Gold & Silver... How Do I Own Thee?
... Let Me Count The Ways
(Part 3)
March 2009
James Macfarlane
Third Party Storage - Store Your Bullion as Gold Certificates
Category: Safety/Maintenance of wealth
Here we have yet a third way to store gold offsite; namely gold certificates. Gold and/or silver certificates have been around for a long time, and are simply another mechanism for being issued a paper receipt for your gold. Historically in the US the issuance of gold certificates took the form of paper money used in every day transactions. Up until 1933, when gold certificates were made illegal, a citizen could literally redeem their certificates for gold coins.
You could trade dollars for gold up until 1933
[Let's make a clear distinction at this juncture. It is very important for you to understand that we are now leaving the realm of direct ownership of gold. The methods covered thus far for purchasing gold/silver are all about either taking physical possession of coins/bars, or taking legal possession and storing the bullion in allocated storage. Those are the only two ways to truly own gold, and the only two ways to maintain your wealth apart from the gyrations and risks of paper currency and counterparty risk (when a party to the arrangement is unable to meet its obligations), which is extreme at present. The price of gold does not really fluctuate much. It's the value of paper currencies that change in relation to gold. This is the core reason to own physical gold. Every other form of gold/silver investments are simply speculations on what will happen to the "price" of gold measured against a particular currency. With that caution, only "investors" need read further.]
Gold/Silver ETFs
Category: Flexibility/Speculation
Moving away from third party storage of your bullion what we have here is a way to invest in gold as you would a stock. An ETF (Exchange Traded Fund), if you don't know, is kind of like a traditional Mutual Fund, only better. Like mutual funds, ETFs allow one to invest in a variety of investment classes (often an index of stocks) much like you would buy and sell shares of stock in a company. Unlike mutual funds, ETFs behave more like stocks in regard to fees and ease of trading, as they can be traded like stocks throughout the day.
Gold and silver ETFs are designed specifically to track the price of gold and silver respectively. These funds are actually backed by their respective metals. In fact, it is through the purchase and sale of the underlying precious metal, that the fund tracks the spot price of that metal. Since the ETF must purchase and store the physical commodity it tracks the price of, as new buyers purchase shares the fund must increase its physical holdings. The most popular of these ETFs, the SPDR Gold Shares Fund, now has holdings of over 1,000 tons of gold… rivaling the stockpiles of some countries.
For those choosing to invest a portion of their portfolios in gold/silver, either as a hedge against inflation, a falling stock market, or for speculative purposes, the gold and silver ETFs are arguably the easiest way to do so. You have an investment vehicle that can be traded through your existing brokerage account, is very liquid, and has a close correlation to the price of the precious metal it tracks. Because of all these features, precious metals ETFs have gained in popularity as the price of gold and silver have risen.
So, sounds pretty good, huh? But if you've been following along, you know what's coming next, don't you? What's the answer to the Big Question? Do the holders of shares in a gold ETF have titled ownership over the physical commodity? Uh… no. But truthfully, no such claim to that effect is made. The purpose of backing the ETF with gold has more to do with giving the ETF credibility -it's not just paper trading they claim- and it's key to stabilizing the price of the ETF to that of the precious metal.
Still, let's slow down here and do a reality check. We have just wandered into one of the fastest growing areas of precious metals investing. The precious metal E-T-F is H-O-T! In the first half of 2009 the amount of gold and silver held in trust by ETFs has grown by leaps and bounds as traditional investors seek a flight to safety through a familiar instrument. Unfortunately gold and silver ETFs have a growing controversy as well. First, let's be clear that a gold/silver ETF is in no way tied to ownership of precious metals. This is a purely speculative investment that simply goes up in price when its underlying metal goes up in price, and vice-a-versa. No one disputes that. One area of controversy though lies in whether or not the amount of gold and silver that is claimed to back these securities does indeed exist. When I researched this debate I found arguments for how well some ETFs manage and audit their holdings, including disclosure of serial numbers of the bars of gold1. On the other side of the debate though is the assertion that even serialized bullion may have multiple claims of ownership, i.e. the musical chairs theme again. Who knows the real truth, but from what I've been able to glean I will express the following thoughts regarding gold and silver ETFs:
- What would happen if even a rumor about ETFs lacking the full backing of their respective metals was taken seriously? The supply/demand mechanics of precious metals ETFs are separate and apart from demand for gold/silver. If these ETF vehicles were fled en mass due to a panic regarding their safety, would the fund managers be able to maintain the equity's price in relation to its metal?
