http://www.zerohedge.com/contributed/2012-09-20/gld-tlt-exploring-dark-side-exchange-traded-funds-etfs-capital-account
Submitted by EB on 09/20/2012 12:14 -0400
GLD & TLT: Exploring the Dark Side of Exchange Traded Funds (ETFs) With Lauren Lyster at Capital Account
Submitted by Bob English (EB) of EconomicPolicyJournal.com
Exchange Traded Funds (ETFs) have become as ubiquitous to investor portfolios, including retirement accounts, as their cousins in the mainstay mutual fund universe. Yet, few are apprised of the differences between these two asset classes. ETFs often have lower costs, are more tax efficient, and can be shorted (much to the delight of Mr. Chanos), while mutual funds may offer greater investor protections under the Investment Company Act of 1940. The latter is a subtle point worth exploring because, as the the half life for the next Fed-induced bubble happily converges with the six month mark on Mr. Bernanke's QE3, these things never matter...until they do (which is when the inevitable Fed brakes foment a crisis).
With the help of the host and producers at RT Network's Capital Account, we will explore just what can (and if one believes in such platitudes as Murphy's Law, will) go wrong when the next BearStearnsLehman cluster occurs, with particular attention to the world's largest gold ETF, GLD (thanks to Ms. Lyster) and the world's "safest" U.S. long bond ETF, TLT.
From Capital Account:
[If embed does not work, click here: http://youtu.be/l36wa9fZEZk]
The partial transcript:
Time now for Word of the Day where we break down a financial term for our smart viewer but maybe not the financial expert. Today it's ETF or Exchange-Traded Fund. By attracting those looking to invest in nontraditional assets and sectors, the global ETF market has inflated to more than a trillion dollars in assets over the past few years...some put that number now at about 2 trillion dollars. David Kotok wrote a book on ETFs and spoke about them on our show recently. However, Kotok warns that investors should conduct serious research before purchasing shares in an ETF. We'll explain why shortly, but first, what exactly is an Exchange-Traded Fund (ETF)? Here's our definition:
ETFs are a portfolio or basket of securities, which provide diversification like mutual funds, yet are unique in that they trade on an exchange just like a common company stock. They usually track an index, either holding the underlying stocks of the index or using derivatives to achieve the same returns as the index. And since an ETF is designed to track a specific market index, one can play an entire sector without being forced to stomach the volatility inherent in any one stock.
Here (at the 2:30 mark), it's worth viewing "internationally acclaimed financial expert," Suze Orman play down (if not completely misrepresent) the virtues of owning physical gold. Contrary to the guru's advice, no: not all physical gold must be re-assayed prior to sale (if one sticks to smaller, well known coins and is not buying from this guy).
In fact, according to the ETF's own prospectus, the average investor can only redeem his or her gold shares for cash. Only those who have large holdings in a fund like GLD have the option to redeem their shares for physical gold, requiring somewhere in the neighborhood of 100,000 shares, which translates into millions of dollars. And even then it's a complicated process.
Building on the prior "allocated vaults" reference by Ms. Lyster and the redemption comment above, we would add that GLD itself does, in fact, maintain physical gold in allocated accounts (meaning numbered bars are held (allocated) in trust for the fund and cannot be seized in the event of bankruptcy of the custodian or storage provider). Yet, according to its prospectus, GLD maintains an unallocated gold account for purposes of creation and redemption of fund units--that is, if a very large investor wishes to put physical gold into the fund or take it out, there is a three day limbo period (which can be extended by the fund manager) where the gold sits in an unallocated account, fully exposed to counterparty risk. More on this in a bit.
Ms. Lyster continues:
Also, in the case of GLD, the Trust does not insure its gold. Which means it may not have adequate sources of recovery if its gold is lost, damaged, stolen or destroyed. And this may surprise you when reading the prospectus as we have. According the prospectus for GLD:
"The amount of gold represented by the Shares will continue to be reduced during the life of the Trust due to the sales of gold necessary to pay the Trust's expenses irrespective of whether the trading price of the Shares rises or falls in response to changes in the price of gold."
And...
"Gold held in the Trust's unallocated gold account and any Authorized Participant's unallocated gold account will not be segregated from the Custodian's assets. If the Custodian becomes insolvent, its assets may not be adequate to satisfy a claim by the Trust or any Authorized Participant."
So if the custodian- in this case HSBC- runs into trouble, it may not be able to make good on your claim.
Accordingly, we might imagine a crisis situation in which substantial redemptions (requests for physical gold by large holders) drain the gold from the GLD allocated account to the GLD unallocated account, wherein the redeemers are exposed to substantial counterparty risk in a narrow, yet strategic window in time. And, if anyone thinks we're prone to paranoia (which is possible), please search our blog for "MF Global JP Morgan." Because when the music stops and the bankruptcy papers are filed, only the last TBTF bank standing matters and is free to seize the booty (thank you Sen. Grassley).
So it would appear the only way to protect yourself as an investor when it comes to ETFs is to do detailed research on the fund, its assets, and carefully read its prospectus, and even then you are still dealing with counterparty risk. This is why some would argue that buying a gold liability, which is what a gold ETF is, defeats the purpose of owning gold in the first place, as precious metals are one of the few asset classes accessible to average investors that are not simultaneously another person's liability.
In any case, now you know about ETFs and if you're interested, you know to get your reading glasses ready to dissect the fine print.
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