Gold ETF Impact 2
Adam Hamilton
Archives
November 24, 2006
Two years ago this week a surprisingly
controversial event occurred in the gold world. The first gold
exchange-traded fund to trade in the States was launched. The
StreetTracks Gold Shares gold ETF marked the dawn of a new era
where investors can now directly buy a gold proxy from within
their familiar stock trading accounts.
The November 18th, 2004 launch
of GLD galvanized long-time gold investors like few other events
I can remember. Hardcore gold investors have long believed in
holding physical
gold in their own immediate possessions, which is definitely
very prudent. All portfolios ought to have a
foundation of physical gold, the real deal, in their owners'
own immediate possessions. Among these faithful gold investors,
GLD spawned a schism.
In one camp were the radically
paranoid, the tinfoil-hat crowd. They believed that GLD was a
grand front by anti-gold forces. They truly thought the GLD trust
would take investors' money, not buy any gold, and instead use
the proceeds as margin to short gold and drive its price way
down. This seems silly, but I am not making it up. I saved articles
and forum comments surrounding the GLD launch because it was
such a seminal event.
The second camp consisted of
much more rational opposition. This generally swirled around
the fact that GLD is merely "paper gold" since it isn't
physical coins in fist. In the first couple weeks after GLD launched,
a damning series of articles emerged questioning all kinds of
highly technical aspects of the trust's operations. At the core
of these attacks was the usual anti-paper-gold bias, "If
it ain't physical then it ain't gold."
One particularly popular article
right after launch, written by a GLD competitor in the digital-gold
business, analyzed GLD's inventory of gold bars and pointed out
alleged irregularities. Apparently some of GLD's reported gold
bars in inventory were duplicates! The strong implication of
this alarmist revelation was that GLD was a fraud. Published
on a Sunday, the following Monday it spawned a minor panic of
GLD selling.
Being a student of the markets
and a CPA, these allegations fascinated me. So I went through
the raw data myself. It turned out that out of 8306 gold bars
GLD listed as inventory, there were 78 duplicate sets, or 156
bars total. Thus only 1.9% of GLD's gold bars were questionable.
I dug deeper and found that in 100% of these 78 cases bars A
and B with the same serial number had very different weights.
So while they did have duplicate serial numbers in the GLD report,
they weren't duplicate bars. I explained all this in depth in
the 12.8.2004 Zeal Speculator.
At the time I concluded, "In
addition to omitting the hugely important fact that the 78 bars
in question were not identical but all have different weights,
he cried "fire" in a crowded theater without sharing
all the relevant facts. Other benign explanations are possible.
All questioned bars have 4-digit numbers, so perhaps some IT
guy at GLD truncated a digit on his import of raw data from GLD's
custodians." My thesis? Someone creating the 160-page
PDF file of GLD's gold-bar holdings just screwed up. No big deal.
A day later GLD issued a press
release and it turned out I was right. There was a minor data
problem in the very early exports of raw gold-bar data from GLD's
custodian. I was willing to give the newly-launched GLD the benefit
of the doubt because I was in the third camp, the hardcore gold
faithful who took a rational and pragmatic approach to GLD. We
believed that even though GLD was certainly no substitute for
physical gold, any new way for non-traditional investors to buy
gold indirectly had to be a good thing and expand the market.
As a physical-gold investor,
I have never personally owned GLD and probably never will. That
being said, there are vast legions of investors out there who
cannot be bothered to go to a coin shop and buy real gold. They
are pure stock-market investors and have little or no desire
to expand their horizons. While GLD was irrelevant to the hardcore,
it was a boon to the mainstream investors who wanted some gold
exposure in their portfolios but would have never attained it
if gold wasn't somehow tradable via their usual stock accounts.
Looking back now two years
later, and still shaking my head at the anti-GLD circus run by
pro-gold alarmists around GLD's launch, the GLD impact has indeed
been very positive in hindsight. The day before the GLD ETF launched,
gold closed at a bull-to-date high of $444. About 18 months after
this launch in May 2006, gold had soared 62% higher to a new
bull-to-date high of $720. Did GLD suppress the price of gold?
