If you’ve been looking at how to invest in gold, chances are you might have come across the notion of paper gold. To some it might look like an easier way to buy gold, while others see it as a riskier asset that isn’t actually always backed by the physical precious metal.
So what is paper gold, exactly? How does it work? And, most importantly, how is it different from physical gold?
Let’s unpack.
What is paper gold?
Paper gold is essentially a catch-all term for different types of gold-related assets that reflect the spot price of gold, but are not gold themselves. In other words, with paper gold, you don’t own the actual physical metal.
Now, let’s see what are the key types of paper gold.
How does paper gold work?
Basically, there are three main types of paper gold — exchange-traded funds (ETFs), gold futures and gold certificates.
Exchange-Traded Funds (ETFs)
What are ETFs: gold ETFs are commodity funds that act and trade like individual stocks. Gold-backed ETFs give investors exposure to the gold price without having to buy the physical metal.
How do ETFs work: in principle, ETFs are shares of gold owned by the fund, and few of them actually hold physical gold. This basically means that even if you redeem a gold ETF, you won’t get the actual physical product. Instead, you will receive the cash equivalent. ETFs usually trade through online brokers and broker-dealers.
Gold futures
What are gold futures: to put it simply, gold futures are a financial contract between an investor and a seller where an investor agrees to buy a specific amount of gold at a preset price and date.
How do gold futures work: buying a gold futures contract doesn't mean you actually take immediate possession of the physical asset. Rather, a futures contract gives a buyer the right to get a precious metal at a future date. Gold futures usually trade on Comex — a futures and options market to trade commodities like silver, gold, aluminum, and copper.
Gold certificates
What are gold certificates: as a type of paper gold, gold certificates are less popular today than gold futures or ETFs. While they are still being issued by some banks and companies, in the U.S., gold certificates now only have a collectible value.
How do gold certificates work: in essence, gold certificates allow you to own physical gold without actually taking possession of it. A certificate is basically a proof that you own a certain amount of gold, which is usually stored in a secure vault by the authority that issues gold certificates.
Is it good to invest in paper gold?
Indeed, paper gold has several advantages that might make it look attractive for some investors. Here they are:
Liquidity: generally, gold ETF shares can be converted for cash quite easily through a broker. They are usually traded on stock exchanges, and you can make a transaction any time during market hours.
Affordability: with gold ETFs, one can invest practically any amount of money. The minimum investment limit is 1 unit, which is equivalent to 1g of gold.
No shipping, delivery, and storage fees: with paper gold, you don’t pay shipping or delivery fees, only the commission a broker charges you for the transaction. The same goes for storage — ETFs don’t have extra storage costs because, like shares, they’re purchased on a stock exchange.
Safety: unlike physical gold that has to be stored in a vault for safety, gold ETFs only exist in digital form. However, this digital form could possibly make them vulnerable to server issues or hacking.
And yet, like any other asset, paper gold comes with a number of risks that are important to keep in mind, especially for beginning investors, before making a decision to invest in paper gold assets.
What are the risks of paper gold?
Counterparty risk: this is one of the most common risks usually associated with paper gold. A company or broker in charge of your ETFs could go bankrupt or fail to live up to their obligations, misrepresenting the true state of their portfolio.
You don’t really own gold: in reality, the institution that sold you an ETF share might only hold a fraction of your asset’s value in physical metal. So, for example, if too many investors wanted to cash in their paper gold, the fund that sold it to them might not have enough of the physical metal to repay everyone.
Tracking error: tracking errors arise mainly due to transaction costs, cash amount held by an ETF as well as the expenses charged for managing the fund. A slight degree of a tracking error is somewhat natural in any ETF product, however, it may also lead to an unexpected profit or loss.
Volatility: the gold futures market can be quite volatile, partly due to the speculative nature of gold futures assets. This basically means that if there is a chance to make 2,000 U.S. dollars, there is also a possibility to lose 2,000 U.S. dollars.
Is physical gold a better investment than paper gold?
For an inexperienced investor, paper gold and physical gold might look like similar portfolio options but, they’re in fact very different.
Advocates of paper gold tend to highlight several risks of investing in physical gold:
- The costs and risks associated with storing and insuring your gold;
- The complexity and costs at resale;
But in reality, you can easily avoid those risks by choosing the right physical gold reseller.
And there’s a number of factors that actually make physical metal a much safer investment than paper gold:
No counterparty risk: with physical gold you don’t rely on any third-party individual or company to hold and own your wealth for you. Whether you decide to store it at home at your own expense, or with free and insured storage with GOLD AVENUE, with physical gold, it’s you who hold it.
Value: unlike paper gold, paper currencies, stocks, bonds, or mutual funds, physical gold is a tangible asset with an intrinsic value that cannot go to zero. Also, when you own a gold coin or bar, it means you own a physical product that holds value as an investment as well as a form of currency.
Reliable hedge against economic downturns: physical precious metals have always been considered a hedge against economic and societal downturns such as a breakdown of the monetary system, for example. It’s not that we’re saying it will happen any time soon, but it will always be easier to pay for your groceries with a silver coin than an ETF. 🙃
So what’s the bottom line?
Fundamentally, a decision of whether to buy paper gold or not largely depends on one’s investment goals and strategy.
If you are an experienced investor looking for a short-term exposure to the gold market and are ready to accept the risks coming from a possible higher volatility and counterparties, paper gold could be a choice. However, if you want to make sure your investment is protected, fully allocated (owned entirely by you), and will retain its value in the long-term, then physical gold could be a better choice.
Or, if you’re looking to diversify your portfolio, investing in both physical and paper gold might an option. As we’ve explained, while it can help you get short-term exposure to the gold price, potential risks attached to paper gold could result in large gains just as well as severe losses. So, one way to protect oneself from such risk could be by hedging this riskier investment with a more stable and safe asset like physical gold.
