The ultimate characteristic of gold as a financial asset, and one that no other financial asset can replicate, is that it is nobody else's liability. But that unique characteristic is elusive, as it applies only to physical gold in the effective and immediate possession of the holder. Smart investors and some central banks (mostly the major holders, among which the US) hold their gold directly in their vaults.
Any other form of gold holding, including so called "allocated gold" is merely a claim on gold held by a third party. As such, it loses the unique property of gold as a financial asset, that of being nobody else's liability. Holding gold in somebody else's vault is holding a paper promise by that somebody to deliver your gold.
There is therefore a difference in nature between "real gold" and "paper gold". Only physical gold is a safe haven. Paper gold is just another risk asset.
The market has only differentiated so far between both in a somewhat subtle way: gold delivered in Asia commands a premium linked to the direct possession of the metal. This premium remains modest (a few cents to a few dollars), but its existence expresses the fact that the prices of "real gold" and "paper gold" can diverge. Whereas this divergence remains minimal, its existence opens up the possibility of a disconnect between the two that would severely disappoint gold investors holding the paper variety.
What are the investment implications of this dichotomy? This opens up the door to a whole set of trades: One can take a position for a widening of the premium between physical gold and paper gold, irrespective of the direction of gold prices. But most importantly, differentiating between real gold and paper gold allows to better understand the gold market as gold acts alternatively as safe haven and risk asset. The following chart (from Yahoo Finance) shows how gold prices diverged from stock prices in the summer of 2011 (Safe haven) while they moved in sync with stocks ever since (Risk asset).
(click to enlarge)
This differentiation allows to position a portfolio for a recognition by the market of this difference between physical and paper gold.
That concretely implies a long position in physical gold offset by an offsetting short position in paper gold. Sounds like a schizophrenic trade? Let's review the rationales:
From a portfolio allocation standpoint, it is a fact that a given allocation to physical gold provides the benefits of diversification, even if less so in times where gold trades as a risk asset. More importantly, physical gold acts in all cases as an "out of the money" option against financial Armageddon.
This justifies the long position on physical gold.
The problem is the pricing of that option. As a protection against doomsday, that option is difficult to price as, on the one hand, it will (should it get "in the money" as a result of a widespread financial collapse) provide enormous benefits since, in an extreme scenario, physical gold in the direct holder's safe possession would be the single asset of last resort, with an attendant explosion of its price.
On the other hand, the probability of this extreme scenario coming to pass is very slim in the foreseeable future as central banks and fiscal authorities have developed their risk management capabilities, as they got more familiar with the forms taken by the Great Financial Crisis threats.
Furthermore, in their current trading range, gold prices anticipate either a high probability of financial Armageddon or a soon to happen dramatic increase in the level of inflation: gold prices have moved from $20.64 at the time of the gold standard (1913) to $1600 so a gold price inflation of 7700% while the CPI accumulated inflation over the same period is 2200%. Gold prices overstate CPI inflation by a factor of 3.5, and that is the current price of the out of the money option covering financial Armageddon.
This would justify the short position on paper-gold.
A pure "basis trade", namely physical vs. paper-gold implies an equivalent amount of physical gold holding offsetting the full short position on paper-gold. For example, a short position on the CME gold futures market (GC contract) would imply ownership of 100 oz. of physical gold, as this is the notional value of the future contract.
But this trade can be flexibly tailored to the particular expectations of each investor:
The pure basis trader in the position described above has no specific expectation (and hence no exposure) to the level of gold prices. His P&L will only be impacted by the moves of the premium between physical gold and paper gold. If, as assumed, financial distress increases that premium, the investor will benefit from the soaring prices of physical gold, while the price of paper-gold (of which he is short) are unlikely to rise as much since paper-gold provides no protection in that scenario (or a very weak one, conditional on the capacity and willingness of the issuer to deliver on a promise of dollar compensation, not a promise of physical gold): the holder may cross borders and buy necessities with ounces in his possession, but carrying evidence of possession of Gold ETFs or of a gold futures contract is unlikely to help.
The trader who feels that the current pricing of the "Armageddon option" is entirely justified can simply open a long position on physical gold, with no offsetting short position on paper-gold. This is in fact the position of gold bulls, who consider that the 3.5 times overstatement of accumulated inflation in current gold prices is the right price for the said option. The cost of this outright long position is of course that the P&L will bear the brunt of any gold price downturn.
Finally, the investor who feels that the Armageddon option is overpriced can simply open a short position on paper-gold and wait for gold prices to correct before acquiring physical gold. The cost here will be the risk of loss if gold price rises.
These three cases are only three discrete options for a trade that comprises an infinity of long physical gold-short paper gold positions tailored to the exact preferences and expectations of the respective investors: one can adjust the short paper gold position to any proportion of the long physical gold position, from 0% to 100%.
How to put this trade in practice?
Real gold: First and foremost, any portfolio should hold some directly accessible physical safe-haven gold. How much is a matter of judgment, but 5 to 10% is an oft-quoted range. This share is not designed for trading; it is an asset allocation decision. As such it is not price sensitive and should be held to through thick and thin.
Paper gold: If and when the gold holder feels that prices are likely to adjust downward as gold trades as a risk-asset, paper gold can be sold short using ETFs (GLD comes to mind) or, if the brokerage account allows access to futures contracts, future contracts can be sold. As mentioned, one CME future contract is equivalent to 100 oz., so this implies a significant physical holding to offset it.
To summarize:
Physical gold, as the single financial asset that is no one else's liability, benefits both from the risk-asset qualities and of the safe haven one.
Paper gold is just one more IOU and as such is a risk asset but not a safe haven.
Currently, their price differs very marginally (Asian premium). Should financial strains worsen, that difference in nature between both assets is bound to widen the price difference to the benefit of the physical, hence the attraction of the basis trade above: long physical, short paper.
The advent of paper-gold has opened up gold investment to a new class of investors. This has led to a run-up of gold prices, which now price the Armageddon option very richly. The above trade allows taking a position on the price of that Armageddon option from a full long (long physical, no paper-gold short) to a full short (short paper-gold, no physical long) and all intermediate stages where the long physical position is only partially offset by the short paper-gold.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long physical gold and short gold futures
