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Fund firms take steps to allay concerns over gold-based ETFs

Critics raise prospect of phantom gold accounts with lax auditing standards

Gold has always attracted conspiracy theorists, and since the introduction of exchange traded funds dedicated to bullion six years ago, there has been a growing chorus of concern about the assets these ETFs actually hold and how they are used.

The worries are most widely articulated by financial websites and bloggers, who raise questions about how much gold is actually in the vaults given the rapid growth in demand for gold ETFs. They raise the prospect of phantom gold accounts where lax auditing standards allow trusts to issue certificates of questionable value. And they fret that the financial institutions storing the gold on behalf of the ETFs are borrowing the bullion to make short sales to other investors.

Sprott Asset Management Inc. felt that there were enough investor concerns about the integrity of some gold ETFs that it would do well by developing its own trust that addressed some of these issues.

In March, the Toronto-based investment firm launched Sprott Physical Gold Trust with a $400-million offering in Toronto and New York. The ETF allows as pure-play a bet on bullion as possible, short of the investor carrying the gold bars home himself, says Jamie Horvat, a senior portfolio manager with Sprott.

From large institutions to individuals, investors have turned to gold ETFs as a means to protect their assets in a time of economic uncertainty. Gold is considered one of the best ways to mitigate financial risk, but the headaches associated with owning the physical asset (storage, security, etc.) had tempered demand in the past.

The creation of ETFs broadened the availability of gold investments, due in no small part to the efforts of the world's gold producers themselves to help develop the ETF market.

The World Gold Council, which represents the major gold mining companies, created the SPDR Gold Shares trust in November, 2004, through its subsidiary World Gold Trust Services. SPDR Gold Shares is the world's largest ETF tracking bullion prices. It boasts about $44-billion (U.S.) in assets.

The World Gold Council describes its mission as "to stimulate and sustain the demand for gold." It seeks "to create structural shifts in demand and promote the use of gold in all its forms," including as an investment and as a reserve asset.

On this basis, the council has had extraordinary success with SPDR Gold Shares. Last year, gold ETFs accounted for 18 per cent of the 3,455.4 tonnes of global demand (excluding central banks), according to the council. But the fact that the mining industry itself has had a direct impact on the development and marketing of gold ETFs has helped to fuel some investor suspicions and conspiracy theories.

Som Seif, president and chief executive officer of Toronto-based ETF specialist Claymore Investments Inc., said a lot of the alarmist commentary is coming from direct sellers of gold who are seeing gold ETFs cut into their market.

"There's a lot of speculation about gold ETFs on the Internet. It's all farce," he says. "People that are saying the vaults are empty ... they're claiming fraud. That's just unacceptable."

The Claymore Gold Bullion ETF has about $450-million (Canadian) of gold bullion in vaults to match the managed assets of the trust, minus any fees. The holdings are audited semi-annually by Ernst & Young, he says.

Because the gold is fully allocated to the trust, there is no derivate exposure and liability is virtually removed, he adds.

ETF firms can lend a portion of their equity holdings to other institutions, but Claymore does not allow its holding bank to uses its gold for shorting purposes or otherwise. "We don't allow lending of our gold in any way," he says.

Sprott has also tried to assure investors about what exactly it is they are buying when they buy its ETF. The rules governing its holdings mandate that gold be fully allocated to the trust, that it is not leant out, that it is subject to both annual and spot audits, and that it be stored at the Royal Canadian Mint. By using a Canadian Crown corporation, which acts as an agent of the Canadian government, Sprott has removed almost all third-party risk, Mr. Horvat said.

As of last week the trust had a net asset value of $706.7-million and held $697.8-million of gold, according to the firm's latest posting. Sprott's management fee runs about 0.45 per cent.

BlackRock Inc.'s iShares Comex Gold Trust has $3.4-billion (U.S.) of assets managed and $3.4-billion of allocated gold in bank vaults, said Kevin Feldman, managing director of iShares in San Francisco.

"We do not permit shorting for the trust," he says. "We take a conservative view on allocation. When new shares are created for the trust on a daily basis, we insist that the gold is purchased with an electronic entry at the bank before certificates are issued."

The iShares ETF is now cross-listed on the Toronto Stock Exchange so that investors can purchase the U.S.-based product using Canadian dollars.

The structure of most gold ETFs does not allow an investor to turn certificates into a physical holding of gold, and this fact has also unsettled critics, who question the nature of the safe haven if bullion cannot be claimed. The iShares gold ETF only allows large institutions the option to actually take possession of the investment's underlying asset. Part of the reason is that the bullion is stored in standard blocks called London Good Delivery Bars, weighing between 350 and 430 troy ounces. That translates into a price per bar of between $462,000 and $566,000.

The reality is that most gold ETF investors are price participants, meaning they are seeking to benefit off the price movement rather than wanting to eventually possess the gold, Mr. Horvat said. Nevertheless, he recognizes some investors will want physical delivery and says Sprott offers that service to large investors. In a worst-case scenario, however, even individual investors could recoup their investment through the Canadian Mint, he said.

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Battling the bugbears

Last year, gold ETFs accounted for 18 per cent of the 3,455 tonnes of global demand (excluding central banks), according to the World Gold Council. Alarmist theorists have sprung up with the growth in demand - so much so that investment firms are trying to reassure investors about what exactly it is they are buying. Here are three with solid assets to back their valuations:

ISHARES COMEX GOLD TRUST

Company: Blackrock Inc.

Ticker: IAU (NYSE)

Share price: $11.84

NAV (net asset value per share): $11.73

SPDR GOLD SHARES

Company: World Gold Trust Services LLC

Ticker: GLD (NYSE)

Share price: $118.36

NAV: $118.91

SPROTT PHYSICAL GOLD TRUST

Company: Sprott Asset Management LP

Ticker: PHYS (NYSE)

Share price: $11.59

NAV: $10.22

Note: All figures in U.S. dollars. NAV refers to each funds' gold assets. iShares Comex Gold Trust also trades on the TSX under the symbol IGT. Sprott Physical Gold Trust also trades on the TSX under the symbol PHY.U.

© 2007 The Globe and Mail. All rights reserved.

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