The Gold ETF/Physical Gold Disconnect

April 23, 2013

Thanks to ETFs, the recent sell-off in gold may be less real than it looks.

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 (NYSEArca: 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.

 

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