Friday, November 19, 2010

The Price of Gold and the Influence of ETFs

The surge in gold prices has encouraged debate as to the future direction of prices. It seems that every week there is a launch of a new Exchange Traded Fund (ETF) aimed at the commodity market. If someone is about to buy or sell a gold ETF or gold bullion, then it makes sense to try and understand the arguments. This article identifies four factors.

The section on emerging market demand relates mainly to Indian and Chinese jewellery & investment demand. Gold ETF demand discusses the growth in the ETF commodity industry and, provides some warnings over future demand. Investor demand focuses on Global investors’ rationale for favouring gold as an asset class. Finally, these strands are put together to create a picture of how someone using an approach based George Soros’ discussion of reflexivity in ‘The Alchemy of Finance’ might view matters.

Emerging Market Demand Boosting Gold in Q2

This is the strongest argument in favour of higher Gold prices. It sees emerging market growth in the context of the expansion of the middle classes in China and India. Both countries have populations disposed towards holding Gold. As their discretionary spending power increases, it is reasonable to expect strong growth in Gold demand. In fact, the trend is already in place.

According to the World Gold Council or WGC, jewellery demand made up 51% of total gold demand in 2009. Of this figure, India accounts for 25% India also accounted for 19% of total net retail investment and 17% of industrial demand in 2009. By early 2010, India was accounting for 29% of global jewellery demand and Greater China 20% It is a similar picture in terms of net retail investment whereby, India accounted for 27% and China for 11% of global demand by early 2010.

In addition, India and China do not possess sophisticated investment markets. There is a lack of other asset classes that their investors would feel comfortable with. Furthermore, the Asian Financial Crises of 1997 has psychologically encouraged them to hedge against currency risk. Gold is seen as a suitable solution. Similarly, both countries run large budget surpluses and have substantial US Treasuries. Gold gives them diversification from this currency risk.

ETF Demand in Q2

The expansion and popularity of commodity ETFs has fed through into Gold. According to the WGC, here is the percentage of total gold demand that is coming from ETFs:

2003 1.2%
2004 3.8%
2005 5.6%
2006 7.6%
2007 7.1%
2008 8.4%
2009 17.5%

The last figure looks dramatic but, should be seen in the context of the extreme levels of risk aversion prevalent in Q1 of 2009. However,the four quarter rolling level is back down to 4.8%

This strong growth is attributable not only to investor demand, but also to structural growth. ETFs are seen as new revenue generators for investment banks and, they have not been actively expanding them in the Gold and Silver ETF market. Increasingly, many have been structuring them with derivative instruments rather than physical gold. This should trigger alerts over the risks of leverage. Furthermore, the increasing use of derivatives will cause the figures for physical demand to be appear less than investment exposure.

The last point will be a concern at the margin, because most of the gold physically held by ETFs is held on a matched basis.For example, the largest single fund, State Streets SPDR Gold Trust, holds between 80-90% of the ETF total and they match physical gold with investor buys/sells. However, the knock-on effects of a liquidity problem with derivatives in gold ETFs should not be dismissed lightly.

Global Investors

Having touched on the specific emerging market investors’ perspective, it is worth considering global investors' rationale for buying gold. They have been favouring gold in a movement towards risk aversion and away from other asset classes. Gold is seen as offering diversification from increasingly correlated asset classes. It has also seen as an inflation hedge. Furthermore, currency volatility and sovereign debt fears have caused gold to be seen as a safe haven.

What about Soros’ Reflexivity?

How might one famous investor bring these arguments together? One of the ideas behind Soros’ book ‘The Alchemy of Finance’ is that asset classes can have self sustaining feedback loops. In this example, as gold prices rise they could cause some kind of underlying trend which then supports more price rises. This continues until the underlying trend rolls over and then the price follows in swift and violent fashion after, a point of inflexion has been passed.

This could be happening with gold. It begins with string underlying price drivers. As gold prices rise, it encourages gold to be seen as a safe haven, which encourages ETF sales and issuance. ETFs start using derivative products to gain leverage, then the price is pushed higher as new investors come in chasing higher prices. Ultimately, this might end as new ETF investors stop coming in for myriad reasons. For example, risk aversion might abate, asset allocators could move away from gold, or retail investment demand could dry up. Jewellery demand could decline due to high pricing or substitution.

As prices start falling, the leveraged ETF players using derivatives might then find themselves in trouble, and the fall could turn into a bust. With this in mind, it is worth noting from the ETF section above that, the share of demand from ETF’s fell to 4.9% from 17.5% from Q1 2009 to Q2 2010. Interestingly, the price of gold still went up 21% in that period, even though total demand fell 9%

Might this be Soros’ inflexion point? It is hard to say for sure, but this article outlines the way that investors could try and discern the underlying patterns.


Soros,George “The Alchemy of Finance” John Wiley & Sons 2003
World Gold Council “Gold Demand Trends” Q2 2010

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