Which Gold Tracker? [Updated]

This is a very interesting article about the various gold trackers available (ETFs but also ETNs, ETCs, etc.) and is definitely worth reading if you already have invested or are planning to invest in gold.

Disclosure: I am currently invested GBS and GLD as well as physical bullions and coins (held in a safe abroad). I also held a line in DBP which is not mentioned in this article but I sold it recently to increase my position in SLV. DBP was futures based and the fact sheet is available as PDF here: DBFunds DBP fact sheet as PDF.

The article is published on Index Universe and is written by Paul Amery:
ETF, ETC, T-ETC, ETN Or Certificate?

Exchange-traded product names seem designed to confuse, particularly so when it comes to commodities.

The UCITS rules for collective investment schemes, which apply to European Union member states, require a minimum level of diversification. Therefore, within the EU, a legal entity tracking a single commodity cannot be set up as a fund, and cannot be called an ETF. For that reason, the gold trackers offered by EU-based firms such as ETF Securities, Lyxor, Source and Xetra-Gold are all technically undated, noninterest-bearing debt securities and are called, variously, ETCs, ETNs, T-ETCs and certificates. So far in this comparatively young market, there's no uniformity in naming conventions, or in legal structures.

All four of the above gold trackers are collateralised-but not necessarily by bullion itself (see below).

In Switzerland-a non-EU member-the regulator allows a fund to track a single commodity. For that reason, the gold trackers offered by Swiss banks ZKB and Julius Baer are called ETFs.

Physical Backing?

The big dividing line in the collateralisation of the tracker products is between those that hold physical metal as backing, and those that are backed by some other financial instruments (for example, government bonds).

In the former category (those backed by bullion) are ETF Securities' Gold Bullion Securities (LSE: GBS.L) and Physical Gold ETC (LSE: PHAU.L); ZKB's Gold ETF (SWX: ZGLD); Julius Baer's Gold ETF (SWX: JBGOUX); and Xetra-Gold (XETRA: DE000A0S9GB0).

Gold trackers collateralised by other assets, typically government bonds, include Lyxor's Gold ETN (LSE: LTNG.L), Source's just-launched Gold T-ETC (XETRA: SGLD.DE) and ETF Securities' Gold (LSE: BULL.L), Leveraged Gold (LSE: LBUL.L) and Short Gold (LSE: SBUL.L) ETCs.

Assets under management for the different trackers show that the vast majority of investors' funds have been directed to those offering exposure to the physical metal.

The bullion-backed gold products hold most of their gold in "allocated" form-meaning that the gold is held under a custody agreement, in a bank vault, as numbered bars. The gold trackers may hold a small amount of unallocated bullion to help manage creations and redemptions.

ETF Securities updates a list of the bars held to back its GBS and Physical Gold ETCs on its Web site daily. The Swiss gold ETF issuers provide this information less regularly-typically quarterly, or on request. Xetra-Gold does not give details of the physical gold held to back its bond.

The ultimate safety of custodial arrangements for bullion is a subject prone to cause heated debate amongst gold bugs. Some observers have pointed to the Swiss gold ETF providers' appointment of their own parent banks as custodians as a violation of the principle that this role should be fulfilled by a third party. The Swiss tend to counter that gold held in other countries may not be safe at all, given the US government's compulsory purchase of private gold holdings in 1934, and the possibility of a repeat during a time of economic crisis.

The World Gold Council's view on this question is that the 1934 confiscation was linked to the constraints imposed on governments at that time by gold standard membership and that, in the current situation, where there is no policy link to gold, there is no rationale for governments to confiscate the metal, as there is no artificial mechanism causing gold to limit their policy options.

Still, recent investor inflows have strongly favoured the Swiss vehicles, implying that concerns about gold's custodial location remain. The ZKB gold ETF has tripled in size since the end of August 2008 (just before the Lehman default), overtaking Gold Bullion Securities as the largest European gold tracker. Hugo Stalder of ZKB told Index Universe that there has been a significant increase in investor interest from non-Swiss-based investors in recent months. Gold Bullion Securities has grown by around 20%, and the ETFS Physical Gold ETC by around 50% over the same period since end-August. The Julius Baer Gold ETF has raised around US$1 billion in assets since its launch in October.

Physical Redemption

An important additional reassurance to owners of the physically-backed gold trackers is the ability to convert holdings into the actual metal.

All five of the trackers in the top half of the above table offer this feature. ETF Securities' two physical gold ETCs require an owner to have an account with the wholesale London Bullion Market to take physical delivery. Both ZKB's gold ETF and Julius Baer's "A" class gold ETF permit physical redemption, subject to a commission of 0.2% and a 1% redemption fee. Xetra-Gold has a sliding scale of charges, including for the delivery of retail-sized trades.

Hugo Stalder of ZKB said that, while almost every interested investor asks about the physical redemption mechanism for his firm's ETF, those who have so far made use of it can be counted on two hands.

What's Being Tracked?

All five of the bullion-backed products and Lyxor's gold ETN track the spot gold price; in other words, the price for immediate (48-hour) delivery. The ETF Securities nonbullion-backed ETCs and the Source Gold T-ETC track gold indices based on futures prices.

As gold tends to trade in modest contango (i.e., forward prices are higher than the spot price), a tracker following futures prices will suffer a slight negative roll yield as it trades from one contract into the next, though this will be offset by interest earned on uninvested cash.

But, other things being equal, it's reasonable to expect some price divergence over time between gold ETFs/ETCs/ETNs tracking the spot price and those tracking indices based on futures.
For more information, read the full article on the link provided above.

[Update:] You might also want to read this other article from Paul Amery about the Structural Risk of ETFs which introduction is quoted below:

In addition to the market risks that any ETF investor incurs, what structural risks remain? In other words, what could go wrong as a result of the financial failure of the links in the ETF management chain?

The collateralised nature of ETFs means that they remain relatively safe by comparison with many other investment vehicles, where investors retain full counterparty exposure to a bank or other issuer (this applies to most retail structured products, for example, or to bank deposits over and above any government-insured limit). However, there are five potential structural risks that any ETF investor should be aware of.

These are:

  1. The failure of the ETF manager/promoter
  2. The failure of the swap provider in a swap-based ETF
  3. Securities lending losses resulting from a borrower default
  4. Custodial bank failure
  5. Non-recognition of segregated liability in an umbrella fund structure

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