May 14, 2009 - 3:33pm EST by
2009 2010
Price: 15.44 EPS $0.00 $0.00
Shares Out. (in M): 361 P/E 0.0x 0.0x
Market Cap (in $M): 61 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 61 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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For those with a smaller portfolio sizes, I suggest a way to bet on a rise in Gold that avoids some of the annoying catches. The idea: shorting the ultrashort Gold ETF, quoted as GLL on the NYSE. It should be a long-term zero but practically your price target will depend on how you play it and some timing.

Readers who have already explored various ways to bet on gold recognize the annoyance in that there's always a catch. No matter what the method, at the end of the day the problem comes down to someone having to deliver gold for your benefit - will they? Another issue surrounding a vehicle choice is that most of us are looking for a leveraged call-option type position, an insurance against inflation tail risk. mpk391's Kinross write-up touches on some of these issues and suggests a good way to proceed; I have personally purchased calls on gold miners and on the GDX at various times. Still, some of us insist on investing in gold directly anyway.

Let's go over the risks first:

1)      Counterparty risk: using futures and other bets exposes investors to counterparty risk; same thing with certain custodial arrangements. Investing in a vehicle that uses futures to implement long gold bets exposes investors to the risk of dealing with the people who made the wrong bet.

2)      Confiscation: If you deal with futures or futures-funds, even if counterparties have the money, they may not be able to deliver the gold is confiscation occurs (either at level or at any custodian involved in the trade). Storing gold in safe deposit boxes exposes you to confiscation risk too and any service that stores gold bullion for is also at risk of being forced by its jurisdiction's government to relinquish the gold.

3)      Theft/fraud: if you keep your gold at home and maybe even if you use one of those bullion storage places, there's a risk that it will be stolen by third parties or fraudulently disappear, which means you end up with neither money nor gold. Simple. Any counterparty that promises you gold via some contract is exposed to the risk of their gold being stolen.

I'd also like to address ETFs that hold gold because I was on the verge of buying GLD calls. GLD is one of the largest gold owners in the world, trailing only a handful of countries. One of the problems with GLD is that when gold eventually spikes up and then reverses back down (which I expect will happen) the fund will trip up and underperform gold. The reason: GLD must invest everything in gold, so in a speculative boom with surging volume, it will become the biggest market participant and will have to pay ever-dearly for every incremental amount of gold. This will cause a blow-off market top that will have to reverse, and during the reversal GLD will be a desperate seller, thus losing even more money.

Beyond this risk, there is a movement - not one that I necessarily belong to - which disputes the very legitimacy of GLD for the following reasons/claims:

-          HSBC is the custodian but there are subcustodians which are not disclosed. GLD warns that it may not know all subcustodians and also that: "The Trustee
may have no right to visit the premises of any subcustodian for the
purposes of examining the Trust's gold or any records maintained by
the subcustodian, and no subcustodian will be obligated to cooperate
in any review the Trustee may wish to conduct of the facilities,
procedures, records or creditworthiness of such subcustodian."

-          Their balance sheet lists the major asset as "Investment in Gold", not "Gold".

-          Lack of insurance of the gold

-          GLD doesn't allow redemptions in gold, only money. There are a couple of ETFs in Switzerland that do allow redemptions in gold, why not GLD?

-          GLD's gold is not fully audited. Many others fully audit their gold.

-          Smaller ETFs have had storage problems at various stages due to rises in investor demand for gold. GLD has never expressed having any such problems despite it becoming huge.

-          GLD's ability to pursue action against subcustodians who somehow lose the gold (fraud, theft, insolvency, confiscation...) is limited.

-          The increase in GLD's gold stash is so large that it cannot be accounted for on public exchanges. If they obtained gold, it must have been private transactions. Where does GLD gets all that gold?

-          And finally, even if this is all real gold, some of the subcustodians are big U.S. banks which surely would cooperate with a government effort to confiscate it.


Shorting a shorting vehicle

GLD calls therefore have a couple of drawbacks plus maybe a potential fraud risk. More importantly, all vehicles that are long any gold-related asset, whether through real gold or futures, expose you to losses arising from some gold not being delivered when it's reached for. The only way to avoid these issues is to not go long anything, or maybe to short something. What can you short? A short ETF.

Introducing UltraShort Gold ProShares (GLL)

GLL seeks to replicate, net of expenses, twice the inverse daily performance of gold bullion as measured by the U.S. Dollar p.m. fixing price for delivery in London.

-          Because the fund seeks to promise the opposite of benefits related to gold ownership, we actually would benefit from the bankruptcy of the ETF's counterparties, we benefit from theft of the gold that backs the futures they trade in, we benefit from its confiscation and we benefit if anyone in the chain is somehow committing fraud.

-          The leverage is good. Shorting gives 2x leverage and GLL is optionable. Buying puts on it gives further  leverage on 2x leverage.

-          Short ETFs have a design flaw that lead them to be 'ruined' not only by a positive performance of the asset class they trade in but also by a volatile performance of that asset class. Furthermore, this flaw is magnified by the ETF's magnification factor, in this case 2x.  For example: if Gold rises 20% and then declines 16.666%, it will exactly break even. However, during that time GLL will NOT break even. As gold rises 20%, GLL declines 40%. Then when gold declines 16.666%, GLL rises 33.33%. That's not enough of a recovery because that gain occurs over a lower capital base and GLL ends up being 20% below where it started off. And because GLL seeks to mirror daily performance, it loses its capital base daily (or every second day, on average, if we want to be mathematical about it). So TWO important conclusions: (1) volatility kills short funds like GLL, so you will make money with rising gold and also with volatile gold. (2) short funds are disproportionally better for shorts vs. longs.

-          GLL not only has expenses but also frictional costs associated with its implementation of -2x gold in the futures market; this too disproportionally favors shorts over longs.

-          GLL will get pretty thoroughly destroyed even with a "mini gold mania". If gold rises just 40%, GLL will decline at least 80%. Even if gold comes back down, it's too late: GLL will be scarred forever as explained above.



If the gold long thesis is even mildly believed, GLL is bound to decline below $3.



gold rally, inflation, money printing, bailouts, perception that any of the foregoing will occur soon.

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