A gold ETF, (exchange-traded fund), is a commodity ETF that holds derivative contracts backed by gold.
Gold ETFs, that is, gold-based passive investment instruments designed to track the ups and downs of the value of that metal, will mark their 20th anniversary as an asset class in March 2023. This is a good time to review the instruments, their pluses and minuses, and their impact on the market for physical gold.
Why Gold ETFs?
Gold ETFs have exerted an appeal to many investors over the years since their creation. Why? They can be inexpensive, and thus accessible to investors who would balk at the price of coins or bullion. Furthermore, investors daunted by the idea of storing and safeguarding physical gold are sometimes relieved to think that this “paper gold” gives them the same risk-adjusted reward with less fuss.
Gold ETFs also offer intraday liquidity, akin to stocks and bonds. This is attractive because it gives people a sense that the door would not be locked should they need to make a quick exit from a tight spot. (We will have something more to say about that metaphorical door later.)
The very attractions of ETFs raise several questions, though:
- How large is the market for gold ETFs?
- Does it have an impact on the physical gold market?
- Should someone holding physical gold, or considering that possibility, worry about negative feedback from the ETF market?
Our answers to those questions below are, respectively: very large; possibly; no. This will lead us to an observation about the reasons why many investors stick with physical gold.
How Large is the Market?
If we exclude from our count leveraged or inverse funds, or any funds with an asset under management figure below $50 million, and if we focus our attention on funds that invest directly in gold futures contracts or gold bullion–setting aside those that own stock in companies that mine for gold–there are 10 exclusively gold-oriented ETFs now trading in the United States.
Even with this narrow definition of the subject matter, the size of the market is impressively huge. Those 10 ETFs have among them, at this writing, more than $103 billion in AUM. That is roughly a respectable 1.11% of the dollar value of the total supply of above-ground gold in the world.
What is the Feedback Mechanism?
The question about the impact of ETFs on their underlying asset is not unique to gold. One can ask analogous questions about the net asset value that underlies any exchange-traded fund. Is the ETF merely a price discovery mechanism, or is there a feedback mechanism? Is an ETF for, say, widget manufacturers a reflection of what is happening in the widget space, or does it become a driver?
There was a lot of turmoil in a lot of markets in March of 2020, as the significance of the pandemic first became obvious in much of the world. For illiquid underlying securities, investors traded in the liquid ETF shares instead. In this situation, ETFs were a valuable price discovery mechanism, working the way their designers long thought they would.
But 10 years earlier, in the flash crash of 2010, feedback from equity ETFs seemed to have played a role in shocking the underlying equity markets.
Considering Two Flash Crashes
The DJIA collapsed on May 6, 2010, falling 998.5 points in 20 minutes. This implied a market value loss of $1 trillion.
As the term “flash” suggests, this didn’t last. The market rebounded and ended the day close to where it had begun. It wasn’t a disaster.
Yet, it was a scary ride, and it threw a harsh spotlight on a number of market structural issues: the rise of high-frequency trading, the use of aggressive algos, and the presence of an “information channel” that allows for feedback between ETFs and their underlying asset.
Likewise, on January 6, 2014, a gold derivative (gold futures at New York’s Comex) had a flash crash of its own. More than 4,000 sell orders hit the electronic trading markets at 10:14 EST. This showed up on charts as a straight vertical line. In milliseconds, gold lost $30 per ounce, from $1,245 to $1,215. Again, the recovery was quick.
Assume that there is an information channel connecting ETF and derivative moves to physical value. Is that a negative factor weighing on the latter? Especially with regard to gold? Perhaps, but the year 2014 was an unremarkable one from that point of view. There was a broad bull rush early in the year, then the ground was lost. The metal ended the year about where it had begun. It isn’t easy to find the effects of derivatives feedback in the noise.
The ETF-Gold Relationship
In theory, one would expect the prices of ETFs to follow the net asset value of the underlying. After all, wouldn’t arbitrage quickly close any gap that developed?
In practice, though, there are inefficiencies at work that involve such gaps.
Let’s return to the question of an “information channel.” The hypothesis of an information channel can be stated simply, and applies to gold as readily as to stocks: if investors are using ETF numbers as a symptom of the near-future value of gold, then those ETF numbers will impact the demand for the physical metal.
If the gold-based ETFs make a sharp upward move, even for a technical reason only tenuously related to the underlying asset, this upward move will cause some people to buy gold who otherwise wouldn’t. Some of these buyers will be mistaken about the value of what they are buying, others may be engaged in deliberate arbitrage.
What we can say in general about the relationship between ETFs and the underlying market is that there is some feedback from the price discovery, and the feedback may be inefficient. But such effects as there are, are generally swamped by noise and evened out, over time, by arbitrage.
Profit Taking in April 2022
To consider a recent development: profit-taking in the ETF markets has been blamed by some for the drop in gold prices in mid-April 2022. Gold was above $1,950 in the middle of the month and fell into mid-May before finding a ceiling below $,1800. By the end of June, it was back above $1,800 but still well below its mid-April value.
It’s possible that profit-taking among gold ETF investors kicked off the downward move. By mid-May, some gold ETF analysts were talking about how they had had to recalibrate their models.
Yet, there are real-world developments that likely overwhelm the paper-gold/physical gold tie. The initial shock of a war in Ukraine may have kicked gold up to unsustainable levels, and the fall may simply be a typical correction.
Where there are inefficiencies and the possibility of mistakes, there is also the possibility of manipulation. None of this should keep one from owning and holding physical gold if it serves a valuable role in one’s portfolio.
A Problem with Gold ETFs
We began with a brief account of the attractions of gold ETFs vis-à-vis the physical stuff. Let’s conclude with the other side of that ledger.
An investor should also consider whether gold ETFs are selling something that they aren’t really providing: a tie to that physical gold. As Addison Wiggin suggested 12 years ago, ETFs can be a vehicle to allow duped investors to believe they have gold when, in fact, they have merely “a claim on the same chunk of gold as, say, Goldman Sachs. But Goldman would have the actual metal. The ETF investor [in a crunch] would have to settle for pennies on the dollar.“
It may turn out, then, that the greater liquidity in the event of a rush for the metaphorical door, one of the attractions of paper gold, is illusory when it is needed most.
A Final Point
As a related and final point, one of the most attractive features of gold, as an investment, is that there is no “counterparty” whom one has to trust to preserve its value. The value of a stock depends on the profitability of the issuer. The value of a bond depends upon its solvency. But the value of gold in storage is blessedly free of such worries.
Paper gold, though? It’s rife with counterparties and attendant risks.
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