Commodity ETFs as Proxies for Private Money 14 comments
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Many free market economists lament the abandonment of Bretton Woods (1971 under Nixon), when the U.S. formally stopped promising gold redemption for Federal Reserve notes (U.S. dollars). It’s not that these free market economists particularly love gold, they just want some kind of constraint on the ability of central banks to print money.
As is the case with many things in life, an innovative financial system and technology have come to the rescue of the problem of governments printing too much money, which causes currency debasement and inflation. Do you want a currency backed by gold? There aren’t very many in the world today, but you can buy the streetTracks Gold ETF (GLD), which represents a tenth of an ounce of gold, and you do have the right to redeem your shares for actual gold. Money is supposed to be a medium of exchange and a store of value. With modern technology , you can buy GLD as your store of value and then sell GLD on your Blackberry if you need the medium of exchange (dollars).
Gold/precious metals as the underlying basis for paper currencies do have some inherent problems. The price of gold is determined by supply and demand, like everything else. Improvements in gold mining techniques, the desire of the newly wealthy in India and China to own gold, and central banks decisions to sell off large amounts of their gold reserves, can all affect the price of gold, whether those of us in search of a stable store of value like it or not.
One solution to the problem of one commodity being erratic is to expand the pool of “real terms” (physical assets that hold value) assets you hold. The iPath Crude Oil ETF (OIL) mimics the performance of the price of a barrel of oil in the Futures commodity markets. People today have the option of hedging higher gasoline and heating bills by buying OIL, which will offset their higher energy costs if oil continues to rise.
Other commodity ETFs are springing up like wildflowers in industrial metals and agricultural goods. In the past, a person’s only ability to fight inflation was to buy more real estate and hide gold/silver coins in the basement. Their financial portfolio and liquid wealth were at great risk in times of inflation.
With the wide range of commodity ETFs available today, you can do a fairly effective job maintaining a stable store of value by buying a diversified set of commodity ETFs. I wouldn’t be at all surprised if Wall Street comes up with some clever way to diversify the risk of single commodities and comes up with something akin to Private Money. Maybe Private Money becomes a basket with an ounce of gold, 10 barrels of oil, 100 bushels of wheat, a gigawatt of power, 100 hours of common labor, or some fraction of all these commodities. With Private Money, you could hold a stable store of value in your brokerage account and sell it to obtain your medium of exchange (dollars) when you needed it.
So am I telling you to sell all your Money Market Funds and buy GLD and OIL? Not really. However, an intelligent person can look at their personal situation and reduce the risk of inflation in their lives/retirement by planning their portfolio for the future. I would argue that the government concept of inflation is not really that helpful at the personal level. If you are a retired couple that has paid off your house, you are not really all that affected by housing costs in your area or the country as a whole. You may like to travel and you like to eat out so you do care about the cost of energy and food prices. So maybe you put some commodity ETFs in your portfolio that will go up in value if food and energy prices increase.
There is a downside of losing money if these commodities decline in value in the future. However, if that happens your paper dollars will buy more of what you want and you will still have the result you want, which is stable purchasing power.
As another example of new financial instruments doing hedging, suppose you knew you were going to spend four weeks in Europe a year from now. You could buy $10,000 of the Rydex Euro ETF (FXE) and you would no longer have to worry about the dollar going down against the Euro in terms of your trip.
The concept of Private Money is neither new nor radical. In the 1800s, many banks in the United States issued paper money that was backed by the private banks’ promise to redeem in gold or silver. New financial instruments and technology improvements make the concept of Private Money feasible again. My guess is that if large numbers of people started using these hedging/commodity instruments as private stores of value, it would act as a constraint on the Federal Reserves’ ability to print unlimited amounts of fiat money.
Disclosure: The author does not hold GLD, OIL, or FXE. The author does hold gold mining mutual funds, energy mutual funds, domestic and foreign energy trusts, and Rydex currency etf’s other than the Euro.
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This article has 14 comments:
My name is Mike Moloney and I work for ETF Securities here in London, I just came across your article on the “Bullion Desk” titled “Commodity ETFS as proxies for private money” which I found interesting, I’m not sure how familiar you are with our list of product offerings, but we provide a vast range of ETC’s including ETFS Gold and ETFS Physical gold along with other precious metal ETC’s.