Not so one would notice! Indeed GLD proved very helpful to
our in-progress gold bull by broadening participation.
The day GLD launched, it had
8 metric tonnes of gold in the trust. No one knew if this stock-account-tradable
gold proxy would be a hit or flop. A week later initial GLD demand
was so strong despite the anti-GLD naysayers that it had swollen
to 100 tonnes. This week, Thanksgiving 2006, GLD's holdings are
up near 416 tonnes. Thus GLD has led to gold investment demand
of over 400 tonnes, much of which might have never existed if
mainstream investors and funds had no easy stock-account-tradable
way to gain gold exposure.
Just how much gold is 400 tonnes?
A crazy lot of it! In addition to being worth $8.3b, 416 tonnes
of gold would rank the US GLD ETF alone as 13th in the world
relative to central banks. In other words, there are only a dozen
sovereign nations that hold more gold in their vaults than the
vaults of the GLD trust! To go from zero to 400+ tonnes in two
years is an incredible achievement and GLD deserves great kudos
for pulling it off.
Regardless of where you stood
in the past or stand today on gold ETFs in general, you have
to admit that GLD's results today at its second birthday are
impressive. And of course GLD is not the only gold ETF in the
world, so in total gold ETFs have spawned much more gold demand
than this one example alone. Yet since GLD is the US leader and
it is so meticulous about accumulating data, examining it is
a great way to get a feel for gold ETFs' impact as a whole.
In this essay I am going to
examine the GLD trust's gold holdings, its daily trading volume,
and its variance from the spot gold price over its two years
of existence. This fascinating data provides an excellent window
into the impact of the GLD ETF. After I reexamined all of this
data this week, it really gave me a warm-and-fuzzy feeling on
gold ETFs in general. Just as originally hoped, they are greatly
expanding the gold market to a far wider pool of investors than
would exist if physical gold coins were still the only game in
town.
The relentless growth in GLD's
gold holdings is fascinating. For the most part they have only
gone in one direction, up. This surprises me as it defies the
expectations I had before GLD launched. Four years ago when thinking
about the theory
of a gold ETF, I had assumed that its underlying gold holdings
would fluctuate, in both directions, far more wildly than they
have in reality. Before I get into that theory and why it didn't
prove true, first some thoughts on this chart are in order.
GLD's gold holdings soared
in the week it was launched. While gold ETFs had already been
live for some time in other countries, GLD was the first such
animal in the US and it generated a lot of press even among mainstream
channels. Initially the GLD holdings continued to grow in early
2005 even when gold was weak. Investors, whether they were individuals
or funds, were apparently still diversifying into GLD following
its introduction.
Then gold itself was flat,
oscillating above and below $425 for most of 2005. A sideways
consolidating market is not exactly the type of environment that
sparks excitement, yet GLD held its own. Even when the gold price
dipped the total GLD holdings were stable. On balance during
this consolidation, a low-demand period for gold, GLD holdings
grew considerably. Even though gold hadn't done much of anything
for a year, on its first birthday the GLD ETF's holdings were
already well north of 200 metric tonnes of gold.
And then the greatest upleg
of this gold bull began in autumn 2005. The first half of this
upleg, into early February, witnessed a fairly orderly rise in
the gold price. During this time GLD holdings soared with increasing
demand as rising gold prices captured investors' attention. Interestingly,
GLD holdings stabilized right near gold's initial interim top
in early February of this year. But after that even when gold
started consolidating lower for the next couple months, GLD holdings
modestly grew.