- ETFs trade on public, government controlled exchanges. Therefore all the cautions regarding exchange trading in times of economic crisis apply. It's not unheard of for markets to be shutdown and trading halted during times of chaos. And some degree of chaos might be in store at some point, when investors may come to understand that stocks are still highly overpriced related to future earnings. Or that the bond market is underestimating inflation. Or that the world will stop buying our debt. Or that the US dollar will be revalued sharply downward. Take your pick of calamities waiting to happen. Any one of them could cause severe disruption from people exiting these markets. That's why you're buying gold, right?
- Gold/silver EFTs are alluring vehicles. They are great for short term trading. They can be used in many cases where direct ownership in gold/silver is not possible (pension funds for example). However, one must understand the counterparty risks with ETFs in today's environment. If a crisis hits, it is possible that these instruments could be one of the early fatalities among the variety of precious metals investment vehicles mentioned in this article.
Here are some examples of popular gold/silver ETFs:
- SPDR Gold Shares ETF (Symbol: NYSE:GLD)
- iShares Comes Gold Trust ETF (Symbol: AMEX:IAU)
- iShares Silver Trust ETF (Symbol: AMEX:SLV)
- PowerShares DB Gold ETF (Symbol: NYSE:DGL)
- PowerShares DB Precious Metals ETF (Symbol: NYSE: DBP)
- DB Gold Short ETN (NYSE: DGZ) this ETN is for shorting gold (betting the price will go down). An ETN is similar too, but riskier than, an ETF. Do your research. There is no equivalent for a silver ETN on an American exchange.
Leveraged Investments in Paper Gold
To review, up until now we have looked at various ways of owning gold and/or silver bullion -both Physical Gold and Paper Gold- as unleveraged investments; i.e. there is 1-to-1 relationship between the dollar amount invested and the amount of gold or silver being controlled. So if you spend $1,000 for a gold coin, you control $1000 worth of gold. If you spend that $1,000 on a gold ETF and the price of gold goes to $1,200, your brokerage statement will reflect a value of $1,200. All the aforementioned vehicles gain or lose value in direct proportion to the price of the underlying metal.
Now we turn our attention to leveraged ways of investing in precious metals. Leveraged investment vehicles, vis-à-vis one mechanism or another, allow you to control more gold/silver than you put up cash for. The result is that your investment gains (or loses) some percentage greater then the price of the underlying metal, depending on how much leverage is applied. Whether through the purchase of an option, buying shares in a mining company, or through other means, the following vehicles provide the opportunity to increase the rate of return compared to an unleveraged investment in bullion.
1 A review of the prospectus for the most popular gold ETF traded on American exchanges, symbol GLD, reveals that at least a portion of the holdings are in unallocated accounts, where one would expect that no serial numbers would be recorded. This and other disclosures in the prospectus seem to allow the ETF a rather lax standard with regard to proof of holdings.
Leveraged Investments - Bullion on Margin
Category: Speculation
Buying bullion on margin refers to financing a portion of your purchase. The leveraged gained is relative to how much of the purchase is financed. A number of gold/silver investment vehicles can be financed, with margined purchases of bullion being one of the more common. There are dealers who will sell gold and silver bars/coins on margin with as little as 10% down. The customer makes a down payment, so to speak, and the gold remains in the dealers vault as collateral on the loan. The customer then makes payments to the dealer for the portion of the bullion not paid off yet, including interest. The idea is that if the price of gold rises, the profits made on that leveraged bullion will far outweigh the interest payments on the loan.
Danger Will Robinson
Here we have double trouble. The problem with buying bullion on margin is that in the short term, gold and silver tend to go down in price about as often as they go up. When the price goes down, the margin on which you control your bullion is diminished and you may get a margin call, meaning you must make up the difference by increasing your payments. If you can't make the extra payments your holdings may be liquidated.
The second consideration with buying gold/silver on margin is that you have the same issue of unallocated vs. allocated storage covered earlier. The bullion dealer most commonly associated with purchases on margin is Monex.com. Monex promises allocated storage, but a check of their site reveals little regarding any third party auditing of holdings. And just another word of caution; if you call Monex and give them your phone number, they will hound you till the cows come home to make a purchase. To be fair though, Monex has been in business for decades. I have a friend who took delivery of a block of platinum from them and he was completely satisfied with the transaction (he just laughed when they offered him a margin account).
Leveraged Investments - Gold/Silver Mining Stocks
A very popular way to leverage your investment in to the price of gold and silver is by owning shares of gold mines and silver mines. Owning the mining stocks is in no way a substitute for owning gold however. Mining stocks are a pure investment. You can think of the 'miners' as being "part of a complete breakfast" for the portion of your portfolio you wish to allocate toward the fortunes of the price of gold, silver, and certain base meals.