If you would like to find out more about our range of products you can contact me at michael.moloney@etfsec... or alternatively visit our website which is etfsecurities.com.
Kind Regards,
Mike.
This is the author. I looked at your etf offerings and they are incredible. When I wrote the article I wasn't sure how far along agricultural etfs where, but your company is all over that area. So for the gold stuff, how does your company make money? I notice gld is slightly less than the quoted price of gold and they say something about holding back 1%. How does your company make a cut when you buy the gold on the behalf of the etf buyer? Do you try to buy 100% of what people order or is it just a percentage?
tax-free retirement account. There are some fairly onerous US tax implications for buying certain kinds of funds - so-called "PFIC Rules" - which make it best to hold many foreign funds and securites in a tax advantaged account like an IRA. I am not 100% sure that ETFs qualify as PFICs, but if they do, its not advisable to hold them in a taxable account.
Thanks for clarifying. I was going to ask whether Mike's product could be bought by U.S. investors. You make another good point. It's not quite private money (a private corporation selling a "store of value" in competition with gov't central banks) if you have to pay capital gains when your "store of value" works, and goes up in nominal terms. ... Flash
Are you quite sure that shares of GLD can be redeemed for physical gold? If so is the distrubution not taxable, as it should be?
Thanks in advance!
yahoo profiles says "The Trust holds gold, and is expected to issue baskets in exchange for deposits of gold, and to distribute gold in connection with redemption of baskets." although this may have to do with the back end etf clearinghouse function (did more people net/net buy or sell gld etf today) rather than a service for individual investors. I just made a call to streetTracks and they are going to clarify for us.
My answer to your tax question is unequivocably that you redeeming your gold would not be a taxable event. You did not sell your gold to anyone else, you just changed the form you held it in. Then you are in the same boat as all the old gold bugs. You can buy gold coins, and if you sell them you are supposed to pay your gains on them. Disclosure: I am not a tax attorney.
The tax angle that came up in this thread does not obviate the idea of using gld as a store of value. In economics they tell you "inflation is a hidden tax", we have just discovered another form of this problem. If inflation was 50% you would still rather have gains on your commodites than hold paper dollars. But the tax angle is an important one to consider.
... Flash
You can only redeem shares for gold if you are an Authorized Participant, which essentially means if you are a bank a brokerage. As of today's information at the website you would need to own $9,102,967.33 in GLD shares and pay a $2000 fee and be an AP in order to redeem GLD shares in gold.
The taxation of GLD capital gains, if any, is quite onerous under US Federal taxes: 28% regardless of time held or dollar value of the gain. (see below)There are also some restrictions on US tax-deferred retirement funds holding GLD. (see below)
All of these same taxation issues would also apply to CEF plus the addition of some Canadian issues.
I do not own either or these securities. I prefer to own actual gold or to own it in paper form in etf's which hold unleveraged gold futures contracts which are taxed much more favorably for US investors and have none of the potential difficulties for tax-deferred US retirement plans. DB has some of such funds. I do not own any of those funds although I may do so in future.
As always, one should read *and understand* the prospectus before buying anything.
The Shares may only be redeemed by or through an Authorized Participant and only in Baskets.
======================...
Per Basket Information: As of 05/21/2008 NAV Per Basket $9,102,967.33 NAV (in gold oz) Per Basket 9,862.37
======================...
Creation and Redemption of Shares
Authorized Participants are the only persons that may place orders to create and redeem Baskets. Authorized
Participants must be (1) registered broker-dealers or other securities market participants, such as banks and
other financial institutions, which are not required to register as broker-dealers to engage in securities
transactions, and (2) DTC Participants. To become an Authorized Participant, a person must enter into a
Participant Agreement with the Sponsor and the Trustee. The Participant Agreement provides the procedures for
the creation and redemption of Baskets and for the delivery of the gold and any cash required for such creations
and redemptions. The Participant Agreement and the related procedures attached thereto may be amended by
the Trustee and the Sponsor, without the consent of any Shareholder or Authorized Participant. Authorized
Participants pay a transaction fee of $2,000 to the Trustee for each order they place to create or redeem one or
more Baskets. Authorized Participants who make deposits with the Trust in exchange for Baskets receive no
fees, commissions or other form of compensation or inducement of any kind from either the Sponsor or the
Trust, and no such person has any obligation or responsibility to the Sponsor or the Trust to effect any sale or
resale of Shares.
