A reaction to zero interest rate policy around the globe. A long-term hedge against the tax of inflation. A safe-haven in times of crisis. These are among the many reasons gold bugs have long sought investment in gold.
But being a gold bug is not always easy. Whether it be riding out long stretches of underperformance, suffering the ridicule of non-believers, or trying to decide what to make of bitcoin as a threat, gold bugs have developed long term patience and a thick skin. As CNBC contributor Guy Adami often states: gold is never a story until it is.
And now, gold is a story.
A COVID-19 pandemic and the resulting response of record-breaking stimulus and federal reserve support would seemingly be the perfect case to determine once and for all the utility of gold as an investment or insurance policy.
As always, different investors with different time frames, needs, and personalities can reasonably reach different conclusions regarding the validity of the gold thesis.
For now, we will stay away from declaring who should or shouldn’t take the gold plunge. Still, if you are looking to step on the water, there are three basic ways to gain such exposure: 1) Physical ownership of coins or bars, 2) “Paper” exposure through Exchange Traded Funds (ETFs) or futures, and 3) Ownership of gold-mining stocks (or mutual funds, ETFs that hold mining stocks).
Physical Gold: Coins and Bars
Most “gold bugs” would say that the best, safest form of gold exposure is physical ownership. This involves purchasing actual coins or bars and personally storing them in a safe or safety deposit box. Physical ownership eliminates counterparty risk. You are not dependent on someone being able to source and deliver gold that is owed to you. Shares that are yours can’t be lent to someone else. The bank holding your unallocated bars can’t go bankrupt and leave you a creditor of the company. While any of these events are unlikely, one of the justifications for holding gold is as a safe-haven in a time of crisis. The exact time that counterparty risk is greatest.
There are some drawbacks to physical ownership, however. First, it is going to cost a little more than buying paper gold. Coins and bars are typically purchased through a dealer or mint, and on top of the market price, an investor will typically pay a mark-up and shipping costs. Once received, the owner must then store the gold. This can be accomplished with a home safe or a bank safety-deposit box. While storage is an issue, when one considers that a standard gold bar weighs 400 ounces, space is not the issue. Safety and insurance are the primary concerns of storage. Liquidity can also be an issue. While dealers will be willing to make a market and buy gold from you if necessary, the process may not be as fast as selling paper gold.
Paper Gold: ETFs and Futures
A quick and easy way to get exposure to gold is by buying a gold ETF. In short, you are purchasing a piece of a trust that holds gold on an allocated (to the trust) basis. Many investors like the fact that an ETF is available through their brokerage account with the push of a button. It can be sold just as quickly. There is theoretically counterparty risk, however. When new buyers come into purchase the ETF, new units need to be created.
If the trust is unable to locate gold to buy, the market price of the ETF may trade at a premium to the actual holdings in the trust. In other words, the trust is not fully funded. Further, the ETFs will carry an asset management fee that may exceed the mark-up cost of purchasing physical gold.
Before the introduction of the gold ETFs in 2004, investors more frequently purchased gold exposure via the futures market. In the futures market, there is a non-zero risk that, in times of crisis, those who have sold gold will not be able to make delivery on the contract settlement date.
While it is the role of exchanges to monitor and step in to prevent such situations, again during a systemic risk event, nothing is guaranteed.
Gold Mining Stocks
The third primary way to get gold exposure is to buy stock in mining companies (or invest in mutual funds and ETFs that hold gold mining stocks). Mining stocks often provide a leveraged return in a rising market of gold prices. This happens when the cost of production remains constant, while market prices rise. The increase in revenue goes straight to the bottom line.
However, mining stocks do not always keep pace with gold prices in general.
The miners often carry a heavy dead load, which can introduce risk. Another potential issue is the cost of production. In a crisis, the energy burdensome mining process could be affected and harm gold mining companies, especially if they have hedged or sold future production at lower than current market prices.
Mining royalty stocks are another choice. Royalty companies provide financing for mining companies. Rather than taking equity (or interest from) the investment, the royalty company receives a percentage of a mine’s production.
If you have a long-term perspective and are looking or the ultimate protection from financial crisis and systemic risk, physical ownership may be the best option. If you are not interested in taking delivery or are looking for some inflation insurance within a traditional investment portfolio, ETFs can fit the bill provided one understands the potential pitfalls. The gold mining stocks have been an enigma. As with any investment decision, be sure to do your due diligence before making any decisions.
DISCLAIMER: Nothing in this article should be construed as a personal recommendation or advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any investment security. Barnhart Investment Advisory Principal and clients may hold positions in securities mentioned above, and subject to change without notice. Consult your investment professional before investing.
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