Years of reading and thinking about this issue and actually investing in both shiny gold bullion and paper/digital gold has given me the following perspective: If you are a long term (read 10+ years) investor looking for a secure hedge against market volatility, buying physical gold beats buying gold ETFs overall.
Some considerations in buying physical gold are management fees in buying ETFs versus storing costs with physical gold, coin or bullion. If you buy an ETF like SPDR Gold Trust (GLD), you lose about .40% of the value of your investment every year in management fees. If you buy physical gold, there are three principle associated costs - storage, insurance, and transportation. Insurance is dependent on the volume of gold you own; however, both storage and transportation costs are less dependent on minor changes in volume.
On the other hand, ETF management fee is totally dependent on volume/value. From an optimization point of view, if you are buying gold long term, in large volumes, and you plan to keep on adding to that volume in good quantities, both storage and transportation costs will go down on a per unit basis. As for insurance, many people will consider paying a few dollars today worth more than nothing when the next MF Global crisis occurs.
In that crisis, the CEO of MF Global, Jon Corzine, and other senior management literally defrauded MF Global customers of hundreds of millions of dollars by investing that money in loss-making European bonds and then using customer money without permission to cover liquidity shortfalls. People who purchased gold futures through MF Global's brokerage arm lost almost all their money because brokerages are required only to store 5% of the total gold in trust as physical gold. So when a brokerage commits fraud and goes bankrupt, you end up becoming just another creditor doing the bankruptcy court circuit. The same thing can happen if, for example, you are invested in a gold ETF that uses a broker who defrauds the company.
Gold is a hedge against the stock market. ETF is part of the stock market. You cannot hedge on an entity by betting on it - you have to get as far away from that entity if you want a good enough hedge. That is the bottom line.
Think once again why people want to invest in gold. As we have shown before, gold is negatively correlated to the stock market, the dollar, and the economy in general. If the stock market goes south, all your paper investments will become just that - paper. This is why you want to have something tangible, something that has intrinsic value (unlike paper, whose value is derived from some underlying asset). In certain land-deficient countries and regions of the world, land is a good hedge; however, gold is a good hedge in any country, at any time. What is more, it is more liquid than land, too, and you can carry it around. It can be relatively easily liquidated anywhere in the world, and can even be used as currency in many situations.
Gold that you store privately - assuming that is possible for you to do that securely - has low to none reporting requirements, although you do have to pay capital gains tax if you are selling it. However, taxes, security and holding costs aside, for a long term investor looking for a hedge to the portfolio, physical gold is the ultimate solution.
ETFs, on the other hand, are better for short term investors wanting to invest in gold. Since they work just like stocks, they are very, very liquid, easy to buy and sell, have zero storage and security problems, and convenient in many ways. However, here is the thing: why would you, a short term investor (less than a year investment period), want to invest in a Gold ETF when there are so many blue chip, dividend yielding, high growth-potential stocks that you can invest in for better returns in the short term?
The reasoning is simple: as far as I understand, there is absolutely no need to invest in a gold ETF in a booming economy. You can get much better results researching a few high grade stocks like Apple (AAPL) or a dividend yielding stock like Verizon (VZ) and investing in them. If you close your position in less than a year, and you keep a constant eye on your investment, then, unless you are really unlucky, you simply cannot lose. While a gold ETF will follow the market (and there will be no dividends), many of the better stocks will beat the market. Take a look at these charts.
However, this chart also tells us another thing. GLD is more or less steady; it doesn't rise sharply, nor does it fall sharply. There cannot be negative news about Gold, there can't be a poor product launch, or death of a founder, or a lost lawsuit - unlike Apple, Gold and its ETF are both steady things. As such, they are better as hedge than any stock, even Apple. To understand that, see the zoomed in graph below.
Striking, isn't this? Starting at around the same levels last month, GLD fell 4% while Apple fell 11%. This is the story, in general, in a downturn economy. Mighty stocks will fall, but Gold will not fall as much. In fact, the above illustration does not really underscore the basic idea behind gold that I have discussed elsewhere; Gold will actually do better than the market in a downturn economy.
To sum up everything discussed here, here's what we want to do:
- Physical Gold - if you are a long term investor, especially someone with no appetite for high risk, looking to invest a substantial amount of money in Gold, buy physical gold.
- Gold ETFs - if you are a short term investor, can keep a close watch on your portfolio, and if the economy is going south but you think it will recover in a year or less, go for Gold ETFs. Gold ETFs will hedge you against a short term downturn in the economy without the headache and costs of buying and storing physical gold.
- Stocks - in the short term, in a booming economy that you are absolutely sure will hold steady during your investing period, and where you are closely monitoring your portfolio performance and are ready to liquidate at the hint of trouble, there is nothing like investing in good stocks.
This is a broad subject with many people on both sides of the fence, and I know I haven't covered everyone's position or arguments in this brief study. Let's do that in the discussion board below.