Has Gold Gone Reflexive?

February 15, 2006

As the price of gold rises, performance-chasing investors are buying gold ETFs. As gold ETFs grow their assets, the price of gold continues to rise. Where will it end?

The word on the Street is that the gold exchange-traded funds (ETFs) have gone "reflexive."  In other words, investors are piling so much money into the ETFs - which buy and store gold in a vault - that it is creating a shortage of physical gold on the market, thereby driving up the price of the metal.  That rising price attracts more investors, who buy more of the ETFs, sending … well, you get the idea.

Reflexivity is the pet theory of Quantum Fund founder George Soros, who dismissed efficient markets theory and rode his beloved "reflexivity" to one of the most successful  investment records of all time.

George has a way with words, and that way is often confusing.  But here's how he explained reflexivity in a speech to the MIT Department of Economics' World Economy Laboratory Conference in Washington, D.C., on April 26, 1994:

"Reflexivity is, in effect, a two-way feedback mechanism in which reality helps shape the participants' thinking and the participants' thinking helps shape reality in an unending process in which thinking and reality may come to approach each other but can never become identical."

Got that?  In other words, what goes around, comes around … almost.

The argument for the reflexivity of the gold bullion ETFs is pretty simple. Since the streetTRACKS Gold ETF launched in the United States in November 2004, the price of gold has gone nuts, rising from $450/ounce to a new 25-year high of $572/ounce.  That understates the relationship, because the price of gold shot up to $450/ounce from $400/ounce in part in anticipation of the ETF listing.  So, in essence, the price of gold has risen 35 percent since news of the U.S. gold ETF launch broke late in 2004. (Gold ETFs already existed in South Africa and England at the time, but the U.S. is a much larger market, and as such, the signpost for any reflexivity argument.)

But the question is: Is the link between the ETF and the price of gold a causal relationship, or is it purely coincidental?

Designed For Reflexivity

The World Gold Council (WGC) would certainly like you to believe that there is a causal relationship between the two.  The WGC, made up of leading gold producers around the world, was created to increase demand for the shiny yellow metal.  In fact, the WGC was the driving force between the creation of the first gold bullion ETFs - and they did so with the explicit belief that it would grow investor demand for gold bullion.

And there's no doubt that it's done that. Globally, the suite of gold bullion ETFs hold 429 tonnes of gold - making them the 12th largest repository of gold bullion in the world, just ahead of the central bank of Taiwan (426 tonnes) and just behind the central bank of Spain (472 tonnes).  That's incredible for a product that only launched in the past few years.  After all, Spain has been around for a long time.

But before we get too excited, let's put things in perspective. The United States, the world's leading repository of gold, holds 8,133 tonnes of the stuff, or 19 times the net holdings of the ETFs. According to the WGC, total aboveground stocks of gold total 155,000 tonnes, making the gold ETFs' share of aboveground stocks just 0.3 percent - hardly something to get excited about.

But looked at another way, things get more interesting.  In 2004, the world's central banks entered into an agreement to limit global gold sales to 500 tonnes per year (Don't worry - it's not collusion when goverments do it...)  As a result - and as a result of the long incubating period for new gold mines -  the elasticity of gold bullion supply is limited.  And seen from the supply/demand perspective, it's easy to argue that the gold ETFs are having some impact.

According to the World Gold Council, the world "consumed" 3,500 tonnes of gold in 2004. The bulk of that came in the form of jewelry (2,600 tons), with the remainder split evenly between industrial and investment demand.  The jewelry figure is misleading, because jewelry is the most common way of storing gold as an investment in many countries, particularly in India - the largest gold consumer in the world.  But that's how they break down the data.

How much did gold ETFs add to demand in 2004?  133 tonnes - or just a few percent of the total demand.  That hardly seems like enough to tilt the supply/demand balance.  But consider this: 2004 was the first year in recent memory that gold demand outstripped gold supply … and it did so by 150 tonnes, not far from the 133 tonnes piled into the gold ETFs.

In 2005, things get even more interesting.  With the rising price of gold attracting speculators from all corners, global demand for gold bullion rose 16 percent through the third quarter of 2005 (the last quarter data is available). That projects out to an increase of approximately 500 tonnes over 2004 levels.  Increased ETF demand accounted for a significant 32 percent of that boost. With supply inelastic, the increased demand for bullion from ETFs - and other users - could be tilting the balance on price, as physical gold become scarce in the market.

Still, you can't pin the entire increase on the back of the ETFs.  After all, ETFs still represent just a fraction of total gold demand each year.  They are not even the single largest source of increased demand for 2005 - that privilege is shared equally between the ETFs, other gold investments, and jewelry demand.

Moreover, looking to the future - and the markets always look to the future - there are even bigger demand shocks on the horizon.  India's economy is booming, and Indians invest a larger percentage of their assets in gold than any other people.  China's middle class is buying jewelry by the pound.  And recently, the central banks of Russia, South Africa and Argentina all announced plans to boost their investments in gold.  Russia alone said it would double its exposure, adding 500 tonnes of the precious metal over the next two years - more than the ETF industry has stockpiled in the past two years.

Playing A Minor Role

It pays to remember that the inherent industrial value of gold is much lower than its spot price; the metal is primarily a store of value.  As such, investors holding assets in gold could just as well hold those assets in dollars, or oil, or silver, or diamonds, or inflation-protected T-bonds; it should just be a question of relative value.

And on a relative value lever, things don't look so out of whack.  Gold isn't the only metal trading at multi-year highs.  Silver and platinum are trading higher than in any time in recent memory, and other metals are close behind.  While anticipation for a silver ETF may be contributing to silver's rise, most metals are rising on there own.   There may be some ETF-related reflexivity in the gold market, but it is not the dominant feature in the market.

(Note:  If the silver ETF gets approved, that's an entirely different matter.  The price of silver is directly related to its industrial value, and supply is very inelastic. A silver ETF could have a real impact on the price of that metal.)

Find your next ETF

Reset All