Gold Custody Wars: Bank Promises vs. Physical Ownership — What's Really In Your Portfolio?

Gold ETFs have emerged as a popular vehicle for modern investors seeking exposure to precious metals without the hassles of physical storage. However, not all gold ETFs are created equal. This comprehensive guide explores the fundamental differences between conventional bank-backed gold ETFs and Sprott Physical Gold Trust (PHYS), helping you make an informed decision based on your investment philosophy and goals.

Understanding Gold ETFs: The Basics

Before diving into specific differences, it's important to understand what gold ETFs are designed to do. Gold ETFs aim to track the price of gold, providing investors with exposure to gold price movements without requiring them to take physical possession of the metal. They trade on stock exchanges just like ordinary shares, making them accessible to both retail and institutional investors.

Key Benefits of Gold ETFs in General

• Liquidity: Trade during market hours at prices that closely follow gold spot prices
• Convenience: No need for storage, insurance, or verification of physical gold
• Divisibility: Purchase in small amounts rather than full ounces or bars
• Transparency: Daily disclosure of holdings and pricing
• Cost-efficiency: Typically lower transaction costs than buying physical gold

With these foundations in mind, let's explore how bank-backed gold ETFs and Sprott's physical gold trust differ in their approach.

Bank-Backed Gold ETFs: Structure and Operations

Bank-backed gold ETFs such as SPDR Gold Shares (GLD) and iShares Gold Trust (IAU) represent the most common structure in the market. These funds have gained massive popularity, with GLD alone managing over $50 billion in assets.

Custodial Structure

Bank-backed gold ETFs operate under a custodial model where:

• A trustee (often a financial institution) oversees the ETF
• A custodian bank (like HSBC or JP Morgan) holds the gold on behalf of the fund
• Sub-custodians may be appointed to hold portions of the gold in various locations

This multi-tiered structure creates an efficient operational framework but introduces what some investors consider to be "counterparty risk" - the risk that one of these entities might fail to fulfill their obligations.

Allocated vs. Unallocated Gold

One of the most critical aspects of bank-backed ETFs involves their use of allocated and unallocated gold:

• Allocated gold refers to specific bars identified by serial numbers and segregated in the vault as the property of the ETF
• Unallocated gold represents a general entitlement to gold within the custodian's overall holdings without specific bars being designated. This arrangement has occasionally led to legal challenges, as seen in past lawsuits against major banks.

Most bank-backed ETFs maintain some combination of allocated and unallocated gold, with the precise ratio depending on operational needs and market conditions. If you're interested in tracking current valuations, check our guide on Where can you find Precious Metals Prices?

Use of Derivatives and Substitutes

The prospectuses of many bank-backed gold ETFs contain provisions allowing for:

• The use of gold derivatives (futures, options) under certain circumstances
• Cash substitutes when physical gold cannot be obtained
• Short-term lending of gold to generate additional income

These provisions help the funds maintain operational flexibility but may concern investors seeking pure gold exposure without any synthetic elements. Furthermore, questions have been raised about the transparency and practices within these structures. For instance, concerns about GLD's disclosures regarding gold held at the Bank of England emerged in 2022, as detailed by analyst Ronan Manly. In his analysis on BullionStar, Manly noted potential complexities: "But gold-backed ETFs lend their shares, which Authorized Participants (APs) then bundle up into baskets and redeem physical gold using the borrowed shares." Such mechanisms, often discussed in forums like LinkedIn, add layers that some investors find opaque.

Beyond specific ETF operations, broader concerns exist regarding alleged gold price manipulation by central and investment banks. With organizations like the LBMA seemingly overseeing the market structure where such activities might occur, some investors question: can you really trust the 'rigged' system that runs these ETFs?

Redemption Limitations

An important limitation of most bank-backed gold ETFs is their redemption policy:

• Only authorized participants (typically large financial institutions) can redeem shares for physical gold
• Minimum redemption amounts are very large (often 100,000 shares or more)
• Retail investors cannot directly convert their shares to physical gold

This means that while these ETFs are backed by gold, the vast majority of investors will never have the option to claim the underlying metal, instead realizing their investment through selling shares on the exchange.

Fee Structure

Bank-backed gold ETFs generally boast competitive expense ratios:

• GLD: approximately 0.40% annual expense ratio
• IAU: approximately 0.25% annual expense ratio

These relatively low fees have contributed significantly to their popularity among cost-conscious investors.

Sprott Physical Gold Trust: A Different Approach

Sprott Physical Gold Trust (PHYS) represents an alternative philosophy to gold investment, emphasizing direct ownership and reduced counterparty risk.

Direct Ownership Structure

PHYS differentiates itself through its ownership structure:

• The trust holds fully allocated physical gold bullion
• Each gold bar is specifically identified with serial numbers
• All gold is stored at the Royal Canadian Mint, a sovereign institution
• The Canadian Mint acts as both custodian and storage facility, eliminating the multi-tiered custodial chain

This simplified structure reduces the layers between investors and the physical gold, potentially decreasing counterparty risk.

