In todays market environment, with more electronic trading than ever before, occasional flash crashes, and confusing derivatives being created every day, investors can understandably find themselves bewildered in any asset class. When ETFs and futures are thrown into the mix, the confusion especially builds as to the best way to gain exposure to two of the most well-known commodities: gold and silver.
There are essentially two different ways to go about buying or selling precious metals: electronic and physical. Electronic trading occurs when a brokerage firm facilitates the transaction and a clearing firm settles the trade. Within electronic trading of gold and silver, investors are mainly presented with exchange-traded funds (ETFs) and futures.
Although the electronic forms of silver and gold investing are appealing because of their (ostensible) liquidity and convenience, they are certainly not without their flaws. As briefly mentioned above, flash crashes have been occurring with greater frequency and velocity lately, and they present a serious risk for anyone who owns shares of a gold or silver ETF.
During the near 8% intra-day equity market dive on August 24 of 2015, when China surprised the world by devaluing the yuan, there was sheer pandemonium in every traded security across the world as many algorithmic and high-frequency hedge funds temporarily shut off their systems to withdraw from the chaos.
As a result of this, there were massive price discrepancies in ETFs in particular, because the buy/sell imbalance was far greater than anyone anticipated. To explain why this happened, its essential to know the basics of how an exchange-traded fund operates. Gold and silver ETFs aim to replicate the price of gold/silver by holding gold/silver futures or bullion. Shares are then offered to the retail customer to gain exposure to this instrument, which mirrors the spot price of gold/silver.
Its crucial to note, however, that supply and demand do not affect the price of an ETF. Instead, sales and purchases of the ETFs shares are absorbed by authorized participants and institutional arbitragers to balance out all of the selling with all of the buying and vice versa,while the share price still tracks the spot price.
This sounds efficient in theory, but when chaos inevitably ensues, it can be disastrous for ETFs. For example, an investor could own 1,000 shares of a gold-tracking ETF trading at $45 with a good-till-cancel stop-loss order to sell the shares if they trade below $39. All it would take is another flash crash, technical glitch, or temporary pricing imbalance to make the ETF have a $39 print that leaves that investor with a $6,000 loss and no gold to show for it. And the likelihood of something like this occurring should not be underestimated.
If this were to happen, as it has in the past, it would likely happen with such tremendous speed that there would be nothing a person sitting in front of a computer could do to thwart the damage.
Of course, this is assuming that the ETF is even trading. If markets get too chaotic, ETFs can momentarily halt altogether, making opening and closing positions impossible.
All of this is hardly scratching the surface when discussing electronic vs physical precious metal investing. One of the genuine, downbeat risks of owning gold or silver via an ETF is that the metals are simply not guaranteed to the investor especially in a time of a financial crisis.
Ironically, for gold and silver ETF owners, gold and silver tend to perform best during times of dire economic adversity and uncertainty. This was precisely the time not that many years ago that major banks, which investors and analysts were positively certain would never fail, filed for bankruptcy. Times like this are an enormous boon for gold, and it would be foolish to partially miss out from a technical glitch in an ETF, or fully miss out with abject institutional financial failure.
Due to these reasons, a handful of investment professionals opt for gold and silver exposure through the use of futures due to the lack of counterparty risk; in a financial crisis, the metals are guaranteed to the purchaser by law. Nevertheless, an increasing number of professional money managers and investors still opt to own gold in its physical, tangible form.
Moreover, when brokerage commissions, the monthly rolling cost of futures, and ETF management fees by the underwriting fund are taken into consideration, a rare metal investors profits are eaten away over time, and the case for owning palpable gold becomes that much stronger. This combined with the fact that a better option actually exists (because this physical ownership option doesnt exist for some stocks, etc.) seals the deal.
Even though warehousing costs for physical rare-earth metals can be circumvented with a home safe, the costs can indeed be present for investors. However, owning gold and silver in a physical state and securely storing it, thereby knowing it will always be there regardless of economic or political happenings in the world, brings peace of mind, and no one can put a price on that.