Odds Favor Shorting Paper Gold

The advent of paper gold in the forms of funds/ETFs/ETNs is a godsend for those who want to play gold on the short side. I don’t claim I can predict the movement of gold accurately, but all else being equal, the odds are stacked against paper gold. If you must own gold, try to own physical gold bullions and bars. If you want to short gold, paper gold is the perfect instrument – it is like being the house at a casino. Here’s why (I will use SPDR Gold Trust (GLD) for some of the examples but this is directed at paper gold in general):

(1) GLD has an expense ratio of about 0.40% per annum. Which means GLD will lose value at 0.40% per annum even if the value of gold stays the same; And if you are on the short side, it is functionally the same as receiving 0.40% per year. Unlike stocks and mutual funds, gold is a non-cashflow producing asset – it will never pay a positive dividend, which means there will never be anything that offsets the 0.40% in fees you’ll have to pay if you’re long or you’ll “earn” if you’re short. Granted, 0.40% is nothing to write home about even in the current near-zero interest rate environment, and it will easily get swamped by any capital gain on gold, but it does move the needle slightly in the short’s favor.

(2) In a doomsday scenario, you have a much better chance of keeping your physical gold than your paper gold. One of the reasons for investing in gold is that it is viewed as the money of last resort when the existing governments/financial institutions/fiat currencies fail. Although most paper gold instruments are backed by actual gold stored in a warehouse somewhere, you will experience counterparty risk on doomsday if you own them. A look at the prospectus of SPDR GLD, we see that it has World Gold Trust Services as its sponsor, BNY Mellen Asset Servicing as its trustee, and HSBC as its custodian. When disaster strikes and one of these institutions fail, it’s unclear how much gold you will be able to claim for your GLD shares.

In another scenario where US Government bans the ownership of gold to save its currency (as they did indeed in the Great Depression), you will have a much better chance of running to another country with your private, physical, stash than to try to claim your gold from a trust. But riddle me this – if you are short the GLD ETF, what happens when the government confiscates all their gold?

(3) Paper gold is exposed to fraud and accounting risks. There could be inaccurate accounting or out-right fraud at the trust/trustee level. Or some dishonest employees at the custodian could have stole some gold for themselves. Or, the custodian may have tight controls, but one of the sub-custodians that the custodian subcontracted to may not. It will be a stretch to say that all of the many precious metal ETFs and funds out there have perfect accounting and controls. If there is anything Bernie Madoff taught us, it’s that there is risk of fraud in the most established of institutions – and this is magnified with paper gold because there can be so many intermediaries between you and your physical gold.

I cannot predict the precise movement of gold the same way I cannot predict the next pai-gow hand at a casino. But what we do know beyond a doubt, is that the odds are stacked, and the house always wins in the long run.

Disclosure: short GLD

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One Response

  1. Also posted on Seeking Alpha: http://seekingalpha.com/article/176945-odds-favor-shorting-paper-gold

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