Gold is up more than 7% this year, mostly on the back of investments in gold ETFs (exchange-traded funds). In fact, starting in 2016, the inflow of money into gold ETFs has accounted for a whopping 34% of demand, the second-highest inflow on record.
The bad news? Investors should be avoiding gold ETFs. Below are four reasons why.
Reason #1: High Counterparty Risk
One of gold’s primary benefits is that it’s a tangible asset. Once you own physical gold and hold it, you are not exposed to counterparty risk. Your gold cannot be devalued because someone—or some company—failed. That’s why gold is always considered a true safe-haven asset.
Unlike physical gold, gold ETF shares are a financial product and thus vulnerable to counterparty risk. Gold ETFs can only be purchased through a trust, which is usually a large financial institution. In other words, you don’t buy gold, you buy shares in the ETFs’ trustee, who then uses a custodian to purchase and store the gold.
In effect, gold ETFs come with the same downsides as any other paper asset, like stocks or bonds, including their significant vulnerability to the potential failure of the trustee. This makes gold ETFs a very poor replacement for physical gold. In addition, when you purchase gold ETFs, your gold will be stored by a sub-custodian, which increases your risk exposure.
Reason #2: No Written Contracts
Gold ETFs were created using old rules created by the London Bullion Market Association. According to those rules, there is no obligation to create written contractual agreements between trustees, custodians, and sub-custodians. The gold you purchased through the ETF’s trustee is held by a sub-custodian that has no contract with the custodian—and the custodian has no contract with the trustee.
Your trustee has no clear title to the gold, so you’d have very little recourse to take legal action against a custodian or sub-custodian involved in fraud or negligence.
Reason #3: Insurance Uncertainty
Trustees don’t insure their gold holdings. They leave that to the custodians and sub-custodians, who, surprisingly, only carry limited general insurance coverage, which falls far short of the actual value of the gold they hold.
Reason #4: No Actual Gold Is in those Gold ETF Hills
Gold ETF shares only represent a paper claim on gold, not gold itself. When you invest in gold ETFs, you become a shareholder, not a gold holder. This fact negates one of the best reasons to invest in gold—that gold offers excellent financial protection during a financial crisis. Your gold ETF trustee could literally go bankrupt while physical gold is increasing in value.
If your goal is to diversify your portfolio with gold assets, you are much better off investing in physical gold than in gold ETFs. Only physical gold comes with the protections and benefits gold has become so famous for, making gold ETFs a poor and risky investment choice.