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By Amine Bouchentouf

Hedge funds are playing an increasing role in the commodities markets as a whole and in the gold market in particular. Whereas mutual funds usually employ a buy-and-hold strategy, hedge funds have the ability to use both long and short trading strategies. In addition, mutual funds usually are restricted to deploying capital in traditional equity markets. Hedge funds can trade credit derivatives, futures, options, credit default swaps, and a range of other instruments. While the mutual fund industry dwarfs hedge funds in terms of size, hedge funds have much more flexibility in how they deploy their capital and in which markets.

Hedgies in the Gold Market

Hedge funds, or "hedgies" as they're sometimes called, have become extremely active participants in the gold markets. Just like every other investor, hedge funds enter specific markets in search of yield and high returns -- and gold has come on the radar of some of the industry's biggest players as a fertile market to generate returns.

Beginning in the early 2000s, gold caught the attention of some of the industry's most prominent funds, such as Soros Fund Management. As gold continued to perform well, hedge funds and other investors found new ways to trade the yellow metal; the advent of the first gold ETF is a perfect example of this. The ETF allowed many hedge funds to trade the gold markets in a rapid and liquid fashion.

While it's difficult to quantify the amount that capital hedge funds account for in the gold markets, suffice it to say that gold has become such a prominent asset class for the industry that some of the world's biggest hedge funds have launched dedicated gold funds specifically to trade the yellow metal. John Paulson's hedge fund Paulson & Co. has sponsored a separate and fully dedicated gold fund it launched soon after 2008. At one point, Paulson & Co.'s gold fund had close to $1 billion under management.

Another prominent hedge fund that's active in the gold markets is run by George Soros, who rose to fame when he "broke" the Bank of England in the 1990s. Soros Fund Management has been active in the gold markets for more than a decade, and counts the yellow metal as one of its primary asset classes, where it takes both long and short bets on gold.

Investments Across the Board

Because of their legal structure, hedge funds' investment mandates allow them to invest in various instruments -- and they have used this flexibility to trade various gold instruments from gold ETFs to gold equities to actual gold bullion. The impact that hedge funds have had (and will continue to have in the gold markets) is significant and market moving.

Let's just take, for example, SPDR Gold Trust (NYSEARCA:GLD), the world's largest and most liquid gold ETF. One single hedge fund (Paulson & Co.) held more than 21 million shares of this ETF, which represented more than 7% of the ETF's total holdings. When you add other hedge funds that hold this asset, that number quickly balloons to close to 20%. This number doesn't include hedge funds that move in and out of the ETF and therefore aren't subject to disclosure requirements. Another area where hedge funds have been active is international gold equities. These are usually precious metals mining companies with operations in mining jurisdictions such as Canada, South Africa, and Brazil.

Companies such as Barrick Gold (NYSE:ABX), NovaGold Resources (NYSEMKT:NG), and Allied Nevada Gold (NYSEMKT:ANV) have been favorites of hedge funds. According to regulatory disclosures, hedge funds usually comprise anywhere from 15% to 30% of total shareholder ownership -- and this doesn't include other instruments the companies issue such as warrants, options, and corporate bonds that hedge funds incorporate into their trading strategies.

Many have blamed the downside in the gold markets recently on hedge funds. While it's unfair to say that the whole market correction was brought on by hedge funds, it can be argued that the downside has been exacerbated by these investment vehicles. Gold has not been the best performer for the funds recently and many have cut their holdings dramatically. However, the short-selling certainly has been pushed by funds and that has played a big role in pushing the price downward.

At the end of the day, hedge funds have large pools of capital to deploy and will keep trading and investing in gold markets for the foreseeable future. While it's tough to quantify their direct effect in gold price movements, it's important to be aware that when you're trading gold, you're not the only shark in the ocean.

Disclosure: The author is long gold.

Source: How Hedge Funds Influence Gold Markets