The Gold ETF/Physical Gold Disconnect

By now you have undoubtedly heard about the massive sell-off in gold and the resulting drop in gold ETF prices. But have you heard the full story?

One of the common points used by any expert extolling the virtues of the ETF structure is the access it has provided to asset classes that were heretofore uninvestable for most retail investors.

Commodities, private equity and master limited partnerships—to name three—are now bundled and traded on exchanges as if they were Dell or General Electric.

The benefits of this, we’ve been told, is that investors now have a near-unlimited arsenal of investment tools at their disposal, and the middlemen that historically have come along with trading in these markets have been taken out of the picture.

That is all fine and dandy and, as someone who is neck-deep in the burgeoning ETF empire, I tend to agree with the sentiment that such an increase in accessibility is a good thing.

The problem is that there are going to be times when the market sends very mixed signals that don’t provide immediate answers. In a world of short attention spans, this can lead to misguided conclusions and distortions of reality.

The quick sell-off in gold ETFs is a perfect example of this.

Just 10 years, ago the notion of an exchange-traded product backed by physical gold would have sounded like a fairytale along the lines of Jack and the Beanstalk. After all, how would you know that the ETF actually held the gold? How would someone audit those holdings? Would I be allowed to redeem my shares for physical gold?

Here we are, just eight years after the launch of the first physically backed gold ETF—the SPDR Gold Shares (GLD)—and the market has responded in droves. There is now more than $75 billion invested in ETFs holding or tracking gold, and GLD is one of the most widely traded securities in the world, let alone one of the most widely traded ETFs.

In other words, the market quickly discovered the utility of exchange-traded gold products and never really looked back.

But that's the rub. For an asset like gold, the tradability of paper-based versions of the metal have a far greater influence on the price of the security than possibly any other asset tracked by exchange-traded products. This can distort the picture of the true supply and demand for the physical metal itself.



After all, not only is gold in relatively short supply globally—remember the image that all above-ground gold in the world could fit into an Olympic-sized swimming pool?—and it’s not very liquid at the margin.

Small-scale physical purchasers of gold must typically pay a high premium to spot prices and they have to deal with everyone from pawnshop owners to local coin dealers to buy it.

A simple thought experiment highlights this. Given the decline of gold prices and of GLD last week, it would be logical to expect a rash of physical sales over the same time frame. After all, if the price of gold and, by extension, the price of GLD, were a proxy for real gold demand, a wave of price declines would trigger a tsunami of panic sales by individual gold investors.

But you would be wrong to draw this conclusion. The Perth Mint, which refines nearly all of Australia’s gold and is the de facto retail source for gold bullion, saw sales double last week .

Meanwhile, back here in the United States, our own mint saw gold coin sales surge sevenfold over the same year-earlier period . In keeping with the trend, retail gold sales in India and China, the world’s two largest gold markets, also surged.

All of this is to say that the sell-off in gold might be traced back to our new friend the ETF, while the true demand for gold seems to be chugging right along, with bargain hunters ready to step in on any correction.

The reasons people invest in gold vary greatly from investor to investor. Most Indian and Chinese demand comes from jewelry purchases.

Then there are those who distrust the central banks of the world and their ability to print paper money by fiat. It would make sense that these investors would be least deterred by a paper-based sell-off in gold, as their entire rationale for investing in gold is grounded in their distrust of paper assets.

It could very well be that these “bargain hunters” are in for a rude awakening and the fantastic bull-run in gold prices has finally reached its apex after an unabated, 12-year rise in price.

Then again, it could also be that we are seeing a “tail wagging the dog” phenomenon, wherein sales of derivative stakes in gold—ETFs like GLD—are having a disproportionate impact on the price of the metal and belie strong underlying fundamentals.

Either way, the gold market is telling two very different stories and, based on the one you choose to believe, you really can’t choose the other.



At the time this article was written, the author held no positions in the security mentioned. Contact Paul Baiocchi at .


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