September 6th, 2011

Are Gold ETFs Creating a Bubble? (NYSE:GLD, NYSE:IAU)

Gold exchange-traded funds have become very famous instruments. Big-wig investors such as John Paulson, George Soros and Eric Mindich have all invested large capital in SPDR Gold Trust ETF (NYSE:GLD). But these instruments are still relatively new, as is their effects on the physical gold market. The first gold-backed ETF appeared on the Australian Stock Exchange in 2003. In 2004, the SPDR Gold Trust ETF debuted on the New York Stock Exchange.

Today, GLD has holdings worth more than $65 billion, adding up to about 1208 metric tons of bullion. That is more gold than held by every single country besides the United States, Germany, France and Italy.

GLD certainly isn’t the only gold-backed ETF, but it’s the largest. The chart below shows all of ETF consumption as of June 2011. Obviously gold values have since increased.

Gold ETFs Provide Accessibility and Affordability

One of the biggest effects of gold ETFs is that investing in gold is much more accessible. Not only can investors purchase shares, but options activity is strong for GLD. According to the World Gold Council, outstanding options contracts on GLD reached a record-high of 16.7 million in Q2 of 2011.

A share of SPDR Gold Trust is based on one-tenth the price of an ounce of gold minus a fee of 40 basis points. There are no hassles of storing the gold or risking its stolen. It’s relatively maintenance-free.

That’s why gold investing has become much more mainstream since 2004. But can it explain the run-up we’ve had in gold prices since around the same time?

Gold Since 2004

The chart below shows the last ten years of gold prices. As you can see, gold prices are fairly level, with a slight upward growth.

After 2004, things begin to get interesting…

• The price of gold begins to skyrocket.
• It hasn’t been inflation… and The Great Recession started in 2008.
• There are no shortages of gold that we know of, since it continues to be mined.

So what could it be other than the advent of ETF funds?

Gold ETFs: A Small Portion of Demand

When looking at the statistics, ETFs make up a tiny fraction of gold demand:

Jewelry by far makes up the bulk of global demand. In 2010, ETF consumption made just about one-third of all investment demand. Bar and coin demand increased a whopping 47.9 percent from 2009 to 2010.

Looking at these numbers makes it hard to believe that ETF gold consumption is powerful enough to be a factor in the run-up. Especially most recently, as ETF consumption sank while other forms of gold investment demand increased.

ETF Holdings Vs. Gold Prices

But take a look at these graphs. The first compares the gold prices to demand:

Normally one would expect higher demand to lead to higher prices. This current run-up in gold is at less demand per metric ton. In fact, demand in Q2 of 2011 was the lowest since 2009.

The next graph compares the holdings in ETFs to the price of gold:

There’s certainly a clear correlation in ETF holdings and the prices. But obviously one would expect ETF holdings to grow with higher gold prices. More people would invest in the paper, which would give the ETF more money to spend on gold. So its arguable if ETF holdings are a cause or an effect of rising gold prices. But they are certainly correlated.

ETF Gold Consumption and the Waterfall Effect

Although the effect of ETF gold consumption on prices is arguable there’s one important thing to gather from the above data. The rise in gold prices is not supported by demand. There are obviously a bunch of global factors that have made gold an attractive safe haven lately.

Maybe ETF consumption has helped drive a bubble in gold. But speculation and fear has definitely pushed prices higher. Because of this, the CME has already boosted margin requirements twice. Both times this leveled gold for a few days, but didn’t cause much damage. Considering silver has experienced seven hikes this year, it’s bound to happen to gold a few more times.

Silver speculation got so bad earlier this year that the CME hiked margin requirements five times in two weeks. The margin hikes led to an abrupt 30 percent drop in the price of silver in May.

Where ETFs will play a factor is when this bubble eventually bursts. As the price of gold falls and investors flee GLD and other gold ETFs, these ETFs will have to drop physical holdings. Considering GLD has more gold than China, this could easily flood the market. Depending on the scale of the drop in gold prices and the evacuation from GLD, things could get really ugly, really fast.

So whether or not gold-backed ETFs are having a big effect on gold prices now… They will definitely affect them on the way down.