======================...
MAXIMUM 28% LONG-TERM CAPITAL GAINS TAX RATE FOR US SHAREHOLDERS WHO ARE
INDIVIDUALS
Under current law, gains recognized by individuals from the sale of ‘‘collectibles,’’ including gold bullion, held
for more than one year are taxed at a maximum rate of 28%, rather than the 15% rate applicable to most other
long-term capital gains. For these purposes, gain recognized by an individual upon the sale of an interest in a
trust that holds collectibles is treated as gain recognized on the sale of collectibles, to the extent that the gain is
attributable to unrealized appreciation in value of the collectibles held by the trust. Therefore, any gain
recognized by an individual US Shareholder attributable to a sale of Shares held for more than one year, or
attributable to the Trust’s sale of any gold bullion which the Shareholder is treated (through its ownership of
Shares) as having held for more than one year, generally will be taxed at a maximum rate of 28%. The tax rates
for capital gains recognized upon the sale of assets held by an individual US Shareholder for one year or less or
by a taxpayer other than an individual US taxpayer are generally the same as those at which ordinary income is
taxed.
======================...
INVESTMENT BY CERTAIN RETIREMENT PLANS
Code section 408(m) provides that the acquisition of a ‘‘collectible’’ by an individual retirement account, or IRA,
or a participant-directed account maintained under any plan that is tax-qualified under Code section 401(a) is
treated as a taxable distribution from the account to the owner of the IRA, or to the participant for whom the
plan account is maintained, of an amount equal to the cost to the account of acquiring the collectible. The
Sponsor has received a private letter ruling from the IRS to the effect that a purchase of Shares by an IRA, or by
a participant-directed account under a Code section 401(a) plan, will not be treated as resulting in a taxable
distribution to the IRA owner or plan participant under Code section 408(m). However, if any of the Shares so
purchased are distributed from the IRA or plan account to the IRA owner or plan participant, or if any gold
received by such IRA or plan account upon the redemption of any of the Shares purchased by it is distributed to
the IRA owner or plan participant, the Shares or gold so distributed will be subject to federal income tax in the
year of distribution, to the extent provided under the applicable provisions of Code section 408(d) or Code
section 402. See also ‘‘ERISA and Related Considerations.’’
Perhaps the sponsors of GLD (and other commodity-holding ETFs, and some of the other commodity-linked ETFs, such as DBC) may have received a private letter ruling that transactions involving their marketed shares (not the creation units) aren't considered to be "Holding" of collectible commodities in a tax sheltered environment...BUT - if the originator of the index issues a K-1 to the IRA's owner via the account # of the IRA, and if the K-1 has a sum of >$1000, in section 20, code V (Unrelated Busines Taxable Income) then the tax-sheltered account must pay federal tax on that income (form 990t) or file a form 920t to show why its tax exempt staus should not be revoked.
What are the risks?.
The K-1 comes months after the 1099R from the brokerage; it is issued by the company that actually does the trading (Deutsche-Bank, not Powershares); it is possible that some or many commodity-linked ETFs will accumulate UBTI for an individual's sheltered accounts in excess of $1000.00 across all of the sheltered accounts for that individual; the payment of federal tax must be made by the IRA, not the individual, otherwise it will be deemed "an excess" or "delayed and disqualified excess contribution".
The same is true for GrantorTrusts, such as DBA, and for Publically Traded Partnerships, (and for these, the tax benefits of return of capital vs dividends, tax-loss carryforwards, etc., available in taxable accounts, are useless in tax-sheltered accounts, particularly for standard IRA's). The section 20 V on the K-1 is a hazard that can disqualify the tax shelter.
