Physical Gold Vs. Paper Gold
When most people think of gold investing, they think of the actual physical possession of gold bars, coins, jewelry and the like. But there are many other ways you can hedge your portfolio with exposure to gold and precious metals. You can hold ‘paper gold,’ as well. Three of the most common vehicles for investing include:
- Gold and precious metal ETFs (exchange-traded funds)
- Mutual funds (open and closed-end)
- Mining stocks and limited partnerships
There are advantages and disadvantages to each of these types of assets. We’ll take each one in turn.
The ownership and physical possession of gold has several advantages:
First, it’s beautiful. Many people enjoy owning gold and precious metals for its natural beauty alone.
It has collector value. Many people enjoy collecting different forms of gold and precious metals, just as they enjoy collecting baseball cards, rare books and old watches.
It hedges against a complete economic and societal collapse. Yes, you may have wealth on paper, in the form of stock certificates. But what if no one will honor them? What if an electromagnetic pulse or massive solar flare knocks the entire Internet offline for an extended period of time?
What if your broker and SIPC both get destroyed by the same financial cataclysm? You may not be able to redeem your shares at any price. But gold coins will likely hold their value and can be traded for food and ammunition.
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Physical gold has some disadvantages, too:
IRA rules. First, you can’t keep personal possession of physical gold held within a self-directed IRA or 401(k). If you own physical gold within an IRA, you must have a custodian hold it on your behalf, via a vault storage service. These custodians and vault storage facilities charge fees, like any other investment custodian. So there’s a cost of carry to owning physical gold and storing it with a vault company.
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Risk of loss or theft. Your home could get robbed or burgled. There's a risk that you could physically lose some of your coins, bars and jewelry held in your possession. If you die with substantial amounts of gold hidden away in your home, your heirs may not know where to find it. This means part of your wealth will not get passed on to your heirs.
Similarly, your surviving spouse may not know what to do with your gold and precious metals holdings. He or she may not know how to get the most value out of it, and wind up selling it at too low a price.
Insurance costs. If you keep physical gold in your home or business, you may want to insure it. Normally, homeowner's insurance policies won’t protect you against the loss or theft of significant amounts of gold. They aren’t designed for that.
You would need to get a special endorsement or rider, or a separate policy, to cover your gold holdings and other items of value in your home. To get this coverage, you will have to pay premiums. You should account for these premiums in any rate of return calculations.
If gold and precious metal markets are flat for a long period of time, you could lose money once you account for storage and insurance costs.
Legislative and regulatory risk. It is conceivable that government could declare the private ownership of gold and precious metals to be illegal. Federal agents confiscated large amounts of privately-owned gold. This type of action is more likely in second and third-world countries than it is in the U.S.
But it did occur in this country once before, in 1933, when Franklin Roosevelt issued Executive Order 6102, "forbidding the hoarding of gold coin, gold bullion, and gold certificates within the continental United States."
While unlikely, it’s conceivable that this could happen again – especially for those holding assets overseas.
Bid/Ask spreads. Dealers charge a premium over spot price to sell most forms of gold. The smaller the gold piece, coin or bar, the higher the premium you may pay over the spot price. To minimize the spread, and to get the most gold for your dollar, consider purchasing the largest bullion bars or coins you can.
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Paper Forms of Gold and Precious Metals
There are also advantages and disadvantages to owning ‘paper’ forms of gold and other precious metals. That is, owning securities that are exposed to gold and precious metals as an asset class.
One popular example is gold-backed exchange-traded funds, or ETFs. These are shares in a portfolio traded on an exchange just like a stock that actually owns physical gold in vaults. Two prominent examples include the iShares Gold Trust (IAU) and the SPDR GoldMiniShares Trust (GLDM).
- Liquidity. Generally, you can convert your gold ETF shares for cash very quickly and easily, via your full-service or discount broker.
