Paper gold - an asset that reflects the price of gold while not actually being gold - it's not backed by real metal, so it’s considered to be only on paper. Holding paper enables one to get exposure to the price of gold without having to possess physical bullion and is considered more useful for trading purposes than for long-term investments. Examples of paper gold include gold certificates, pool accounts, gold futures accounts, and most exchange-traded funds (ETFs).
Paper Gold Instead Of Physical Gold - Why?
The first answer is you might want to avoid storage costs. If you invest in a sizable part of your capital in physical bullion, you might not want to keep your metal at home (you’ll need a safe and perhaps other additional equipment). In this case, you might prefer to choose a custodian - an institution that stores your metal for you. This storage service is not free of charge (neither is transportation to the storage facility, nor its insurance), so you need to take this cost into account, and it diminishes your returns on gold. By buying paper gold, you get a paper that more or less reflects the price of gold and allows you to avoid the cost and headache of storage.
In addition, paper gold enables you to invest in gold even if you don’t have enough capital in US dollars to buy an ounce of physical metal gold. This is because ETF shares, or similar investment vehicles, usually reflect less than one ounce of gold - most commonly they follow the price of 1/10 of an ounce. If you do not have enough money to fill a full ounce, ETFs might be a solution. This is another reason for the popularity of ETF vehicles with individual investors.
Is Paper Gold Safe?
You might ask yourself whether it is reasonable or safe to invest in paper gold if you do not actually possess the gold metallic metal you bought. This is an important question because by buying paper gold you get exposed to counterparty risk (the risk that your transaction partner will fail to fulfill their promises).
In short, that’s ok if you use only a small portion of your capital for purchasing paper gold (for instance by speculating on its price movements). For example, if you buy a gold ETF share with USD, you get a paper that trades roughly in the same direction as does gold. You may sell it to any other investor just like a stock and SPDR gold shares or the NYSE and HSBC and receive money. Please note, however, that most ETFs do not allow redemptions in gold. In other words, if you want to sell your ETF shares, you will not be able to exchange them for gold and have to accept a disclaimer.
The ETF tries to make the price of its shares trade without direct connection to the demand for these shares. If many investors are willing to buy shares of a particular ETF, the price of these shares will most likely go up. This involves certain volatility. In such a situation, an ETF (along with its partners) issues more shares to weaken the price pressure and backs the new shares with physical gold or some kind of derivative on gold (like futures contracts).
As a result, increased demand for the shares of an ETF will result rather in an increase in share numbers than in the surge in the price of a share. Conversely, if the demand for these shares is low and pulls the price down, then the ETF (and its business partners) will sell a part of its physical holdings and use the acquired cash to redeem existing shares. Such an action limits the supply of shares and pushes the price back up.
The above mechanism is important, as concerns have been raised that ETFs may not have all of their shares backed with physical gold or gold bullion on stock exchanges. This would mean that the overall value of shares issued by a given ETF exceeds the value of gold this ETF holds. At first, it may seem of little relevance, as you usually cannot exchange your shares for gold with the ETF. However, after a short consideration, such a situation begins to look unsettling.
The main reason is that when you want to exchange an ETF share for cash, the ETF (and its partners) has to obtain this cash to redeem your share. If the ETF holds physical bullion, it may simply sell an appropriate part of its holdings to get the desired amount of money from financial markets. On the other hand, if it does not hold physical bullion or gold bars or gold coins and runs out of cash (for example because of default on the futures market), it may not be able to pay you for your share - and this would be a default of the ETF and gold dealers. In this case, you would lose your money on the gold market instead of gaining it by selling gold or precious metals at a very high spot price.
As long as the demand for ETF shares is sound and you are able to sell them to other investors (and not to the ETF), even ETFs without enough physical gold will manage to make good business. However, if there is a default in the gold derivatives and/or gold declines and/or the demand for these shares falls significantly, it may turn out that such ETFs are unable to redeem all of their shares. The less physical gold the fund actually holds, the higher the probability that in an extreme situation you may find yourself out on a fragile limb.
The Golden Rule
If you invest in gold ETFs it is crucial to choose either the funds that allow redemptions in gold (there are only a few such ETFs) or those that have their shares fully backed by gold. Apart from that, you should always remember about diversification - in this case, it would mean holding both physical gold for long-term investments and non-physical (futures, options, ETFs, pool accounts, certificates) for small, quick trades.
If the derivatives market collapsed, then the rocketing price of your physical holdings would more than compensate for the losses on the speculative paper golds. This is why diversification is important in this case.