Unlike physical gold, which is a tangible asset, exchange-traded funds (ETFs) are financial products with counterparty risk, meaning there is risk that one party in the agreement may default or fail to fulfill its obligations. As we discussed earlier, one of the main advantages of gold is that it is the only financial asset that does not simultaneously assume other liabilities. Therefore, these ETFs are a poor alternative, and the problems quickly become apparent when we examine how these ETFs operate. Let's analyze the operation of the world's largest gold ETF – SPDR Gold Trust (GLD). To invest in gold, investors purchase GLD shares through authorized participants, typically large financial institutions such as market makers, who are responsible for acquiring the assets needed to create the ETF shares. When they do this, they are buying shares of the fund's trustee—SPDR Gold Trust. The trustee then uses a custodian (in this case, HSBC) to purchase and store gold for them. Since the custodian's role is to purchase and store gold on behalf of the trustee, they are the primary counterparty in the transaction. This is the first problem: many investors buy gold as portfolio insurance to protect against systemic failures in the financial system. Because GLD is intertwined with one of the world's largest banks, this is not suitable for this purpose. If HSBC suffers a loss, GLD stock could be negatively impacted. But the issue goes deeper. Custodians like HSBC may use sub-custodians (such as Bank of England) to purchase and store gold. Therefore, in addition to custody risk, investors also face sub-custodian risk. This sounds like the risk associated with many trading counterparties, but if problems arise, rules must be in place to protect investors, right?

Under the old LBMA rules, there was no written contractual agreement between the sub-trustee and the trustee or custodian. Therefore, the trustee and custodian had limited legal recourse against the sub-trustee. Consequently, if the trustee were to fall into distress due to any negligence, was the trustee insured to cover such events? In reality, trustees did not guarantee their gold holdings; they delegated insurance liability to the custodian… This further complicated matters. The custodian could only insure the contents of the vault with limited general insurance coverage, a level significantly lower than the value of the gold held within the vault. In summary, investors have no recourse if anything happens to any of their trading counterparties, and in addition to bearing significant risk, gold ETFs present another problem.

You might be surprised to find that gold ETFs don't give you physical gold, but it's true. The GLD prospectus states that "GLD represents an indivisible interest in a trust." When you invest in a gold ETF, you are buying shares in the trustee; essentially, you are a shareholder of the trust, not a holder of gold. Ironically, gold prices can skyrocket, while ETFs can simultaneously go bankrupt. Given these issues, long-term investors are best advised to avoid gold ETFs. Fortunately, for those who want to buy physical gold, there's never been a better option than holding physical gold.