Bullion ETFs

Allocated versus Non Allocated Bullion

There are two ways to own physical bullion. When you actually take delivery of the bullion that you purchase, whether this be delivered to you personally to store or kept at a storage facility run by a bullion vendor, this is called allocated bullion.

Your bullion in this case is allocated to you, either given to you or kept in your name somewhere, and there is therefore actual bullion connected to your purchase. Upon redemption, this actual bullion will be sold, either back to the dealer or to someone else.

Many people prefer allocated bullion, but much of the bullion that is bought and sold is non allocated. Contrary to what many people believe, non-allocated bullion does not involve the dealer keeping an inventory of bullion in storage, and they will often instead just keep a float to manage redemptions.

Should there be a run on their bullion so to speak, meaning that many of their customers will look to redeem it, they will purchase “your” bullion on the spot market to fill the orders. There is serious market risk here, not because your price will change, but theirs certainly might, and it might change a lot.

This can leave the depository well short when it comes to meeting their obligations if the price that they have to pay for the bullion redeemed has moved a lot from the price they received for it. Non-allocated bullion is as close as the old-time bucket shops as we’ll ever see, because you have only purchased bullion in theory, and your getting it or benefiting from it will depend in large part on the counterparty’s ability to purchase it later on the market.

As long as the price of bullion remains stable, this all can work pretty well, but while you may be betting on the price of your bullion going up, the dealer is betting that it won’t go up by a lot, and your money is at stake with both bets.

If you bought an ounce of gold for instance at $1000, and if when you are looking to sell it the price has risen to $3000, and the dealer does not possess your gold and has to instead buy it, this additional $2000 an ounce needs to come from somewhere. While dealers do look to hedge against this somewhat, in this situation it is quite possible that they will just not be able to deliver on their obligations to you, and may just go bankrupt, leaving you with only your original investment or worse.

How Bullion ETFs Manage Allocations

Because bullion ETFs involve what many consider to be paper bullion, securities based upon bullion in other words, there are many people who think that this sort of bullion trading is in some sense less real or even much less so.

While ETF bullion is non-allocated, as it would simply be too inefficient to allocate the bullion of individual investors, there is actual bullion backing up these shares. Unlike the bullion market in general, bullion ETFs are tightly regulated, and the securities regulations are much more robust than what we see in the gold market, which is hardly regulated at all actually.

The bullion market in general is a good example of why we need regulation, what would happen if banks and other large players in the market were left to call the shots, and this is how we got to what many may consider to be a ridiculous amount of risk involved in the way that non- allocated bullion is handled in general.

This is just one example of the lack of transparency in the bullion market, and these markets to a large degree operate in the dark, where even regulators don’t have that good of a picture about what is really going on behind the scenes.

Every ounce of bullion with ETFs is backed by actual bullion though, and this is a benefit that is more than psychological. While there is still some counterparty risk with ETF bullion, for instance the counterparty needs to remain solvent and conform to the regulatory standards, there is always counterparty risk and there’s always a slight risk that the ETF may fail, but investors will get most of their money back if this happens.

The Speed of ETFs versus the Slowness of Old Fashioned Bullion

There are two main advantages that ETFs have over private ownership of bullion. They are some pretty substantial advantages though, two big thorns in the side of bullion ownership, and ETFs eliminate both problems quite nicely.

Bullion ETFsThe first issue is the time it takes to buy and sell bullion if you are looking to take possession of it. Allocated bullion simply takes time to process orders, whether that means that the bullion will be delivered to you directly or it be assigned to you at a remote storage facility. At a minimum, someone needs to fill your order and allocate your bullion, and if you are having it delivered to you, that takes even longer.

This is not an issue that many bullion investors give much thought to, but it is only because they haven’t considered the alternative, because for so many years there simply was no other alternative.

Now, with ETFs, you can enter and exit bullion positions instantly, with the only lag being how long it takes for your order to reach the market and get filled. ETFs are traded on exchanges like stocks are, and therefore the time it takes to complete an order and hold a position in bullion has been reduced from days to a few seconds.

This is obviously a huge advantage if you’re looking to hold bullion for shorter periods of time, as you can trade bullion with ETFs the same way that you can trade other securities, and you can be in a position for only minutes or even seconds if you desire.

Longer term traders may think that none of this should matter to them, but anytime there is a market lag like this, this involves more than removing the ability to close your bullion positions quickly.

The lag involved with taking delivery and delivering bullion also gets priced in to the purchase and sale, because this lag represents a real risk to dealers. If they are quoting you a certain price to buy your bullion, they know that the price they will get will be set later, as they don’t have the bullion yet to sell. This especially can be an issue when the price is moving a lot.

It’s not that there isn’t a lag with ETFs, as they will add or remove from their inventory as the market dictates, in a timely way. However, with ETFs you are buying shares in the fund, and own a certain percentage of the inventory they already have, so any lag in their managing their inventory will have much less of an effect on you.

By reducing the length of time that it takes to enter and exit bullion positions, bullion ETFs have truly brought bullion ownership into the 21st Century, combining the benefits of real bullion ownership with the utter speed of electronic trading. Bullion markets can move pretty quickly, and now we have a means to completely keep up.

Bullion ETFs are Also Far More Efficient

The biggest drawback, by far, to private bullion trading is the huge spreads that you will pay your broker to buy and sell bullion. This is simply due to just how inefficient it is to buy and sell smaller amounts of physical bullion.

Dealers mark up the price of bullion very significantly over the spot market, as they do have to make a profit, and smaller orders, the ones that private investors make, do require a certain markup per order.

If, for instance, you bought an ounce of gold and then sold it back, you would be out as much as a couple hundred dollars or even more in some cases due to the spread. The price of your investment needs to rise by the amount of this spread, plus any other costs involved, including delivery, storage, and insurance, before you break even.

Even if you hold your bullion for many years, you are always going to be out the spread, and if the spread is $200 an ounce, it will cost you that much for the trade even decades later.

Having to make 20% or 30% to break even on an investment is not an exciting prospect. This serves to limit the ways that bullion can be used as both an investment and a hedge, as this commits the investor to a fairly long period and it also makes hedging with bullion considerably less attractive due to the added losses of the spread.

Bullion ETFs, on the other hand, enjoy huge economies of scale, and the spreads that they offer traders and investors are a small fraction of what you could get buying and selling bullion on your own. Large bullion ETFs combine the buying power of a Warren Buffet or a large investment bank with the speed of electronic trading, which should be something that bullion investors should find very appealing indeed.

Instead of spreads with gold of a couple hundred dollars for instance, with gold ETFs, the spread becomes reduced to under a dollar, a very significant difference indeed.

The difference in these spreads will remain regardless of how long the investment is held, and this does impact one’s profit and loss on a trade significantly, where the ETF trader will always be up the difference in the spread over the traditional private bullion investor.

Buying and selling physical bullion has been around for thousands of years, although it’s only in the last few years that the process has been made far more efficient with the advent of bullion pools offered by way of ETFs.

Bullion ETFs represent a huge leap in the way we buy precious metals, and while many people still prefer to buy and sell bullion on their own, the sheer advantages of bullion ETFs are not to be taken lightly.


Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: monica@marketreview.com

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