Julian Phillips: Allocated and Unallocated Gold, Can a U.S. Investor Hold Gold Securely?

BENONI – The attention of the gold world was grabbed by the action of a the University of Texas Investment Management Co. that switched their gold investments to bullion and actually took delivery of around 20 tonnes of gold in the form of 6,643 gold bars, then worth $987 million.   It is now stored in a bank warehouse in New York.   This event was treated as remarkable in the United States.  In Europe and nations east of Europe, the concept of holding gold bullion is more than normal, it is good sense.  So in a nation that is used to investing in gold derivatives why has a leading U.S. investment fund turned to physical gold bullion registered in its name?

The Texas fund’s $19.9 billion in assets ranked it behind only Harvard University’s endowment, making its action all the more important.   The reason given was that the fund’s managers sought to take delivery of bullion to protect against demand for the metal overwhelming supply.  

In a nutshell the advisor to the fund gave his reasons for buying gold in the first place.  It was one that we have highlighted persistently over time.   It was, “Central banks are printing more money than they ever have, so what’s the value of money in terms of purchases of goods and services.   He said, “I look at gold as just another currency that they can’t print any more of.”  With that in mind it becomes obvious that gold held in a derivative form is not really holding gold at all.   [The Texas Fund said holding cash wasn’t a better choice because the rate of inflation exceeds money-market rates by 2.5% to 3%, eroding the value of cash.]

This reason and the reason to hold gold in the name of the beneficial owner directly, raises all sorts of questions.   “What levels of security of gold ownership do investors really have?” is perhaps the most important question for a gold investor.  
THE DIFFERENT WAYS OF HOLDING GOLD AND THEIR SECURITY

Clearly, investors trust in banking institutions and derivative markets to access the gold, their gold instruments imply, is diminishing.   In addition, the reality that there is far less gold available than the sum total of derivatives imply is becoming a market factor.   Overall the concept of the profit motive in gold markets is giving way to the concept of preserving wealth with physical gold bullion, a concept almost foreign to U.S. investors until now.

COMEX – OPTIONS & FUTURES

Holding an investment related to the price of gold is not owning gold.   For instance, an option to buy or sell gold is a financial instrument that does not involve gold itself, unless the option is exercised.   It is only the right to buy or sell gold.   A small percentage of the value of the gold where the investor has the ‘right’ to buy or sell gold is paid to the option grantor.   Usually as the date of the expiry of the option nears the option holder either walks away from the option so as not to take a loss, or exercises the right and immediately buys or sells the underlying gold to close the position.   In that case no physical gold is involved not is physical gold owned until [and if] delivery is taken.  

In the case of a ‘futures’ contract the investor puts down a deposit [around 10% or more] and buys or sells gold at a future date, paying the interest due or receiving it during the period of the transaction.      At or near the date of the expiry of the contract a matching transaction, to close the position, is taken.   Hence 95% of such contracts are financial contracts only and don’t involve physical gold.  

Indeed, if the intention is to take or give delivery of gold, under COMEX rules, the counterparty must be informed and agree to be the counterparty in a physical, gold transaction.   As COMEX itself will confirm, only 5% of such transactions will involve physical gold.   So COMEX is not really the place to buy gold.   As the Texas fund said, “the fund’s managers sought to take delivery of bullion to protect against demand for the metal overwhelming supply.”   Their fear of COMEX is, “Open interest in gold futures and options traded on the COMEX typically exceeds supplies held in its warehouses.   If the holders of just 5% of those contracts opted to take delivery of the metal, there wouldn’t be enough to cover the demand.”  

Few investors take physical delivery of bullion.   As of April 14, 2,860 contracts this month, about 0.5% of total open interest, had been converted to metal, exchange data show.
GOLD EXCHANGE TRADED FUNDS AND “UNALLOCATED GOLD”

The bulk of the World Gold Council sponsored gold Exchange Traded Funds, holds ‘unallocated’ gold, where the Custodian [the bank that holds the gold] does not ‘allocate’ specific gold bars to the individual client, but rather, states that from its stockpile of gold, the Fund is a part owner.  

Against this the gold Exchange Traded Fund issues shares to investors with each share representing a specific amount of gold.   It is generally accepted that the gold holdings of the fund is equal the total number of shares issued.   As the shares are bought and sold, so the fund buys and sells the gold equivalent.   The investor therefore does not own actual gold, the fund does.  Most investors trust the integrity of the Fund managers and the bank acting as Custodian to ensure that there is gold to meet the shareholding.   Some funds may allow outsiders to lease the gold from them to add income to the fund but this adds the risk that the gold may not be returned by an outside party.   Some investors feel that the bank’s, current, unallocated gold holdings may not match its gold obligations and when push comes to shove [as the Texas Fund fears] there may be a shortfall and all investors not able to take delivery of their gold.  

GOLD TRUSTS

There are gold Trusts where the gold is owned ‘on behalf of investors’.  

These can take one of two forms.   They can hold gold in ‘unallocated’ form by the Trust, where leasing or leveraging is permitted, which does involve risk to their gold holdings.   Like the Texas Fund feels, a shareholder in such Trusts may feel that the link to the actual underlying gold is insufficient.  

We are aware of a Trust that satisfies its clients that the gold is held for them and they can check on it every day, for the Custodian does provide a reconciliation on its gold holdings on a daily basis.  Such a Trust comes with many more benefits.  

DIRECT BULLION OWNERSHIP

Any individual that feels his home or other storage facilities is secure can hold his own gold without fear of losing it.   Most Asian investors hold it this way.

Then of course for small holdings, bank deposit boxes can be used.   As this is private even from the bank housing the deposit, many feel this way is sufficient to give them the security they want.  

Other gold investors just don’t trust the government they are under and want to hold their gold bullion outside the country.  They generally preferred location is Switzerland with its remarkable history that has protected individual investors even from their own government for centuries, even during wars. 

Companies like ‘The Bullion Vault’ and ‘GoldMoney’ offer ownership of gold held in Switzerland. 

The Bullion Vault holds the gold in the client’s name, giving him a ‘codename’ allowing him to check on a daily basis that his gold is in with the Bullion Vault’s allocated gold in a private vault.   This is a company that is also backed by the World Gold Council and a Rothschild’s Investment Trust.   The direct benefit of this method is that the client knows that his gold is there, unleveraged, un-leased and linked to him directly.  This company is outside the banking system too.   This is important because banks rely on governments for their licenses.  Hence, they will obey a government even at the expense of their clients.   So a private vault, of good reputation, is far more secure that a bank vault in hard times, we believe.  

The Texas Fund holds its gold in a U.S. bank warehouse so that it feels secure in that ownership.   But it is still vulnerable to action by the bank or the U.S. government, but the Texas Fund has, for the meantime, direct ownership of its own gold.  

Holding gold bullion in London is a route sometimes selected by a U.S. investor, because he feels that he is then out of reach of his own government.   That may well not prove to be the case though.

Julian Phillips is a long time specialist analyst for gold and silver and is the principal contributor to the Gold Forecaster – www.goldforecaster.com – and Silver Forecaster- www.silverforecaster.com – websites and newsletters

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