INVESTORS with money in physical gold exchange-traded products (ETP) might have had a scare this week as gold-backed ETPs came under heavy fire in a paper by Hinde Capital, a hedge fund. The hedge fund compared precious metal exchange-traded funds (ETF) to the collateralised debt obligations (CDO) at the heart of the financial crisis and warned that “ETFs should not be owned by serious professional investors”.
But although Hinde’s report makes a sensational headline, investors should not confuse its analysis of the risks of US-listed ETFs with those of their European counterparts. Products that give exposure to physical precious metals in the UK are legally different entities, with different risks. What the row does highlight is that investors should be sure to investigate the legal structure of the product or fund they are buying: in the event of a default or crisis, it can make all the difference.
The first point is that although many UK products physically backed by gold call themselves ETFs, they are, in fact, not ETFs. This is because under EU regulations, funds (which enjoy certain tax benefits) are neither allowed to physically own gold nor are they allowed to buy products that give them direct access to physical gold.
So when a UK investor buys shares in a physical-backed “ETF”, such as ETF Securities’ Physical Gold or Gold Bullion Securities, she is actually buying stocks in an exchange-traded note (ETN), not a fund. This also applies to those products labelled as exchange-traded commodities (ETC). An ETC is not a legal definition – it is simply a marketing term. This is important because it means that UK investors have a different risk exposure to their US peers.
Alongside that, the investor should be aware than even a physical gold-backed ETN will never give physical access to gold bars. They are designed in this way because many ETN investors are funds, which, as mentioned, are not allowed to invest in anything that gives direct access to gold.
The role of the physical backing, therefore, is not to give investors the comfort of owning gold bars. Instead, it means that if the issuer of the ETN defaults, it can sell its stored gold to pay back the holders of the ETN. Moreover, this issuer is a separate legal entity from the bank or company that you might think issued your ETN. ETN-issuers are instead sealed off from the entity under which the product is marketed (such as RBS or Deutsche Bank) so that you are exposed only to the risk of the issuer going bankrupt, rather than to the risk of RBS or Deutsche defaulting. As iShares states: “ETN investors have direct counterparty exposure to the issuer of the note or to any third party that is guaranteeing the security’s performance.”
This issuer passes ownership of the gold to a trustee. This separates the gold from the issuer’s other assets, so that if the issuer should default, its ETN-holders are not grouped with its other creditors, but have the rights to the proceeds of selling the gold that backed the product. The only other movement of gold that occurs stems from the payment of management fees (whereby the ETN sells off some gold to pay the fees) and from inflows and outflows.
While Hinde Capital’s attack on gold-backed ETFs falls short in the case of equivalent European products, its paper emphasises the importance of reading the small print. For physically-backed products – where investors are looking for something as safe and secure as possible – this applies all the more.