Comments following Tuesday's post on silver focused on my preference for investing in the actual physical stuff. I replied in the comments on 2 risk aspects, and for completeness I thought I'd summarise my views on some of the range of risk issues involved, as bullion neatly illustrates quite a few. For avoidance of doubt, these are strictly generic and academic 'Risk 1.01' views that you'll find in any (good) textbook ...
1. Price risk: pretty obviously, investing in bullion represents outright speculation, with all the attendant exposure (unless it is part of a hedged strategy). I often describe gold etc as a 'hedge against Bad News', but that should be seen for what it is - a very loose use of the word 'hedge'. There is no precise inverse correlation of the sort that true hedging implies: it's a 'dirty hedge' at best.
2. Basis risk: investors wanting exposure to (say) the gold price, but not knowing how to get direct exposure, have often bought (e.g.) gold mining stocks as a proxy. Only empirical analysis can determine how closely the prices of gold and mining stocks are correlated (answer - not very highly, by risk-management standards): and even if two things have been very well-correlated for a long period, this correlation might subsequently collapse - I could cite many cases. This is an example of what is known in the trade as Basis Risk.
3. FX risk: if something is denominated in a currency other than your own, this can open up another source of risk. Of course, gold, though generally quoted in USD is readily quoted in all currencies, and anyway FX itself is an ultra-liquid market; so is gold 'really' denominated in USD? An interesting question, not easily answered. But we could fairly say that oil is definitely denominated in $, FX notwithstanding, because its price formation is driven inter alia by the dollar itself.
4. Credit risk: when you want to cash out, can you ? and with what certainty ? This is where serious DD really counts, & it leads directly to some other risk considerations ...
5. 'Wrong-way' risk: where the credit standing of your counterparty is related to the very economic conditions your investment is concerned with. If you buy an out-of-the-money put from an oil company, you'll be wanting to exercise it when oil prices crash. But that's just when the oil company will be in trouble ... The same might be true of (e.g.) an ETF, relative to Bad News - Alphaville has published long articles on this.
6. Illiquidity: at the best of times, some markets / asset classes are more liquid than others, & in troubled times this can become acute. Bid-offer spreads can become ugly, too. The latter can also result from volatility which of itself, for the trader, is not always a bad thing in terms of opportunities presented. But wide bid-offers only favour market-makers.
7. Premium on physical: this is where we came in. For several of the above reasons, commodity buyers (both private investors and industrial end-users) prefer owning the actual stuff, even if (on a good day) paper 'equivalents' have a near-identical financial performance. Of course, owning the actual stuff often comes with additional costs and complexities of its own - who can handle 1,000 tonnes of coal, or 1 MWh of electricity ? Typically, only a specialist player.
But it also comes with a greater measure of certainty, which in difficult times can be a serious advantage. Related to what is termed the 'convenience yield', it can frequently outweigh the 'cost of carry', amounting to a premium on holding the actual, physical commodity - particularly when credit issues abound, and there is reason to be suspicious of contractual performance.
Sound familiar ? Back to doing your own DD, chaps.