How safe are gold ETFs?

Gold is a hot commodity again. The price of bullion has jumped by more than US$100 an ounce in the past 30 days, fuelled by the new round of quantitative easing announced earlier this month by the Federal Reserve Board.

That has prompted a number of reader questions about how to buy gold and the safest way to do it. Here’s one:

“In the past you have recommended the iShares Gold Bullion Fund (TSX: CGL) and mentioned the Royal Canadian Mint’s gold bullion ETR (TSX: MNT) as instruments to own physical gold. I have been slowly buying both of these to increase my portfolio’s exposure in this area. I was wondering what your thoughts were on the difference between these two funds with regard to investment strategy, e.g., relative risk/security, which to sell first when the time comes, etc.” – Don M.

Both these funds are inexpensive ways to own bullion and both do much the same thing: they acquire physical gold and hold it in vaults for the benefit of investors. There is no active management and no distributions. MNT keeps its gold in the Royal Canadian Mint while the iShares ETF stores it in the vaults of ScotiaMocatta, a division of the Bank of Nova Scotia.

Is one safer than the other? From the point of view of return on investment, both will react in much the same way depending on whether the price of bullion rises or falls.

But what about physical risk — the possibility that something might happen to the gold bars that form the basis for your investment? Back in 2009 the Mint was embarrassed by the news that $15 million worth of gold bars had gone missing and called in the RCMP to investigate. In the end, it turned out there was no theft, only some bad accounting and processing losses in the chlorination baths. But it raised the issue of what might happen if a Hollywood-style raid on the Mint resulted in the genuine loss of a lot of gold.

On its website at www.reserves.mint.ca the Mint says it “bears all risk of physical loss, damage, or destruction of gold bullion in the Mint’s care, custody, and control (regardless of culpability by the Mint) except in the case of circumstances beyond the Mint’s reasonable control” (my italics).

In the information statement put out at the time MNT was launched, the Mint said that the gold backing the ETR “will be unallocated within the general supply of physical gold within the Mint’s refinery and production operations”. In other words, you don’t own a share of a specific gold bar. It went on to say: “In the event that any of the gold held by the Mint on an unallocated basis is subject to non-compensable loss, damage, or destruction, all owners of such unallocated gold, including both ETR Holders and non-ETR Holders, will be subjected to such loss on a pro rata basis.”

The iShares ETF stores its gold in the vaults of ScotiaMocatta, which seems about as safe as the Mint. But many people don’t realize that several tons of gold and other precious metals were stored below Four World Trade Center in New York on 9/11. According to the official report, all of it was eventually recovered but conspiracy theorists insist that hundreds of millions of dollars worth of bullion went missing and has never been found. Some have even gone so far as to suggest that the attacks were intended to be a diversion for a massive heist. That’s absurd, but some people are willing to believe anything.

Oliver McMahon, head of product management for iShares Canada, says ETF investors would be protected by insurance if anything similar should happen here. However, he acknowledges that all insurance policies have some exclusions such as Acts of War and Acts of God. Of course, if something cataclysmic should happen, other worries would have a higher priority in the minds of most people than the value of their ETFs.

So from a safety perspective, there does not seem to be much to choose between the two. From a cost point of view, MNT has an annual service fee of 0.35 per cent while CGL is more expensive with a management fee of 0.5 per cent and an MER of 0.55 per cent. Since both hold only gold bullion, in theory the only difference in their performance should be the MER differential. On that basis, an investor who holds both and wants to sell off one should start with CGL.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go here.