Then, provocatively, during
the second parabolic half of gold's latest upleg from late March
to early May the GLD holdings were fairly stable. For some reason
there wasn't a flood of unbalanced fresh demand for GLD so the
trust didn't have to add to its gold holdings. While gold blasted
from $550 to $720 in a very short period of time, the GLD gold
holdings just grew modestly. And then when the parabola
crashed the selloff in GLD wasn't all that big. There was
just a trivial dip in GLD's holdings while the gold price plummeted
into June.
Since its mid-June interim
lows, the gold price spent most of the summer consolidating sideways.
During phases when gold was rising like in late June and early
July, GLD holdings grew. But during other times when gold was
grinding lower or falling like from mid-July to early October,
GLD holdings remained stable. Indeed overall GLD managed to grow
in size during this latest high consolidation in gold. It is
really quite remarkable.
Why? Per ETF theory, a gold
ETF should act as a conduit between stock-investor capital and
the physical gold world. A gold ETF needs to track the price
of gold to be effective. And in order to track gold, the gold
ETF actually has to shunt capital from stock investors into gold
or from gold back to stock investors. In other words it really
has to buy and sell actual gold. If there was not some mechanism
to equalize supply/demand imbalances on either the gold or stock
side, then the gold ETF would soon careen off track and not mirror
gold at all.
So when the gold price is rising,
the GLD ETF will be bid up in sympathy. But if stock investors
are bidding up GLD faster than gold traders are bidding up gold,
then the ETF custodians have a problem. The only way for them
to keep GLD's price from decoupling from gold to the upside is
to take the flood of stock capital buying GLD and pass it through
directly to the gold market. They buy physical gold. So when
GLD's physical-gold holdings are growing, it means that demand
for GLD shares is growing at a faster pace than gold itself.
The GLD custodians take this
excess capital and shunt it directly into gold. This helps stabilize
the tracking of GLD to the real gold price. Excess GLD demand
that would push GLD's price too far above gold's is funneled
into the gold market via GLD trust purchases of gold. This forces
the gold price to rise faster and keep pace with the GLD ETF
demand from the stock side. Without this active supply/demand
link, any ETF would be doomed to failure.
Obviously since the GLD ETF
creates a conduit for stock capital to flow into gold, it should
increase the volatility in gold. Before the ETF launched, I assumed
this would be a two-way street. On the downside, if GLD shares
were being sold faster than gold itself then the custodians would
have no choice but to sell some of their physical gold to provide
capital for redemptions. This would force excess GLD selling
pressure into the gold market and ensure GLD tracked gold to
the downside too. It would exacerbate gold volatility.
But amazingly, so far GLD only
appears to have enhanced the upside volatility of gold. GLD holdings
rise when gold is doing well, a testament to increasing GLD ETF
demand. But even when gold is doing poorly, there are seldom
any net redemptions, selling of GLD gold to keep the ETF tracking
its underlying commodity. This means a couple things, both of
which should be very exciting to all gold investors.
First, overall demand for GLD
is growing with the price of gold. This means the pool of capital
ready to chase gold is getting larger all the time. So as gold
marches higher on balance, net net even during gold's sharp corrections
there are more than enough new purchases of GLD shares to offset
GLD sales. The GLD trust shunts this stock demand directly into
gold by increasing its gold holdings. Overall GLD demand is growing
with the rising gold price, a very bullish omen for gold.
Second, the stability of GLD's
holdings even during the sharpest gold corrections such as the
brutal May/June one strongly suggests that it is largely investors,
not speculators, buying GLD. These strong-handed investors are
probably buying GLD for portfolio diversification over the long
haul, so they don't care if gold is up or down today. This validates
the wildest dream of the gold ETF concept, that by providing
an easy way for everyone to gain gold exposure it would dramatically
increase the ranks of investors interested in holding gold.
If it was only speculators
in GLD, then their manic buying and selling would cause the underlying
GLD holdings to track gold much more closely. This includes falling
sharply during gold corrections. But since GLD hasn't had to
liquidate its gold when the gold price is falling, whoever owns
GLD is holding it without regard for short-term gold psychology.