Fully Allocated Physical Gold

Unlike bank-backed ETFs that may use a combination of allocated and unallocated gold:

• 100% of PHYS gold is fully allocated
• No unallocated gold positions are maintained
• Each bar is physically segregated and specifically identified as property of the trust
• Regular physical audits are conducted and publicly reported

This approach resonates with investors who place high value on the certainty of specific physical gold backing their investment.

No Derivatives or Lending

Sprott emphasizes the purity of its gold exposure by:

• Prohibiting the use of derivatives or gold substitutes
• Not engaging in gold lending programs
• Maintaining a strict mandate to hold only physical bullion
• Avoiding any form of leverage or hypothecation

For investors concerned about the potential risks introduced by derivatives and lending practices, this conservative approach may be appealing.

Physical Redemption Option

Perhaps the most distinctive feature of PHYS is its redemption policy:

• Qualified investors can redeem shares for physical gold bullion
• Redemption is available for 400 oz gold bars (approximately 10,000 shares)
• While still substantial, this threshold is more accessible than most bank-backed ETFs
• The option exists even if rarely exercised, providing assurance of the gold's existence

This redemption feature creates an arbitrage mechanism that helps keep the trust's trading price relatively close to its Net Asset Value (NAV), though PHYS may still trade at a premium or discount to NAV based on market sentiment.

Higher Fee Structure

The more direct ownership model of PHYS comes with slightly higher costs:

• Approximately 0.42-0.45% annual expense ratio
• Potentially higher trading spreads due to lower trading volume than the largest ETFs
• Additional costs associated with the physical redemption process if utilized

Investors must weigh these higher costs against the perceived benefits of Sprott's approach.

Tax Considerations

An often-overlooked aspect of gold ETF selection involves tax treatment, which can vary significantly:

Bank-Backed ETFs:

• In the U.S., often taxed as "collectibles" with long-term capital gains taxed at up to 28%
• May be less favorable than the standard long-term capital gains rates that apply to most securities
• Tax reporting is straightforward through normal brokerage statements

Sprott Physical Gold Trust:

• May qualify for more favorable capital gains treatment in certain jurisdictions
• For U.S. investors, may qualify for treatment as a Passive Foreign Investment Company (PFIC)
• Investors can make a Qualified Electing Fund (QEF) election potentially resulting in lower tax rates
• Requires additional tax paperwork and potentially specialized tax advice

The specific tax implications vary by jurisdiction and individual circumstances, making consultation with a tax professional advisable.

Investment Philosophy Alignment

Ultimately, the choice between bank-backed gold ETFs and Sprott's physical gold trust often comes down to investment philosophy:

Bank-Backed ETFs May Be Preferred By:

• Investors primarily seeking gold price exposure at the lowest possible cost
• Traders with short to medium-term horizons
• Those who prioritize liquidity and trading efficiency
• Investors comfortable with the traditional financial system's custodial arrangements
• Cost-sensitive portfolios seeking simple gold price tracking

Sprott Physical Gold Trust May Appeal To:

• Investors who value direct ownership claims on physical gold
• Those concerned about counterparty risk in the financial system
• Investors with a longer-term horizon who view gold as a form of monetary insurance
• High net worth individuals who appreciate the physical redemption option
• Those who align with a "gold ownership" rather than "gold exposure" philosophy

Market Performance Considerations

While both approaches track the price of gold, there can be performance differences:

• Bank-backed ETFs typically track gold prices very closely due to their efficient creation/redemption mechanism
• PHYS may trade at a premium or discount to its NAV, which can either enhance or detract from returns
• During periods of market stress, PHYS has historically sometimes commanded a premium, reflecting investor preference for its structure
• During normal market conditions, the performance differential is typically minimal

Making Your Decision

When choosing between these different gold ETF structures, consider:

1. Your purpose for holding gold: Inflation hedge, portfolio diversification, or speculation?
2. Time horizon: Short-term trading or long-term wealth preservation?
3. Risk perspective: How concerned are you about counterparty risk in the financial system?
4. Cost sensitivity: How important are minimal expense ratios to your investment strategy?
5. Tax situation: Which structure provides optimal tax efficiency for your circumstances?
6. Philosophical alignment: Do you view gold as a financial asset or as a form of money/insurance?

Conclusion

Both bank-backed gold ETFs and Sprott Physical Gold Trust offer legitimate approaches to gaining exposure to gold through exchange-traded securities. Bank-backed ETFs provide efficient, low-cost exposure to gold price movements through a traditional financial structure. Sprott offers a more direct ownership model with reduced counterparty risk and the option for physical redemption, albeit at slightly higher costs.

The "better" option is not universal but depends entirely on your investment needs, philosophy regarding gold ownership, and risk tolerance. Many sophisticated investors maintain positions in both types of vehicles, leveraging the advantages of each for different portions of their gold allocation.

Whatever your choice, gold ETFs of both varieties have democratized access to gold investment, allowing investors of all sizes to incorporate this ancient store of value into modern portfolio strategies without the traditional challenges of physical ownership.