I have spoken about the need for proper diversification and asset allocation in the past. However, there is more to asset allocation than many people suspect when it comes to precious metals. It turns out that how you hold gold can be even more important than holding gold depending on the circumstances.
The great virtue of precious metals as an asset class is that they are not someone else’s liability. When financial institutions fail, the holders of precious metals face no counter-party risk. Unfortunately, that is only true if you hold them in the right way.
There are two ways to protect yourself from counter-party risks with precious metals: You can hold bullion directly, or you can open an allocated precious metals account. These accounts are known as allocated because specific coins or parts of a bar of precious metal are allocated to you. This metal is legally your property. A company that holds allocated precious metals for you acts as a trustee and has no claim on your gold or other precious metals.
The London Bullion Market Association estimates that more than 90% of the precious metals traded on the over-the-counter market are unallocated. When you have an unallocated gold account, your asset is simultaneously someone else’s liability. Your counter-party may hold bars of gold or gold certificates to offset that liability, but most institutions that offer unallocated gold accounts also have other liabilities. Your counter-party’s bondholders may take possession of the gold in the event of bankruptcy because bondholders are usually considered senior to other creditors. Unallocated gold accounts do not protect you from this counter-party risk.
The gold ETFs that are traded on stock exchanges add additional layers of risk and complexity. Gold ETFs typically have complicated trustee agreements, and individual investors are usually unable to withdraw physical gold. What is more, you must also hold the ETF itself with a brokerage. Brokerage accounts are protected by SIPC in the United States, but brokerages represent another layer of counter-party risk. The stock market can also be forced to close, depriving you of access to your funds in a crisis. The New York Stock Exchange was closed down because of Hurricane Sandy in 2012 and the terrorist attacks of September 11, 2001.