- Efficiency. For individual investors, the market for ETF shares is much more efficient than it is for actual gold. Smaller investors can invest more efficiently with smaller amounts of money than you can buying physical gold. The bid-ask spreads are less of a factor. You also don’t pay shipping or delivery fees – only whatever commission your broker charges you for the transaction.
- Storage fees. ETFs shares don’t have storage costs. Yes, the investment company that manages the ETF must pay storage costs to their vault companies to provide accounting, security and insurance. But that cost is spread out across thousands of investors. It’s ‘baked into the cake.’ You don’t have to pay extra storage fees, insurance premiums, etc. All that is included in the price of a share in the ETF.
- Retirement Accounts. The law prohibits the direct possession of precious metals owned by your IRA or other retirement account. You can buy bullion in the form of coins and bars for your IRA, but you can’t store them in your safe or garage. Instead, you must have a custodian hold the metals for you, such as a third-party vault company. This adds a layer of cost to holding gold, since you have to pay the vault company fees and insurance. It may be more cost-effective to own shares in a gold ETF or other security – especially with smaller amounts.
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Disadvantages of Paper
The disadvantages of paper forms of precious metal investing are the inverse of the advantages of owning physical gold and other metals:
Market risk. Any given security could become worthless. An actual gold, silver, platinum or palladium bar or coin tends to retain its value, especially during times of economic insecurity.
Counterparty risk. Paper also adds an element of counterparty risk to owning precious metals: The people running the ETF or mining company or limited partnership could be inept, or they could be crooks, misrepresenting the true state of their portfolio. One or more of their sub-custodians could file for bankruptcy. This is not a factor for those with direct possession of actual bullion.
Note that even if the market is doing fine, you could still have counterparty risk.
Tracking error. Mutual fund share prices may not precisely track the movements of the broader spot prices of gold and other metals. Open-end, closed-end and ETF prices are all subject to market forces of their own. They could trade at a premium or discount to the spot price at any time.
Closed-end fund prices will generally have the widest tracking error. This may not be terrible, if you can buy shares at a discount to NAV (net asset value). But there’s no guarantee that the discount will narrow, and could even widen. Supply and demand for the shares themselves affects the price of the stock, independently of the price of the underlying metals.
ETF tracking error will generally be smaller than it is in closed-end funds, but it does exist.
Country risk. Problems in a foreign country could affect your holdings in a mutual fund or ETF. For example, many institutions concentrate their physical gold and coin holdings in vault companies in the UK. But the UK could conceivably issue a gold confiscation order in some future crisis, which could affect your holdings.
Mining stocks are perhaps the most volatile means of exposure to precious metals. Individual mines can vary wildly in their success and performance. They have substantial internal operating costs. But if they discover a new vein of metal, they have the potential to do extremely well.
Mining Stock Advantages
Many times, these investments are available in the form of limited partnerships, rather than as shares in a corporation. These limited partnerships may be more tax-efficient than ownership of a C-corporation for those in high tax brackets.
Shares in mining stocks or partnership interests in a mining company are much easier to store than actual bars and coins. But they may not be more liquid. It could cost time and money to unload your interest in a limited partnership, for example.
Mining stock disadvantages
Risk. Mining stocks are also very sensitive to changes in the spot price of a given metal. A small increase in spot price can result in a significant price increase for a given mining stock. Conversely, a small dip in spot prices can tear a big chunk out of the company’s market value, as well.
Poor liquidity. Not all mining stocks are publicly traded. Shares in privately-held companies may also be difficult to sell. Even if shares are traded on a major exchange, they may be traded very thinly. This means there may be substantial bid/ask spreads on these investments.
Mining stock and limited partnership considerations
Investors considering direct investment in mining stocks and limited partnerships should carefully consider a number of factors:
- Management’s track record;
- Operational costs per ounce of metal yielded;
- Oil cost trends, since oil/gasoline is needed to operate a mine;
- Your individual risk tolerance and time horizon;
- Your tax sensitivity.