GLD is helping to broaden overall long-term investor exposure
to the gold market. The more long-term investors and capital
involved, the longer and higher a bull will ultimately run.
The growth in GLD investment
demand that isn't fleeing gold on weakness is also apparent in
the GLD trust daily trading volume. Like a normal stock, GLD
volume increases when the gold price is rising. And the higher
gold gets in general as its bull progresses, the more interest
grows in GLD and hence its trading volume rises over time.
Following an initial massive
spike when the GLD ETF launched, volume stabilized at relatively
low levels as gold consolidated sideways in 2005. And then as
the latest gold upleg started marching higher in late 2005, GLD
volume ramped up in sympathy. This volume growth was pretty orderly
and it reversed as soon as gold appeared to hit an interim top
in early February. GLD volume then waned with gold over the next
couple months until gold's parabola started rocketing higher
on sharp US dollar weakness.
As gold soared vertically,
GLD trading volume followed. Since each share of GLD represents
a tenth of an ounce of gold, near the May top the 21m shares
of GLD being traded daily represented a staggering 64 tonnes
of gold changing hands daily among stock investors. The GLD ETF
had created an entirely new market where none had existed before
since it was extremely unlikely the vast majority of the stock
investors trading GLD would have gone and opened futures accounts
if GLD hadn't existed.
Finally GLD volume hit an all-time
high on a capitulation mega-spike on June 13th, the day gold
plunged a staggering 7.3% to a new interim low. On this day alone
an incredible 81 tonnes of gold effectively changed hands via
the GLD ETF! Yet, despite this capitulation, apparently plenty
of buyers of GLD were there to eagerly take the sellers' shares.
How do I know this? GLD's gold holdings barely dipped during
this sharp gold crash so the demand for and supply of GLD shares
specifically was almost balanced.
Since the parabola and subsequent
crash of gold earlier this year, daily GLD trading volume has
once again stabilized. But it is really exciting to see that
it is stabilizing at much higher levels. Where GLD was averaging
around 2m shares a day for much of its first year, during the
last five months average daily GLD volume has soared to nearly
5m shares! GLD is getting more popular, and seeing more trading
action, as the gold price marches higher. This is great to see
and is good news for all gold investors.
Now the purpose of GLD is not
to take the place of physical-gold coins, but merely to track
the gold price. As such, my final chart looks at how well GLD
is tracking gold. The yellow GLD price is multiplied by ten to
get to a one-ounce equivalent and is charted over the blue spot-gold
price below. Then the volatile red line calculates the daily
variance between where GLDx10 is trading compared to where gold
itself is trading.
The white variance line does
the same thing but compares GLDx10 to the London PM Fix in gold.
This particular gold price is more relevant than spot gold to
GLD's performance since it is this London PM Fix that the GLD
custodians are using for their official tracking benchmark. Overall
GLD's custodians have done an outstanding job of ensuring that
their ETF closely tracks the underlying gold price just as it
is supposed to.
Overall the daily correlation
between GLD and the spot gold price is nearly perfect, running
0.9993. Initially GLD tracked gold incredibly tightly as the
nearly identical yellow and blue lines in 2005 illustrate. For
most of its first year the daily variance between GLDx10 and
the London PM Fix was trivial and even its extremes were usually
within +/- 1.2%. But during its second year of operation, since
last November, GLD's variance has widened slightly.
Note that the oscillating white
variance reading above is widening compared to the early days.
Today the extremes in this measure of the effectiveness of GLD
in accomplishing its gold-tracking mission are largely between
+1.8% to -1.2%, a 3% extreme range. I suspect there are a couple
reasons for this slightly looser tracking.
First, the underlying gold
price itself has been far more volatile in the second year of
GLD's life than in its first. During GLD's first year the gold
price just pretty much ground sideways and didn't move around
all that much. With gold being pretty sedate, it was probably
easier for GLD to track it closely.
