What is the Downside of a Gold ETF? - Teranga Gold (2024)

Meta Description: Dive into the pros and cons of gold ETFs, including costs, liquidity, and the impact on sustainable mining practices.

Investing in gold has traditionally been seen as a safe haven or a hedge against inflation and economic uncertainty.

One of the most accessible ways to invest in gold for many investors is through Gold Exchange-Traded Funds (ETFs).

While gold ETFs offer a range of benefits, including convenience and liquidity, they also come with specific downsides that are crucial for investors to understand before diving in.

A notable concern with gold ETFs is the question of whether they are fully backed by physical gold. Our findings show that while most reputable gold ETFs hold the physical gold they claim to, the structure of these funds can introduce complexities.

For instance, the gold may be stored in various locations, adding to the counterparty risk. Additionally, the liquidity of gold ETF shares means that fund managers might struggle to maintain a perfect balance between issued shares and owned gold, sometimes resorting to derivative contracts to simulate gold ownership.

This potential discrepancy becomes particularly concerning in times of gold scarcity or market turmoil. If too many investors decide to sell their ETF shares simultaneously, the fund might not have enough physical gold to back all its shares, leading to the possibility of settlements in fiat currency instead of gold.

This situation could undermine one of the primary reasons investors choose gold in the first place: as a hedge against the devaluation of paper money.

Based on our observations, the liquidity of gold ETFs is often highlighted as a major advantage, allowing investors to trade shares quickly and efficiently, akin to stocks. This feature is particularly appealing in a fast-paced investment landscape, where the ability to respond to market movements swiftly can be crucial. However, this very liquidity can also amplify volatility in times of market stress.

During periods of significant financial uncertainty or geopolitical turmoil, the ease with which gold ETF shares can be sold may prompt a rapid sell-off, exacerbating price swings and potentially leading to heightened volatility.

This scenario contrasts with physical gold, which, due to its tangible nature and the logistics involved in selling it, tends to be a more stable investment in turbulent times. The physical market's slower pace can act as a buffer against the knee-jerk reactions often seen in financial markets.

This is a stark contrast to the more favorable long-term capital gains rates that apply to most other investments, which can be as low as 0% for some income brackets.

Moreover, the structure of certain gold ETFs that invest in futures contracts introduces additional tax considerations. These ETFs are typically structured as partnerships, requiring investors to report gains annually using a K-1 form, rather than the simpler 1099 form used for stocks. This can complicate the tax filing process and potentially lead to unexpected tax liabilities, even in years when shares are not sold.

Drawing from our experience, we can confirm that the tangible nature of physical gold offers a psychological comfort that digital or paper representations of gold, such as ETFs, cannot match. Being able to physically handle and see your investment can provide a sense of security and permanence, especially in times of economic uncertainty. This psychological aspect of gold investing is significant for many, offering peace of mind and a feeling of direct ownership that is absent in gold ETFs.

For some, the act of physically securing their gold, whether in a safe deposit box or a personal safe, is part of the allure of gold investing. It's not just about the potential financial returns; it's about the intrinsic value they place on the physical asset itself. This emotional connection to the investment can make physical gold a more appealing option for those who value the tangible assurance it provides.

The gold mining industry is fraught with environmental and ethical challenges, from the destruction of ecosystems to labor rights abuses. For socially conscious investors, these issues are a significant concern. While owning physical gold doesn't absolve one of these concerns, it does offer a bit more control over the source of the gold. Investors can choose to buy recycled gold or gold from mines that adhere to higher environmental and ethical standards.

On the other hand, investing in a gold ETF can feel like a step removed from these considerations. The fund may invest in a broad array of gold sources, some of which may not align with an investor's ethical or environmental values. This lack of transparency and control can be troubling for those who wish to ensure their investments do not contribute to environmental degradation or human rights violations.

While some gold ETFs strive to address these concerns by adhering to responsible investment criteria, the indirect nature of ETF investing can make it harder for investors to assess the impact of their investment dollars. This highlights the importance of due diligence and the selection of ETFs that prioritize responsible gold-sourcing practices.