Thursday, December 24, 2009

Gold is overdone as a disaster hedge, and costly to carry

I first met John Burbank in probably late 2001 when Passport Capital was a very small enterprise. Incredibly bright, nice guy. I don't recall if "Passport" was then a reference to fleeing the country. My recollection is not. Today's WSJ piece on Passport's gold investing raises some interesting issues for gold as a hedge against all disasters.

Passport set out to take delivery of physical gold against futures to see if it was really as easy as it seemed. They did a 100 ounce test. Here are my thoughts.

They claim physical delivery is cheaper than ETFs.
  • Custody problems.  Gold has to be verified as gold.  This is not free.  Once you take delivery of gold bars and have them in your possession, as far as the market is concerned they are no longer gold bars.  There's a cost to verifying that they remain gold bars.
  • Storage costs.  Sure, Passport was willing to take a $90,000 flier.  They are very wealthy guys.  The situation would be substantially different if they took delivery of $90 million.  There would be security costs, transportation expense, and serious storage problems.  This is exactly the point of a prior WSJ story about the dearth of official gold storage facilities in and around New York City.
  • Liquidity.  There's a lot to discuss here.  For the most part, custody and storage cover the trading costs of gold.  Why's that?  Sell financial futures short, and deliver physical against settlement.  However, delivering physical against settlement isn't so easy if you don't have official storage.
That's not to say I love the ETFs. There's a fundamental problem, I believe, when dealing with serious dollar disasters as a US investor. The Federal Government has outlawed private gold backed currency. I don't think it is much of a stretch to argue the ETFs that hold physical gold are a privately issued, gold backed currency. Each share is a claim on physical gold held in trust. It's really there, that's the appeal. It isn't a purely financial instrument. So, except for costs of physical delivery (much like the old days of going to the Fed to demand gold) the certificate for the ETF is "as good as gold." That means when the real disaster strikes, you're out of luck. The US government has good grounds to seize your property.

I know this sounds far-fetched. But, if you are really thinking about holding gold for the end of the world scenario, you need to understand the risks.

Now, one last problem, that a friend of mine always raises: What do you do with the gold? Do you really think you slice off a couple of grams of your 100 oz gold par to buy some cans of tuna fish??

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