Commodities Trades Usually Don’t Require Physical Delivery
These deals function much like contracts for difference in the futures market, where you may buy a contract for, say, 100,000 gallons of gasoline with the intent on selling it later at a profit, or at a loss if need be. You’re never planning on taking delivery of all that gasoline, or all those live hogs, or whatever commodity you’re trading, and the same is true with a lot of bullion trades.
Of course, some participants in the commodities market do intend on taking possession or delivering the physical commodities, but these days most futures or forward contracts involving commodity transactions settle for cash anyway, and then you can take the money and buy whatever you want, including all that gas or all those hogs.
If you’re selling the gasoline, you get the difference and can still sell what you have on the spot market and get a lower price than the contract provided for, and the profit from the contract will make up the difference. If you came out on the wrong end of things at the expiration of the contract, you bought yourself some insurance that you didn’t need and just sell your product for the higher price, with the higher price you get covering what was lost on the deal.
So, this functions the same way as if the physical commodity changed hands, even though it did not, but as long as the spot market still exists, and it must if there’s a futures market for a commodity, it’s just easier and simpler to settle these contracts for cash, with only the difference in cash changing hands.
The same principle applies to bullion trading, at least when it comes to speculation. If one is using bullion as a hedge, this can also work very well, although this won’t hedge against economic collapse. Paper bullion in this case may not be worth the paper that it is written on, as they say.
The Appeal of Possessing Bullion
There’s also a special appeal about holding bullion in your hand, aside from the physical appeal they have. This is what draws so many people to buy the bars and coins. Gold in particular is very portable and packs a lot of punch per unit of weight, given that an ounce of it is worth over $1300 at the time of this writing. A million dollars would weigh less than 50 pounds and not take up much storage space.
You can put a lot of gold in a modestly sized safety deposit box. People may also choose to keep bullion at home in a secure safe, although in this case you definitely should consider insuring it against loss, but policies can be usually bought to protect against this.
Buying physical bullion as opposed to investing in it by other means does involve additional costs. There is of course the dealer markup, which is usually fairly modest compared to the markup retail dealers usually use, but it’s still a meaningful amount.
Buying physical bullion is therefore not very suitable if you’re just looking to speculate on it, as there will be a significant spread between what you will pay for the bullion and what you would get if you sold it. It’s nice to know that you can indeed sell it back to the dealer, or elsewhere, but don’t expect thin spreads, because this is how they make their money.
There are other costs involved, such as delivery charges if you have it sent to you, and insurance and storage charges whether or not you take delivery or if it is stored for you. Allocated bullion does cost more because it has to be bought and stored, where unallocated bullion does not involve as much cost, since no one holds it and it’s basically just paper trading.
Buying ETFs Based Upon Bullion
Another popular way to hold bullion based assets is to buy exchange traded funds, or ETFs, that either invest in or track bullion. This is becoming more and more popular among individual investors as they become more aware of the benefits of ETFs.
ETFs are bought and sold like shares are, on exchanges, and this is where the exchange part of their name comes from. People can buy and sell these online from a personal trading account the same way they can buy stock in companies on the stock market. This makes bullion investing much more convenient than actually going out and buying and selling bullion.
The real appeal of bullion based ETFs, and ETFs in general, is the higher level of liquidity they provide over physical bullion trading, whether allocated or unallocated. You buy and sell shares of these funds, which may hold the bullion or they may not, depending on the ETF. There are synthetic ETFs which may just track the price of a precious metal such as gold, and never actually buy it.
The idea here though is that the value of the shares is set up to track the value of the underlying precious metal, using financial derivatives called swaps. The fund will contract with a bullion provider, usually a bank, to provide a certain amount of bullion on demand, so that the fund never really has to take delivery of any bullion, and this is where the synthetic component of the fund comes from.
Synthetic ETFs allow for more efficiency, although they do involve more risk as well, the risk tha the counterparty, whomever is supposed to deliver the bullion, ends up not being able to perform. The risk here is pretty low though and these ETFs are seen by many as a benefit overall to asset based ETFs due to the lower management costs with synthetic funds.
There are ETFs that do trade in physical bullion, although there’s no real reason to ever possess the metals, and even in these cases, someone owes them the bullion, in other words, it is generally unallocated. Most bullion is unallocated these days though and that’s no reason for investors to become concerned.
It’s Really Just a Matter of Preference
In a real sense, virtually all bullion trading is synthetic, it’s just that the investments labelled synthetic are more up front about it, rather than leading people to believe that there is bullion with their name on it being held in some vault somewhere, waiting for them to sell it. This is simply not an efficient way to trade bullion though, even though, for an additional cost and a corresponding loss of liquidity, allocated bullion can be bought and sold, where it is actually held in vaults and stamped to signify its owner.
One can choose the most illiquid and expensive form of bullion trading, taking delivery of physical bullion, and provided one is willing to pay the price of increased costs and increased difficulty of selling it, and prefers this over just logging into one’s trading account and buying and selling ETFs, then that can be a good choice.
ETFs have so many advantages though that it’s no wonder why they have become the most popular way by far to invest in bullion related securities. In a sense, you are buying and selling bullion when you buy an ETF, even though no bullion may ever change hands with the fund.
There’s really not much reason for it too though, and the sophistication of today’s financial markets have really removed the need for this. It’s all about storing money in various things, and bullion has persisted as one of the most popular ways of all time to do this, and there’s no reason why this won’t continue indefinitely, whether in natural or synthetic form.