The leverage from owning mining shares derives from a number of factors, but basically in a bull market mining stocks tend to have a greater percent gain relative to the price of the precious metals they mine. When you own shares in a mining company you do not ever own any precious metals; you simply own a piece of a company that extracts precious metals from the ground and sells the commodity at market.
As an investment it is arguable that in the not too distant future mining stocks will be one of the most profitable segments in the class of investments known as equities; i.e. ownership of a company through its publicly traded shares. You just want to remember though that mining companies are affected by far more factors than what pure bullion is exposed to. If something happens that prevents the mine from producing… say the gold runs out, labor costs too high, lack of electricity, lack of financing, or any of a number of other factors… the shares may plummet. Also, if the price of gold/silver falls, the shares of a mining company may fall even further. That's the price of leverage. On the other hand, mining shares are one of the safest leveraged instruments over the long term, as they are less time sensitive then any other leveraged instrument listed in this article. There are no margin calls if the share price drops, and the shares never expire (as options do), with the exception that eventually the mine will reach end-of-life when the ore is exhausted.
In terms of gauging the likelihood that the miners will outperform bullion in the remainder of this current bull market in precious metals, we have some interesting history to go by. If we look back to the beginning of the current bull market that commenced around the time we rolled over to a new century, the miners generally outperformed the metals for much of the bull run. Then last year, when the general stock market dipped, so did the mining stocks. Big time. The miners of course have recovered quite well going into the first quarter of '09, but a good sized chunk of the gains enjoyed by the miners from the start of the bull market have been erased. So, there are two ways to look at the upcoming prospects for the miners. One could say that it is the absolute best time to buy mining shares on the basis that they are a relative bargain and are likely to greatly appreciate as the price of bullion rises further. New money may be attracted to mining shares as traditional stock investors engage in a flight to safety away from traditional equities. Conversely one could say there is great risk that the mining stocks will collapse again if the general stock market declines further, regardless of what happens to the price of gold. That diversity of opinion of course is what makes a market. However, if the price of gold continues to rise as expected, it would seem reasonable to conclude though that over the long haul the price of mining shares will be valued higher than they are now, as the good mining companies will be profitable, and profits (earnings) are what ultimately determine the share price!
Now let's get a bit more specific. Keep in mind that the relative risk of mining stocks is tricky to determine. Below miners are categorized simply by how close the mine is to production, but in fact there are many, many variables. Most folks are better off with a mutual fund comprised mostly of miners or perhaps a mining ETF (both referenced later). Short of that you could subscribe to a good stock picking service such as zealllc.com or growthstockweekly.com. Diversity is key with mining companies!
Producing Mines
Category: Investment/ Speculation, depending on mine
A producing mine is one that is currently retrieving gold and silver from the ground and bringing it to market. Producing mines tend to have the highest stock prices as they are theoretically making money. Producing mines are the safest, but also carry the least leverage.
Near producers
Category: Investment/ Speculation, depending on mine
A near producer is a mine that has proven resources and has spent money on infrastructure to retrieve the ore. Operations are due to commence in the near future. It is expected that, all else being equal, the share price of near producers will rise as the mine goes into production and starts making money. Leverage on such miners is much higher.
Juniors and Explorers
Category: Speculation/wildly speculative, depending on mine
Junior mining stocks represent companies that may be several years away from production. These are often, but not necessarily, properties that have proven resources. Since juniors often lack a built out infrastructure and are some time away from production, the price of their stock is usually well below that of the producers and near producers. The explorers are often "shell" companies sniffing around to prove resources they suspect are there. These stocks have the greatest growth potential and may provide returns of many multiples for those patient enough to hold on until the mine come online. A junior also has just a good a chance of fading into eternity after its stock price goes to zero.
Purchasing Mining Stocks
Mining stocks are traded on various stock exchanges around the world. Shares are purchased through a stock broker, so your current broker may be able to help. Keep in mind however that not all brokerages are able to purchase mining stocks through all the exchanges. For example many mining shares are traded in Canada, such as on the Toronto Stock Exchange (TSX), and not all brokers are registered with the TSX.
Remember that this article is just a primer on investing in gold/silver, and that if mining stocks interest you there is more to learn. One thing further research will reveal is that the country the mine is located in is of paramount importance. It is not unheard of for a foreign government to nationalize a mining company, thus nullifying any foreign ownership of the stock. For that and other reasons, Canada, and to a lesser extent Mexico, are popular foreign countries for investing in the miners.
Reducing the Risk of Mining Stocks
Reducing the risks of owning mining stocks mainly has to do with diversification, a.k.a. spreading your risk across many companies, in various stages of development, with assets in more than one precious metal (and possibly base metal as well).
(The Final Part will be posted shortly)
Feedback to HowToBuyGoldSilver@hottrainingmaterials.com
Email this Article to a Friend 
Printer Friendly Version