Physical Gold vs Paper Gold

Physical Gold vs Paper Gold.

If part of the reason you’re investing in precious metals is as a hedge against an economic downturn, black-swan events or experimental monetary policy with a longer-term outlook, there is no substitute for owning physical gold, stored in your name.

While investments in ‘paper-gold’, i.e. gold stocks or shares in exchange traded funds (ETFs) can be an effective way to gain exposure to gold and to hedge physical holdings, they will never replicate the control and assurances that come with physical ownership.

One of the key reasons for investing in precious metals is their function as a natural hedge against monetary or banking crisis and potential systematic collapse. If such an event were to transpire into a loss of confidence in money, and paper-gold investors were to try to exercise or deliver the physical gold, what would happen? There is a possibility that investors might not be able to take delivery and ownership of the underlying assets. This is due to the low level of actual physical gold backing the paper gold.

For instance, take the largest and most liquid futures and options contracts, CME Gold futures. The open interest on the 20/09/2016, at 100 troy ounces per futures contract, equates to 79,317,700 troy ounces[i]. The underlying COMEX/CME warehouse stocks on 23/09/2016 were roughly 10,687,512 ounces[ii], of which only 2,165,480[iii] were ‘eligible’ for delivery.

I have used CME futures as an example, but the theme with Gold Exchange Traded Funds and other forms of leveraged paper gold shows a similar trend. Alpha Broking suggests that, in general, clients hold 10% of their investment funds in physical bullion. If part of your reasoning for investing in gold is to hedge against black-swan events and experimental central banking, there is no substitute for physical bullion.

Another consideration is the relative cost of physical gold vs paper gold. Physical gold costs are very transparent – transaction, storage and insurance. Paper gold has obvious transaction costs, but carries some other, less transparent costs. Any form of margined exposure to gold incurs borrowing costs on the margined amount. ETFs typically incur various fees, such as management fees, which are built into the share price movement as opposed to standard billing. Many ETFs are also market-made, and the bid/ask is presented as a spread, which acts as a further percentage-based transaction fee.

In the event of a major crisis or systematic failure, when the dust settles, paper gold will be little more than a piece of paper. A bar of gold will always be a bar of gold.

[i] http://www.cftc.gov/dea/options/other_sof.htm Precious Metals COT Activity date 20/09/2016

[ii] CME Group Metal Depository Stocks Activity Date 23/09/2016 – rounded to the ounce

[iii] CME Group Metal Depository Stocks Activity Date 23/09/2016 – rounded to the ounce

Written by Ben Foster, Security and Futures Advisor.
You can contact Ben on 03 8662 4003 or by email, ben.foster@alphabroking.com.au

 

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