Owning Physical Gold........
Passport Capital's Experiment:
By Alistair Barr
This summer, John Moran picked up 100 ounces of gold from a locker run by the
Comex exchange in New York.
The bars, which were light enough to carry in a backpack, marked the
culmination of a $95,000 experiment by Passport Capital, a San Francisco-based
hedge fund where Moran is director of business operations and strategy.
Passport, headed by John Burbank, wanted to find out how easy it would be to
buy physical gold, rather than futures contracts or gold exchange-traded funds.
The firm was also interested in testing conspiracy theories about the
availability of the precious metal.
Moran used his own money because Passport didn't want to run the test with
its investors' cash. Everything went smoothly. In July, Moran bought a futures
contract on 100 ounces of gold at roughly $950 per ounce for delivery in
August. When the contract expired, Comex sent him a notice saying the gold was
available for collection in New York at a specific time and date.
With gold prices down from a recent record, Passport is poised to repeat the
process on a bigger scale for investors in its $1.2 billion Global Strategy
hedge fund.
Like several other hedge fund managers, Burbank sees inflation from trillions
of dollars that have been pumped into the global economy by the Federal Reserve
and other central banks in the wake of last year's financial crisis.
Gold may be a good hedge against this and physical gold could be an even
better investment if the financial system runs into trouble again, Burbank
reckons.
"A year and a few months after the crisis, there's no recognition that we
have to change," he said in an interview. "Instead, the U.S. is borrowing and
spending again, like a rogue trader doubling down."
"We're liable for another collapse of some sort," he added, noting that
"physical gold could go to very high levels" in such a scenario.
Gains And Losses
Unlike some leading hedge fund firms, Passport isn't a recent gold convert.
The firm has invested in gold ETFs like the SPDR Gold Trust (GLD) and gold
mining companies since about 2002. However, it sold its gold ETF positions
recently and has been waiting for prices to slide so it can buy physical gold,
possibly before the end of 2009, Burbank said.
Burbank's research into gold and the modern financial system led him to a big
bet against subprime mortgage securities. That generated returns of 220% for
Passport's main hedge fund in 2007, according to a recent investor update
obtained by MarketWatch.
However, Passport was particularly hard hit last year, when the mortgage
meltdown grew into the worst global financial crisis since the Great
Depression. Passport's Global Strategy fund lost 50.9% in 2008 and it has yet
to recoup some of those losses, returning just over 17% this year, through
October. Still, the fund has gained more than 24% a year since it started in
2000. Burbank declined to discuss performance.
No Contracts
Despite a recovery this year in the stock market and the economy, Burbank
sees a risk that contracts will be broken. This could happen to contracts
between counterparties on either side of investments or between heavily
indebted sovereign nations with lots of unfunded future liabilities and
individuals or investors in those countries, he explained.
Owning physical gold is an insurance policy against such financial
catastrophe because it involves no contracts. In contrast, gold futures and
ETFs are just types of paper contracts that could be broken in a crisis,
according to Burbank.
"If someone can't pay, an exchange closes or a counterparty goes bankrupt,
you don't actually own gold in those situations," he said. "And that's when you
want to own it most."
Delivery
Passport reckons physical gold prices could rise more than gold futures and
ETFs as more investors demand physical delivery when futures contracts expire.
Indeed, the firm argued in a research note earlier this year that the price
of gold futures has little connection to the actual metal because about 99% of
contracts are settled in cash.
For most commodities, like copper, oil or corn, taking physical delivery and
storing the stuff is tricky and expensive. But gold is much more portable and
storable. All the gold ever mined would fit into a cube roughly 65 feet per
side, Passport estimated.
"There could effectively be a global run to physical gold as people
simultaneously converge on gold markets and demand delivery," the firm wrote.
That could trigger a surge in physical gold prices, a bit like a short
squeeze which forces traders to close bearish bets by buying back shares
they've borrowed and sold, Passport explained.
"For investors to profit from a short squeeze in gold they must be in a
position to deliver physical metal," the firm added. "Having a paper substitute
for gold may not necessarily provide the same results."
In February 2005, new Comex rules allowed delivery of gold-backed ETFs
instead of physical gold to settle a futures contract, creating a "pressure
release valve" in the even of a short squeeze, Passport noted.
Cheaper
Passport also favors physical gold because it's cheaper than investing in the
metal through an ETF.
Owning physical gold through a bullion bank costs 5 to 30 basis points a
year, while gold-backed ETFs charge roughly 40 basis points, Passport noted in
its research report. (A basis point is one hundredth of a percentage point).
Even if investors follow Passport's experiment and take Comex futures
contracts to delivery, then leave the gold bars with one of the exchange's
depository institutions in New York, it will cost them less than 30 basis
points a year, the firm added.
This may be the case even though Passport is planning to pay extra to have
its bars "allocated." This means the gold is segregated from other investors'
gold in vaults. The act of allocation moves the title of the metal from the
bank to the investor.
In an unallocated account, investors have a general claim on the bullion bank
for a certain amount of gold. Investors who own gold this way assume
counterparty risk with the bank. If the institution goes bankrupt, these
investors have to get in line with other creditors to get their gold, "or
whatever is left of it," Passport explained.
Canada, Norway, Australia
Once Passport buys physical gold, the firm is planning to store it in
countries like Canada, Norway or Australia, which are politically stable,
resource rich and fiscally fitter than the U.S.
The firm has a big framed replica of Franklin D. Roosevelt's 1933 declaration
banning private ownership of gold hanging by the bathrooms at its headquarters
near the Transamerica building in downtown San Francisco.
Americans were ordered to turn in most of their gold to the government, which
gave them almost $21 for each ounce of the metal.
Soon after, Roosevelt changed the conversion price to $35, "an act of
taxation by inflation that effectively transferred 40% of the gold held by the
Fed for American citizens to the U.S. government," Passport wrote in its
research note earlier this year.
While another crisis may be resolved without governments resorting to such
draconian measures, Burbank reckons investors should try to establish residency
in politically stable countries with little debt, such as those in Scandinavia
or New Zealand.
"People should establish residency in other places like this as a 'life
hedge' if they can," Burbank advised. |
