Gold or a gold ETF?

There are many tools available to buy gold, which is the bedrock of any portfolio. These include coins, bars, futures contracts, certificates, options, and what has recently perhaps become the most popular instrument of all, the gold exchange-traded fund – the so-called ETF. But which of these many tools is the right one for you?

The answer to this question begins by first determining your objective. In other words, it is necessary to identify the reasons you want to own gold. Once these are clearly understood, the right tools can then be chosen to enable you to meet the objective you intend to accomplish by owning gold, of which there are two.

First, fluctuations in the price of gold enable skilful traders to profit from these moves, buying when they expect the price to rise and selling in anticipation of a lower price. In this sense, gold is often characterised as an investment, but it isn’t that. Gold is a sterile asset that does not generate cash flow. It doesn’t have a management team or a balance sheet, so clearly gold is not an investment. Gold is money, and therefore is part of the liquidity everyone needs in his or her portfolio, which leads to the other reason to own gold.

Gold is a safe haven. It does not have counterparty risk. Because it is a tangible asset, its value does not rest upon someone’s – or more to the point – some bank’s promise. When you own gold, you own money completely outside the banking system.

From the above two observations, you may be starting to sense that there are actually two types of gold: paper gold and physical gold. The former is a financial asset, which means it has counterparty risk. The latter is altogether different. Physical gold is a tangible asset, and consequently, it therefore does not have counterparty risk. Only physical gold provides a safe haven.

So do not view any of the gold ETFs as an alternative to physical gold, because they are not. The ETFs meet the first objective by providing exposure to the gold price, but they are not a safe haven. The ETFs should be compared to a gold futures contract, not to physical metal.

A futures contract tracks the future price of gold in the form of a tradable contract. In a similar vein, an ETF tracks the spot price of gold in the form of a tradable security.

I favour the concept of a gold exchange-traded fund, just as I think a futures contract can be useful. But one needs to choose the right tool for the right job. Physical metal is one thing, and the paper representation of metal in an ETF that simply tracks the gold price is something entirely different. Importantly, it is physical gold itself – and not just the promise to pay metal – that is the bedrock asset of one's portfolio.

Consequently, use gold ETFs as you would a futures contract – as a trading tool. It is not an alternative to owning physical metal. If you want to own gold because of its safe-haven attributes, then buy physical metal.