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TheStreet Open House

Do Gold and Silver ETFs Make Good Investments?

Those are the facts around silver and gold ETFs, now for the controversy. For examples, I will use the GLD's prospectus as a proxy as it is the second largest ETF in the world.

First off, there are questions as to the quality of the gold and silver in ETFs. Page 11 of the GLD's prospectus reads, "neither the Trustee nor the Custodian independently confirms the fineness of the gold bars allocated to the Trust in connection with the creation of a Basket." Basically you don't know the grade of the gold you "own."

Secondly, the trustee does not insure the gold, the custodian does and their liability is very limited. The custodian is only made responsible for damages to the gold they directly inflict, but if the gold isn't good or is in fact wooden bars painted gold (but they didn't do it), then most likely the custodian would be protected and the trustee wouldn't be liable.

Also hidden in the prospectus is the fact that a custodian is free to store the gold with sub-custodians until the gold is delivered to the custodian's main vault. In other words, the gold can be in various places at once. When the gold is with the sub-custodians, it's on its own. The prospectus says "failure by the sub-custodians to exercise due care in the safekeeping of the Trust's gold bars could result in a loss to the Trust."

The sub-custodians are not accountable for the gold they store and are also free to appoint other sub-custodians to hold the gold. The trustee also has no right to visit the sub-custodians to examine the gold or check out its records. The trustee may visit the gold in the custodian's vault but only on a limited basis. There is usually one independent audit at the end of the year and one surprise audit.

Also, since most custodians are banks, if they fail, the trust becomes an unsecured creditor. There might be a substantial delay or fees associated with obtaining the allocated gold. Granted the custodians are reputable large investment banks, but as we saw in 2008, any of them can become insolvent.

Another big issue some analysts have with the ETFs is the fact that JPMorgan and HSBC, both custodians, have short positions in the gold market. Chris Powell, secretary and treasurer of the Gold Anti-Trust Action Committee, which argues that governments manipulate the gold price, says " We doubt the reliability of the major gold and silver ETFs ... because their metal can be borrowed by parties seeking to drive previous metal prices down, against the interest of ETF investors ... these short positions are not disclosed in the ETF prospectuses."

Nevertheless, the GLD has rallied 17% this year in tandem with the gold price.

Another worry is that because the ETFs can have unallocated futures contracts, they might have to roll over their futures positions and get caught out of the money, namely that the contract they hold would become worthless. In that scenario, the ETFs would not be as closely correlated to the spot price of their underlying metal but to options expirations instead.

Don Dion, portfolio manager of ETF Action, argues that the rollover issue is more of a problem with gold exchange-traded-notes that are entirely based on futures contracts. "Since physically backed ETFs don't rely on futures contracts for their strategy, price dislocation is not an issue ... Investors don't have to worry about the rolling of futures impacting the price of their fund."

These issues have led many gold bugs and conspiracy theorists to shout warnings about the safety of precious metal ETFs: Does the gold you think you own really exist and in what form?

However, despite these risks, for an investor looking for pure exposure to the gold price, ETFs are an attractive option to trade, speculate and hedge. Here are the facts you need to know about the five physically backed silver and gold ETFs available in the U.S.

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