Be Aware Of the Dangers In Holding Exchange Traded Funds Long-Term

Many believe that ETFs are great investments to own long-term. However, most investors do not know the fact that some ETFs do not literally own what they are represented in their names or prospectus to own. This aspect of ETFs is a danger for investors in them and also dangerous to the economic climate. Some ETFs are actually more like derivatives, which sometimes the party that created the derivative or is on the opposite of your position/investment cannot honor its end of the bargain.

Using the Gold ETF, GLD, as an example if you own GLD you probably know that it is somewhat like owning gold, and there is a lot of people who think it is exactly the same as owning gold bullion. However, these two beliefs are false and there is a big difference. Only theoretically the GLD ETF Trust owns about 850 tons of gold, but in reality it does not own that much real gold. In fact, it does not own much real gold at all.

In the GLD Trust Prospectus of late 2004 we found it has no method of guaranteeing how much real gold it does own. Also, GLD ETF has no knowledge and no way of finding out that the gold that is held in trust for it, is actually there or not.

One possibility could be that the bank that should be holding their gold already has it leased out. Stated another way, banks could be playing the same game with the GLD trust gold that they do with your money. They hold your money on deposit, theoretically, but most of it they do not have for long and it is given out in loans.

Recently, there has been worries about the government confiscating gold. So what would happen if the 850 tons of gold GLD only theoretically owns (about $25 billion worth) suddenly disappears? It would certainly hurt investors in the GLD trust ETF, and probably have other economical effects.

GLD, has no way to legally confirm if the gold being kept by the custodian (which is the European bank HSBC) is actually in the their vault. Also, HSBC has the right to use other banks as "subcustodians" to hold some of the gold making it even harder for GLD to actually know what is being physically held. Taking it to extremes, these subcustodians actually can use other subcustodians of their own, meaning GLD has sub-subcustodians.

With the way GLD is set up, there are multitudes of legal barriers that prevent anyone from verifying if the gold is in the vault or leased out. Thus, GLD could very literally have actually no Gold at all on hand to actually back up the 850 tons of gold it claims to have.

The ability of the Trustee to monitor the performance of the Custodian may be limited because under the Custody Agreements the Trustee may, only up to twice a year, visit the premises of the Custodian for the purpose of examining the Trust's gold and certain related records maintained by the Custodian (p. 37).

Following information is from the GLD prospectus:

The Trustee and auditor are not allowed to visit the Custodian “when no gold of the Trust is held in the Custodian's vault.” (p. 48). And this could occur when it is being held by subcustodians. Thus, the Trustee of GLD has a limited ability to determine what the Custodian is doing and no ability to determine what the subcustodians (at any level) are doing. “The Custodian is not responsible for the actions or inactions of subcustodians.” (p. 44) And the Trustee has no right to audit the gold or even any financial records about the gold of the subcustodians.

“In addition, the Trustee has no right to visit the premises of any subcustodian for the purposes of examining the Trust's gold or any records maintained by the subcustodian, and no subcustodian is obligated to cooperate in any review the Trustee may wish to conduct of the facilities, procedures, records or creditworthiness of such subcustodian." (p.37). Furthermore, the Prospectus states that “because neither the Trustee nor the Custodian oversees or monitors the activities of subcustodians who may hold the Trust's gold, failure by the subcustodians to exercise due care in the safekeeping of the Trust's gold could result in a loss to the Trust.” (p. 12).

Current subcustodians appear to be one US bank: JP Morgan (which has $US93 trillion in derivative exposure), one Canadian Bank: The Bank of Nova Scotia, and four European banks: the custodian, The Bank of England, Deutsche Bank AG, and UBSAG.
All of these banks actively lease gold.

Another noteworthy factor to consider is that the GLD trust does not insure its gold. Stated in the Prospectus, only the Custodian is responsible for insurance and “shareholders can not be assured that the Custodian will maintain adequate insurance” (p. 11). Furthermore, “Custodian and the Trustee will not require any direct or indirect subcustodians to be insured or bonded” with respect to gold held by the subcustodians on behalf of the Trust (p. 11).

“Consequently, a loss may be suffered with respect to the Trust's gold which is not covered by insurance and for which no person is liable in damages” (p. 11). If subcustodians are used outside of the U.S., it may be difficult or impossible to seek legal remedy against the subcustodians (p. 12). This is significant because the Custodian's primary vault is in London. The subcustodians' vaults can be anywhere in the world. If the subcustodians fail to return any gold that they have to the HSBC, the major custodian, there is no contractual obligations that can be enforced.

According to many analysts the European banking system is going to experience problems for quite some time. It is this banking system that holds the gold in the GLD Trust. The Daily Telegraph reported several months ago that European banks may have to write off nearly ten times more than the U.S. banks. This is because they have lent aggressively to Emerging Europe, which has imploded and been even more aggressively involved in the subprime debacle than their U.S. counterparts. Furthermore, they have no printing press like the Federal Reserve to print trillions of Euros to exchange for the junk debt like the U.S.

GLD and in my opinion most ETFs are fine for short term trading. However, for holding long term positions, they could face a disaster with solvency and liquidity issues. And if one of the most well known ETFs, GLD, is organized in this manner described above, then as a long-term investor you should really look at the prospectus of any other ETF that you plan to hold for any substantial length of time.