I wrote a comment in an earlier posting about the K-1 hazards for tax-sheltered accounts; particularly for the securities that already have a tax-shelter registration number, such as a PTP, and the IRS doesn't want to know that the commodity, or futures, or PTP had all kinds of income or costs in the IRA...only that UBTI is a serious hazard, particularly as it is reported later than a 1099, and directly from the index maker, not the brokerage, when it is too late to pay the Federal Tax on the IRA's UBTI, from the IRA's earnings or cash!.
thanks for the detailed and extremely informed tax information. I guess the rest of us just look at these etf's as something we can buy, but clearly it's more complicated than that.
deuxsous,
your research was great. I haven't heard from streetTracks yet but clearly I need to say now that retail investors can't redeem gld stock certificates for physical gold. I agree with your points that an investor who wants the benefits of gold should look at a lot of different options of how to hold. This wasn't meant to be a goldbug, "gold is the only store of value over time" kind of article. What I was pointing out was that commodity etf's together with technology have created something that looks very close to what used to be paper money backed by gold redemption.
You wrote: "Perhaps the sponsors of GLD (and other commodity-holding ETFs, and some of the other commodity-linked ETFs, such as DBC) may have received a private letter ruling that transactions involving their marketed shares (not the creation units) aren't considered to be "Holding" of collectible commodities in a tax sheltered environment..."
GLD says they did get a private letter OK from the IRS, and DBC and others feel they qualify on the UBTI issue. But I agree with you that people shouldn't rush off into the US collectables and UBTI tax thicket without some thought and expertise.
In general I think people will do well to buy small gold bars and/or gold eagles and keep them (insured) in a bank vault and buy "blue" chip golds and very selective ETF's if needed.
For Flash: thanks for your remarks!
In an environment like this, who blames anyone for buying instead something useful and in short supply (food, energy) and of course storing value the old fashioned way with Precious Metals?
For holders of USD the answer seems obvious: get out of dollars.
good words. it goes without saying we would all prefer a central bank with a primary goal of a paper currency that maintains its value over time. but with congress/pres deficit spending, everyone 2nd guessing the fed any time the slightest thing goes wrong in the economy none of us can be sure we'd do a better job as fed reserve chairman.
... Flash
In writing this article I got caught up in the similarities between a Gold ETF and fiat money that was backed by gold or silver. What I missed is that a Gold ETF is an investment and you have to pay gains on it if you sell it at a profit, a Gold ETF is clearly not simple money. Money as a store of value is best understood by an example. Say you work hard in a given year, pay your taxes, and have $5000 left over and you want to take a domestic vacation a year later. The store of value means you will be able to buy as much vacation a year later as you did in the year you earned the money. So if you sell your $5000 of Gold ETF a year later and gold went up, you have a taxable gain, which is different than what would happen if you lived in a perfect world of stable paper currency that gave you the same $5000 a year after you earned it.
D_teller above makes some excellent comments about the tax implications of selling Gold ETF’s above and for those of us who don’t work with taxes for a living, I am going to try to Cliff Note some of his important points. One way to avoid taxable events is to hold the asset in an IRA, so maybe you hold some Gold ETF’s in an IRA, use after tax money for your spending, and your entire portfolio position is stable because you successfully held some Gold assets that hedged against inflation. The IRS considers gold coins as “collectibles” and only a few gold coins like the American Eagle qualify to be held in an IRA. Some of the Gold ETF’s are so transparent that they are considered collectibles. I think d_teller was questioning whether the IRS would consider some Gold ETF’s as eligible to be held in an IRA. Here I would just say that if Schwab or Fidelity lets you buy Gold ETF’s in your IRA, I would just do that and let Schwab and Fidelity worry about the high level tax implications.
Another issue came up about redeeming your shares for real gold. streetTrack (GLD) will not redeem gold for retail investors, for large amounts they will redeem gold for banking institutions like Schwab and Fidelity. The main point about redemption is to make sure that the etf you bought is really holding gold and not vacationing in the Bahamas with your money. The fact that there is any redemption is good, even if you personally can’t redeem. I have heard impressive things about streetTracks in terms of the care they take to hold real gold on your behalf. So just like in the days of money issued by private banks, the reputation of the issuer is monitored and needs to be monitored.