Should you be buying physical gold, or an ETF that tracks gold? Gold is an investment that everyone should have some exposure two. The basic idea here is that holding an ETF enables one to get exposure to the price of gold without having to possess physical bullion and is considered more useful for trading purposes than for long-term investments. Besides and ETF, other examples of paper gold include: gold certificates, pool accounts, and gold futures accounts

Why would you consider something other than physical gold, such as an ETF? Well you might want to avoid storage costs. If you invest a sizeable part of your capital in physical bullion, you might not want to keep your metal at home (you’ll need a safe and perhaps other additional equipment). In this case, you might prefer to choose a custodian – an institution that stores your metal for you.

This storage service is not free of charge (neither is transportation to the storage facility, nor its insurance), so you need to take this cost into account, and it diminishes your returns on gold. By buying and ETF, you get an asset that more or less reflects the price of gold and allows you to avoid the cost and headache of storage.

In addition, buying an ETF enables you to invest in gold even if you don’t have the finances to actually buy an ounce of gold. This is because ETF shares can often reflect less than one ounce of gold. Most commonly they follow the price of 1/10 of an ounce. If you do not have enough money to buy a full ounce, ETFs might be a solution.

While buying an storing gold comes with its own risks, you might ask yourself whether it is reasonable or safe to invest in paper gold if you do not actually possess the metal you bought: This is why diversification is important in this case.

For example, if you buy a gold ETF share, you get a paper that trades roughly in the same direction as does gold. You may sell it to any other investor just like a stock and receive money. Please note, however, that most ETFs do not allow redemptions in gold. In other words, if you want to sell your ETF shares, you will not be able to exchange them for gold.

The ETF tries to make the price of its shares trade without direct connection to the demand for these shares. If many investors are willing to buy shares of a particular ETF, the price of these shares will most likely go up. Conversely, if the demand for these shares is low and pulls the price down, then the ETF (and its business partners) will sell a part of its physical holdings and use the acquired cash to redeem existing shares. Such an action limits the supply of shares and pushes the price back up.

The above mechanism is important, as concerns have been raised that ETFs may not have all of their shares backed with physical gold.This would mean that the overall value of shares issued by a given ETF exceeds the value of gold this ETF holds. At first, it may seem of little relevance, as you usually cannot exchange your shares for gold with the ETF. However, after a short consideration, such a situation begins to look unsettling.

As long as the demand for ETF shares is sound and you are able to sell them to other investors (and not to the ETF), even ETFs without enough physical gold will manage to make good business. However, if there is a default in the gold derivatives and/or gold declines and/or the demand for these shares falls significantly, it may turn out that such ETFs are unable to redeem all of their shares.The less physical gold the fund actually holds, the higher the probability that in an extreme situation you may find yourself out on a fragile limb.

OVerall, If you invest in gold ETFs it is crucial to choose either the funds that allow redemptions in gold (there are only a few such ETFs) or those that have their shares fully backed by gold. Apart from that, you should consider physical assets.