not looking to trade. If gold doubled this year, I would not sell;
I would only wonder if my “worst case” investment thesis was coming
to pass, and whether I should increase my position while there was still time.
Similarly, if gold fell in half this year, I would not sell—it would
be an opportunity for me to get longer at lower cost. When I thought about
it, then, the “low transaction cost” rationale for ETF ownership,
really wasn’t that much of an advantage. I want a 10% net worth position
in physical metals, and I want to hold it long term as a hedge. Period, paragraph.
Second, it isn’t like purchasing physical gold is all that expensive.
Krugerrands are widely available at about a 1% markup (spot + $10) if you live
in a town where there are some reasonably large bullion dealers. And even if
you don’t, you can always buy from a reputable internet dealer like Tulving,
and pay perhaps 2-3% over spot, provided you are able to purchase five ounces
or more at a time to amortize the shipping cost.
Third, even though you might pay more at the front end, if you plan to be a
long-term holder of gold, you slowly recover this cost by avoiding the annual
.40% expense ratio charged by ETFs. If you plan to hold five or more years,
the up-front cost of physical purchase via the internet, is entirely offset
by
avoiding the recurring ETF expense ratios.
Fourth, ownership in an ETF provides significant regulatory and taxation risk.
Under current law, capital gains on gold sales are taxed at 28%, and there
are no limits on buying and selling. But who knows what might happen in a hyperinflationary
environment? As most fiat currencies fail, the government attempts to stave
off collapse by instituting “official” exchange rates, or limitations
on currency conversions, to avoid a wholesale run on the currency. In order
to have an effective currency control, it seems obvious that you also need
to put controls on intermediate stores of value, such as gold. (Otherwise,
you would just sell your de-valuing dollars and buy gold, and then subsequently
swap into a stable asset).
Physical gold is much more difficult for the government to “control” (setting
aside the somewhat paranoid “confiscation fantasies” of many gold
bugs). Moreover, the asset is much more difficult to tax. I’m not advocating
tax evasion in normal circumstances, but I could certainly imagine a situation
where desperate times call for desperate measures. Perhaps the government is
imposing confiscatory “wealth taxes” on financial assets, as former
Secretary of Labor Robert Reich has proposed, and which some states like Florida
had (until it was recently repealed); or perhaps high taxes are levied on gold
profits in order to discourage ownership of gold, and impose a de facto currency
control. Even my conventional imagination can dream up many dark scenarios.
Fifth, I hadn’t fully appreciated, until I thought about it, exactly
how compact a form of wealth physical gold really is. At current prices, if
you were buying one ounce Krugerrands, you could transport $1,000,000 with
only about 1,100 coins. This amount of gold would fill around 44 coin rolls
(of 25 Krugers
each), and would weigh about 88 pounds. Easily cached, transported, even smuggled
if necessary.
Sixth, when I looked into how secure ETFs were, I could never quite get comfortable
that you actually owned, in a risk-free way, the gold backing the ETF. I’ve
come to understand that the bullion banks that settle the world’s gold
trades, have both “allocated” and “unallocated” accounts.
With the former, your ownership of the gold is absolute—the gold is titled
in your name, secured separately, etc. However, with unallocated accounts,
your claim to the gold is merely an interest against a collateral pool which
may or may not be adequate to cover all claims; this is particularly true because
bullion banks apparently lend out gold from unallocated accounts, thus approximating
fractional reserve banking! All of this was new to me. Granted, some of the
sources I relied on were sort of gold-bugish, like this
report, pp. 66-70
-- but on the other hand, the report was well written and mostly well reasoned.
Reading
the iShares ETF prospectus didn’t clear up anything at all, except it
established that GLD does in fact use both allocated and unallocated gold accounts.
Since I couldn’t figure out one way or the other what the truth was for
certain, it seemed that physical gold was just a safer course.
Seventh, I realized that it was in my best interest to gain expertise in “normal
times” about how to source, authenticate, transport, and store physical
gold. I’ve since spent many hours, developing relationships with local
dealers, reading gold forums, investigating the reputation of online dealers,
observing eBay auctions, sourcing gold through Craigslist, etc. I’ve
also bought several different sets of instruments from Fisch
Instrument (recommended
on SurvivalBlog), a digital scale, a set of digital calipers, and a bullion
reference
guide.
All of this knowledge should be valuable, if
it ever looks like there will be a dollar run, and I want to try to build a
large [precious metals] position fast. While others will have to research,
I’ll
have pre-existing relationships, multiple sources, and most of all, experience,
that might give
me an advantage over others.
Eighth, it turned out storage was really not a big deal. My local bank offers
a nice sized safety deposit box free of charge, that is easily capable of storing
several million dollars of gold. I’m comfortable leaving the asset there.
Really, when you think about it, it seems just as safe behind a five ton steel
door,
as it does at some bullion bank in Zurich with god-knows-what institutional
risks embedded like naked short gold positions, derivative counterparty exposure,
etc.
These were basically my reasons for ending up with physical metal rather than
synthetic ownership. Thanks for forcing me to challenge my earlier assumptions.
- DC
