6 Reasons Why I Fled Commodity ETFs And You Should Too

Includes: GLD, PALL, PPLT, SLV
by: Mike Burns

OK, I get it. I really do. You and I both believe that all of the money printing, QE, race to the bottom will produce too much money chasing too few goods. We both lived through the Nixon-Carter years and know the pain of inflation. Uncle Ben Bernanke comes from a previous generation, and is bent on preventing a repeat of the Great Depression. He is an intelligent man, a true scholar, but his zeal to prevent deflation at any price blinds him to the dangers of going too far the other way, and therefore we're doomed to relive the stagflation of the mid to late 1970s.

During the stagflation of 35 years ago, stock P/E ratios were halved, or worse. Holding stocks was economic suicide because earnings shrank while inflation continually eroded even the principle. So you look around for something of enduring value to weather the gathering storm. Holding real goods, precious metals, oil, or real estate seems like it could at least keep even with inflation. Commodity ETFs give the protection of owning real "stuff" coupled with the liquidity and ease of trading online that comes with stocks.

I too have owned commodity ETFs for about 6 years now, and have enjoyed the run-up, though it was choppy at times. Recently I sold off all of my commodity ETFs in favor of miners and other investments. The latter investments still give me exposure to commodities, since they sell on the spot and futures markets, but without the drawbacks that I outline below.

1. Commodity ETFs pay no dividends

This is the chief criticism that Warren Buffett uses when dismissing GLD and the other ETFs. Though to be fair, Mr. Buffet and company also have, as one of their chief tenets, to preserve capital. Most buyers of these instruments aren't looking for the next Google or Microsoft, but rather want to come out of the inflation years with some capital remaining in order to buy the bargains after stocks get beaten down.

2. Management fees mean that you will fall behind inflation

Even if you own an ETF based on a commodity that you think will keep even with inflation, the management fees will insure that you slowly lose a portion of your capital. Currently, management fees are around half a percent for GLD and SLV, two popular commodity ETFs. This might seem small, and is almost certainly less than inflation, but it is still significant over a 10-20 year time horizon.

3. Tax consequences are worse for commodity ETFs than for stocks

Commodity ETFs are bizarrely labeled "collectibles" by the IRS, which means that gains are treated like ordinary income, so at about a 25-35% marginal tax rate in the U.S. For stocks the capital gains tax rates apply, which means a tax rate of 15%, nearly half the rate at which commodity ETFs are taxed.

4. There are hidden counterparty risks

Some of the gold in GLD is loaned out or leased to other parties, in order to help generate more fees to cover the cost of storage and accounting. How much do we know about the counterparties and their trustworthiness? As it turns out, this aspect of the commodity funds is quite opaque and therefore potentially risky.

5. Big banks are short and can effortlessly go even shorter

Also, there is growing divergence between the paper gold or silver markets and the physical markets. If other people lose faith in the paper commodities (GLD, SLV, PPLT, PALL) then it is quite possible for the physical commodity to continue to increase in value as the corresponding ETF decreases in value.

On Friday morning, April 19, 2013, about 100 tons of gold flooded the Comex exchange. There is some evidence that it was done with the intention of driving down prices. Had the seller wanted to get the best price for his gold, it would have been sold in smaller increments over a larger time. But instead the seller (rumored to be Merrill Lynch) sold it in a huge chunk, probably to trigger as many stop-loss orders as possible. Then again 2 hours later, another 300 tons of gold was sold. These were apparently naked shorts, in effect creating the paper gold contracts out of thin air. The curious thing is that there was no SEC investigation. Maybe the seller had U.S. government backing or approval.

6. The U.S. government has the incentive and the means to cause a stampeded out of the commodity ETFs.

Desperate times call for desperate actions, at least that's the excuse often used by those in power when they want to victimize the less powerful. In 1933, Roosevelt confiscated all of the gold, in preparation for a large dollar devaluation. Currently, Ben Bernanke is rolling out one new quantitative easing after another in hopes of reviving a sluggish economy. When all of the dollars thus created start to have a higher "velocity of money," inflation could result.

Rather than admit that bad policies have caused inflation, governments throughout history have sought to blame others. Hitler and Staling blamed Jews, bankers and speculators. In the 1970s Nixon and Carter blamed big business greed for raising prices. More recently, Greek prime minister Papandreou blamed speculators for Greece's economic problems, which were actually the results of bad government policy.

When inflation comes to the U.S., it's a safe bet that there will be no mea culpa from Bernanke, Geithner and Obama. Rather they will have their careful talking points and find a suitable scapegoat. A convenient scapegoat would be speculators and hoarders, i.e. the large commodity ETFs. It would be simple enough to engineer a mass-exodus from the ETFs. For example, the tax treatment could be changed to a tax rate of 50% or 80%, whatever it would take. This would make the ETFs far less attractive to own, and so in the short term many people would run for the door, trying to get out of the ETFs before other people. All of the commodities backing the ETFs would hit the market in a short time, greatly driving down prices for those commodities. While the drop might be temporary, it would still serve the purpose of deflecting blame, and the holders of the commodity ETFs would be sacrificed.


Sometimes knowing what not to do is half the battle. If you can avoid making a big mistake then your other choices are put more clearly into perspective. In this case, there appear to be huge risks in owning the commodity ETFs. Many people would like to get protection from possible inflation, but these instruments are not a good choice. Better would be one of the large mining stocks, of which there are many to choose from.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.