But during the past year gold
has been all over the place. The wider and sharper the underlying
swings in gold, the less likely day-to-day GLD supply and demand
will match day-to-day gold supply and demand perfectly. As such,
a wider variance should be expected with more underlying gold
volatility.
Second, as the yellow and blue
lines show GLD's tracking of gold is loosening. This is partially
caused by the slow cannibalization of GLD. GLD, like any ETF,
has to fund its own management and operation expenses. The way
this is done is the same way it happens in a pure stock ETF,
by gradually selling off pieces of itself. In GLD's case its
annual expense ratio runs about 0.4%. Thus over each year of
its existence 0.4% of GLD's holdings are gradually sold off to
finance its operations. Thus today one share of GLD does not
represent 0.1 ounces, but 0.8% less than that after two years
or 0.0992 ounces.
This is why the yellow GLDx10
line is running lower than the blue gold line to a bigger degree
as GLD ages. At year 3 it will be 1.2% lower and at year 10 it
will be 4% lower. Now I know this concept bothered a lot of gold
investors initially, but I have never had a problem with it.
This is standard in the ETF business.
Every ETF cannibalizes itself
gradually over time to cover its own management expenses, even
the vaunted QQQQs. The expense ratio of the QQQQ NASDAQ 100 ETF
is running about 0.2% per year. Not only is the gold ETF vastly
smaller, but it is a heck of a lot more work to manage changing
physical-gold inventories compared to changing virtual stocks
inventories. The 0.4% GLD expense ratio is perfectly reasonable
for this service.
Another reason why the gradual
cannibalization of GLD doesn't bother me is because of the way
the gold-coin market works. Commissions on buying and selling
gold coins are absolutely gigantic compared to commissions for
trading stocks. On just a single round-trip buy and sell, a gold-coin
investor could very well pay 2% to 3% in commissions each way.
So an effective 4% commission over a decade in the GLD ETF compared
to 4% to 6% per each round-trip trade in physical gold coins
makes the 0.4% per year GLD expense ratio look trivial. And indeed
it is.
Today the GLD gold ETF, just
turning two, is doing fantastically well. Its physical gold holdings
have grown a staggering 50x in two years! And since these holdings
seldom drop even during sharp corrections in gold, GLD holders
as an aggregate are buying and holding. GLD demand from the stock-market-capital
side is stable and growing despite the wild volatility in gold.
This is a dream come true for the gold market.
The GLD ETF has created a conduit
through which pure stock capital can be shunted into the gold
world to broaden participation in the underlying gold bull. This
benefits every gold investor, whether you own physical coins
and gold stocks like us or whether you are a mainstream investor
who only owns GLD. The bigger the GLD trust and the other gold
ETFs grow, the higher the gold price will ultimately run in this
bull market since these ETFs add to overall global gold demand.
The more investors the merrier this party!
While we have never recommended
GLD specifically at Zeal and probably never will, we are in the
midst of a new deployment into elite gold stocks that are likely
to thrive in the next major gold upleg. Increasing demand for
GLD will help drive up gold prices which will in turn light a
fire under the gold stocks. Please
subscribe to our acclaimed monthly
newsletter today so you don't miss the new trades to ride
the next big gold surge higher!
The bottom line is GLD has
been a runaway success in its first two years. Not only did it
silence the naysayers and their crazy antics, but it exceeded
the dreams of its proponents in broadening investor participation
in the gold bull. The gold ETFs have opened up conduits through
which the vast pools of pure-stock-market capital can indirectly
bid up the physical-gold price. This is wonderful for all gold
investors!
While the gold ETFs are not
a replacement for physical gold for hardcore gold investors,
they were never intended to be. The gold ETFs like GLD exist
solely for mainstream stock investors who can't be bothered to
buy physical gold directly, and for mutual funds which can't
legally trade outside the stock markets. We ought to welcome
these gold rookies into this bull with open arms since they are
helping to drive up gold prices for all of us.
Adam Hamilton, CPA
November 24, 2006
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
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