Gold is traditionally sought after as a store of value in times of severe economic dislocation, an insurance policy against financial Armageddon. Most notably, gold has in the past proven a useful hedge against inflation. Its value as an inflation hedge and its low- to negative- correlations with most broad asset classes can make gold a worthwhile investment for a small portion of an investor’s portfolio. While gold has exhibited a low level of volatility relative to equities over the past quarter century, the massive price swings experienced from the early 1970s through the mid-1980s serve as a worthwhile exhibit to the effects fickle investor sentiment can have on the value of the yellow metal. It also underscores why an allocation to gold should probably only occupy a small portion of a well-diversified portfolio. As for an investment in physical gold through an exchange traded product (ETP), we think that gold ETPs are easily some of the least costly and most liquid vehicles for one’s gilded aspirations.
Gold has no intrinsic value. The yellow metal does not produce earnings or cash flows which it can share with investors, like equities. Nor does it throw off fixed or floating coupon payments, as a bond does. Financial theory tells us that a security’s intrinsic worth is equivalent to the present value of the future cash flows it will generate. With no cash flows to project and discount back to today, gold is a purely speculative instrument: it is only worth what someone else is willing to pay for it.
The speculative nature of an investment in gold doesn’t differentiate it from other commodities like oil or wheat, which like gold, have no clear future cash flows. What makes gold different from most commodities is that it has little practical use. Gold cannot fuel an automobile or provide nourishment. According to the World Gold Council’s “Gold Demand Trends” report for the full year 2012, only about 7.8% of current gold demand comes in the form of practical uses--such as in dentistry and electronics. The largest portion of gold demand (43.3%) comes from the jewelry industry, with India and China being the most notable drivers of incremental consumption in recent years. Meanwhile, (34.8%) of the global appetite for the yellow metal comes from investors. The remainder (12.1%) comes in the form of official sector purchases. The world’s central banks have been playing an increasingly important role in the gold market in recent years. Indeed, official sector gold purchases increased nearly six fold in 2011 versus 2010, and climbed another 17% in 2012, according to the World Gold Council. Also, investment demand for gold has surged in recent years as concerns over paper currencies have flared and the world’s most precious metal has been made increasingly accessible to the masses, thanks to a growing number of industrious ETP providers.
As this ETC is backed by physical gold, it will track movements in the spot price of the yellow metal, less fees. The security is benchmarked to the P.M. London Gold Fixing. The London Gold Fixing takes place twice each business day at 10:30 A.M. and 3:00 P.M London time. The fixing process determines the settlement price for contracts arranged amongst the members of the London Bullion Market. This price--which is expressed in terms of U.S dollars per troy ounce--is in turn used as a benchmark for the vast majority of the gold products and gold-related derivatives around the globe.
Physical Gold Securities are limited recourse debt obligations of ETFS Metal Securities Limited. These secured, undated, zero-coupon notes entitle holders to payment in cash (USD) in an amount equal to the per security entitlement to gold (published daily on ETF Securities’ Web site) upon redemption. These securities are backed by physical gold. HSBC is the current custodian of the company’s bullion, which is vaulted in London. Because gold does not generate cash income to defray any expenses or commissions incurred by the securities, these levies will gradually reduce the amount of physical gold held per security over the long term. Unlike some competing products (including ETFS Gold Bullion Securities) ETFS Physical gold does not allow investors to redeem their securities for physical gold. Physical redemption is limited to authorised participants and market makers.
The ETC levies an annual expense ratio of 0.39%. This product is most liquid on its home exchange--the London Stock Exchange--but secondary listings on the Deutsche Borse, Euronext Paris, Borsa Italiana (each of which is denominated in euros), and the Tokyo Stock Exchange (denominated in yen) are all fairly liquid as well.
Gold ETPs are an alternative to a direct investment in physical gold. Relative to owning bullion or coins outright, gold ETPs offer the benefits of lower carrying costs (in most cases) and superior liquidity.
There is a broad menu of physical gold ETPs. In our opinion, TER and custody and storage fees (in aggregate, carrying costs) are key differentiating factors for physical metals funds--with lower TERs and fees obviously being better. Given the nature of these funds, carrying costs are the chief source of tracking difference relative to the spot price movements of the metal, and thus the primary determinant of relative performance amongst competing products.
In the case of all physical gold ETPs--with the notable exception of Xetra Gold--the TER is inclusive of all custody and storage fees.
In the case of the Physical Gold Securities (PGS), its TER of 0.39% puts it near the back of the pack from an expense ratio perspective, inline with the ZKB Gold ETF (which also has a TER of 0.39%) but behind competitive offerings from the likes of Source, RBS (whose physical gold ETCs have TERs of 0.29%), and iShares (0.25%). PGS ETC is very liquid on the secondary market--especially on the London Stock Exchange. The benefits of higher liquidity--as measured by average secondary market trading volumes--in larger gold ETCs like PGS may defray their relatively larger price tags for those looking to actively trade their gold position.