Tracking Gold

Recently, we've received a number of emails from readers asking why the primary gold ETF, SPDR Gold Trust (NYSE:GLD), doesn't more closely track the price of gold, and other related questions. For those readers who aren't already familiar with the workings of this innovative way to "own gold," it's worth going over a few of the details, because there are some common misunderstandings regarding the ETF.

The creators of GLD were as savvy as it gets. They saw a market crying for something like this and turned that need into one of the most successful new financial products ever introduced. The ETF burst upon the scene in November of 2004 and was immediately latched onto as a means of riding the gold bull market without the inconvenience of having to transport and securely store actual bullion. In the past seven years, its rise has been meteoric. It has steadily ascended the list of the world's leading gold repositories, until today it has the sixth-largest global stash of the metal, at more than 1,230 tons, or 39.57 million ounces, worth over $70.7 billion.

First misconception: Contrary to popular opinion, the SPDR Gold Trust does not buy and sell gold. It creates and redeems paper shares in the company. These are passed through a group of market makers, who trade them on the NYSE, then deposit into or withdraw from the HSBC vault in London the corresponding amount of physical bullion, in the form of 400 oz. London Good Delivery bars.

And even that description is somewhat misleading. GLD deals only in "baskets" of 100,000 shares, with the goal being for the share price to track gold's market value as closely as possible. Since each share represents slightly less than a tenth of an ounce of gold, that means each basket must trade close to 10,000 ounces of gold. That'd be impractical if the buying and selling had to be done on the open market.

So how do they pull it off? Well, the company is not exactly forthcoming about its inner workings, but after extensive conversations with officials, I was able to determine that what actually happens is that the gold is moved either into or out of the GLD-allocated section of HSBC's vault, to or from another section of that same vault. When I found that out, I envisioned a guy on a yellow forklift, driving pallets laden with thousands of ounces of gold back and forth across the vault floor. Such a job.

Beyond the basics, we don't know much. You will not be allowed to see the vault, whether or not you are a GLD shareholder and no matter how many shares you own. In fact, a high trust official in New York told me that even he isn't allowed inside there.

For the most part, GLD does a pretty good job of following the spot price of gold. A share will never be priced exactly at the value of a tenth of an ounce of metal, simply because the trust deducts transaction fees and other expenses. But it's close. During August of 2011, for example, the net asset value (NAV) of a share of GLD varied from 97.3635 to 97.3867% of the gold price, as fixed each day at 10:30 a.m. New York time.

However, if you are an investor in GLD, or are considering becoming one, there are a few things to keep in mind. First of all, it can't be stressed enough that this is a paper asset. It is not a way to buy gold and have someone else store your holdings for you. That can be done in other ways. There are depositories that specialize in this service, both domestically and in foreign jurisdictions like Switzerland. But that isn't what GLD is about.

Now, theoretically, it is true that you can convert your GLD shares to physical gold and take delivery of it. But practically, you can't. For one thing, you have to be approved to do so (generally meaning, you're either a broker or a market maker), and then you have to redeem a minimum of 100,000 shares. And even if you meet those qualifications, buried in the firm's prospectus—a very tough read, by the way—is a provision stating that they have the option of redeeming such shares in cash equivalent rather than bullion.

This is to say: If there is a sudden run on physical gold, GLD is not contractually obligated to provide actual metal, in exchange for however many shares, to anyone.

Thus our position has always been: Hold as much gold in coins and bullion as you comfortably can. Use the ETFs to generate profits if you like, but make sure you realize that all of those profits will be of the paper variety.

Furthermore, there is the little matter of taxation. You may well understand that GLD shares are not a substitute for precious metals, and you may be in it only as a way to make money from a rising gold price by simply placing an order with your regular stock broker. If so, well and good. But what you may not know is that GLD shares, although they trade like stock, are not stocks in the same sense as Apple shares. Not when the taxman cometh.

If you buy shares of Apple and hold them long term, for more than a year, then sell them, you are taxed at the prevailing capital gains rate, currently 15%. Gold, however, is considered a "collectible." If you buy gold coins, for example, and hold them long term, then sell them, your tax liability is at the rate for collectibles, presently 28%. If you sell them for a short-term profit, you're liable for taxes at the same rate as for ordinary income, which is determined by whatever bracket you're in.

Of course, GLD shares are not gold, as I've just taken some pains to point out. Ah, but here's the rub. GLD is structured as a grantor trust, not a mutual fund. A grantor trust is ignored for tax purposes so that the investor is treated as owning a pro-rata share of the underlying holdings, not the entity as it exists on paper. That is to say, if GLD were a mutual fund, shares would be taxed at the normal capital gains rate, but because it is a grantor trust, its long-term gains are taxed at the applicable rate for the gold it holds. . .which is 28%.

This situation leads to some rather odd tax peculiarities. Say your ordinary income is in the 25% tax bracket. You're actually better off selling GLD shares short term than you would be if you held them long term and got pushed into a 28% liability.

None of this is to disparage GLD. For ordinary investors, the ETF represents a way to (indirectly) participate in gold "ownership" without the hassle of actually taking physical delivery and finding a suitable place to vault your metal. Plus, there are no storage fees, bid/ask spreads, threats of theft, or dealer markups to worry about. And finally, for those who like to really play the market, shares are amenable to all the tricks of the securities trade. They can be optioned, shorted, hedged, bundled, margined, whatever. Little wonder GLD is so wildly popular.

So use GLD if you are of a mind to. Just be certain you understand what it is you are dealing with.

[There's a good reason that more and more investors seek the security of gold and gold investments: the US is bankrupt, and the runaway national debt is threatening not only us but future generations as well. Learn more in our FREE online video event, The American Debt Crisis—How Big? How Bad? How to Protect Yourself, on September 14. Five Casey experts plus guests Mike Maloney, Lew Rockwell and John Mauldin will discuss what to expect and what you can do.]