The S&P GSCI Gold was up 22% over the first 10 months of 2020. There are a number of drivers behind its upward performance. The global pandemic has persuaded investors that gold is a valuable addition to their portfolios as a hedge against equity returns, near zero interest rates, a depreciating U.S. dollar, and lagging economic growth. Many institutional investors are also using gold as protection against possible deflation or conversely, against an uptick in inflation, the effect of massive fiscal, and monetary stimulus.
Investors have available to them a myriad of vehicles to invest in the performance of gold—from gold bars and mining equities to derivatives and financial products based on derivatives. Two of the more popular gold investment instruments professional investors use are gold futures, including financial instruments based on gold futures, and exchange-traded products (ETPs) based on physical gold. In many cases, both derivatives and ETPs are appropriate choices, but there are noteworthy differences in terms of price discovery, liquidity, leverage, cost structure, counterparty risk, and customization that warrant investigation before any investment decision is made.
Gold bugs may tout holding physical gold as offering protection from a true black swan event, such as the complete collapse of a fiat currency, but there are legitimate questions regarding how practical a few gold bars would be in the aftermath of such an event. Nevertheless, the focus of this paper is to compare the advantages and disadvantages of investment instruments backed by physical gold versus those based on gold derivatives, not on holding physical gold bars and coins (see Exhibit 1).
