Ownership is important. Make sure you know what you actually own

In this modern financial world, care needs to be taken to ensure you actually have ownership your investments.

Ownership can be misleading

For example, a modern financial invention has been the Exchange Traded Fund (ETF). A key difference is whether they are physical or synthetic. These funds are a structure which allow you to invest in a range of separate assets, simply and cheaply.

The wording and structure of these innovations aat first glace would appear quite similar, so if you don’t look at the details, you could easily miss the fact that they are actually very different in terms of what you own and the risks you are accepting when investing in them.

A physcial ETF represents an undivided interest in the underlying assets of the fund. So a FTSE 100 ETF physically owns a portion of the largest 100 shares listed on the London Stock Exchange. Your ownership of one ETF means you indirectly own a tiny portion of 100 very large multi-national companies.

A synthetic ETF, however, does not own the underlying assets, but relies on derivatives to execute the proposed investment strategy. So what happens is that you can track the performance of an index without actually owning any of the shares or asset the derivative is tracking!

You are reliant upon the derivative provider to fulfil its obligations to provide the agreed index return. You are essentially providing a complicated form of lending to an investment bank and what you own is a contract – which is just a promise written on a piece of paper.

The key lesson that needs to be understood and never forgotten is that financial institutions are inherently unstable and cannot be trusted. They have proven this time and time again throughout history and I don’t expect them to change any time soon.

Why take on complicated risks without even owning the asset you are attempt to invest in?

Surely it makes more sense to either directly or indirectly physically own the underlying investment.

Famous investor Warren Buffet says,

The idea that financial markets would close at first glance appears an extreme comment to make, however there is past form, albeit usually in disastrous periods of war.

If the financial markets were to close, how much value can you place on those derivative contracts? What would you own when a market re-opens? What happens if an investment bank collapses?

If you own shares outright, or you have an indirect title to these shares, you actually own things of tangible value (companies own buildings, products and intellectual property, brands and goodwill etc.). If the very worst were to happen it would be extremely inconvenient, but you would still be left with at least something of value (and with large amounts of patience, those businesses may survive and eventually grow).

Ownership of physical gold or shiny contracts.

It’s not only the share market where care needs to be taken. The gold market appears to have more paper claims on gold than there is physical gold available – at least that what it looks like on the surface.

In 2010 famous hedge fund manager Kyle Bass famously advised the University of Texas Endowment to take physical ownership of $1billion of gold bullion.

Here is what Kyle said about this decision in this engaging and interesting interview from 2011.

Apparently at the end of 2015 there were 293 ounces of gold claims per ounce of physically deliverable gold held in COMEX warehouses.

Now with futures contracts, most people have no interest in claiming gold; they are speculating on the price so wouldn’t claim ownership on the gold (the vast majority of contracts are cash settled).

There is also gold stored elsewhere which backs some of these contracts, so the claims on gold to the physical gold available ratio is highly unlikely to be as severe as 293:1.

However for those buying derivative based contracts thinking they own gold, they should probably think twice and understand that if the ratio isn’t 1:1, then you may well have a problem.

Many people with these contracts have little interest in physical gold. These contracts are basically just a means for them to try and profit from an adult version of pass the parcel. But when there is rapidly diminishing interest or ownership of the underlying physical asset, how valuable is that contract?

Now this isn’t an issue while the music continues to play. You just push it onto the next person in the chain.

But what happens when the music stops? What do you own?

A piece of paper giving you contractual rights to what quantity of gold? Where is it stored? To whom do you go to claim this gold? How do you know they even have it, let alone if they will actually be willing or able to give it to you?

One thing is clear to me from my research into the gold market; No-one seems to know exactly how much gold is avalable in the market, who owns what and how many claims on gold there are for the physical bullion available. At best this should raise some concerns about the integrity and transparency of these markets, at worst this is an example of blatant criminality.

It begs the question; Would you really want to be at the back of any gold claiming queue?

Is it not far more sensible to be certain you actually own the gold you would like to own.

Our economic system is largely built on trust. But the problem with this system is simple. The financial system and far too many operators within it do not warrant your trust.

It’s crucial to look through the products and into the details and be certain that you have ownership of something with tangible value.

These are just some examples of why ownership is so important when creating your financial plan and building your investment portfolio.