How ETFs Have Spurred the Gold Bubble

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Includes: DGP, DZZ, GDX, GLD, IAU, SGOL, UGL
by: ChartProphet


Introduction of ETFs

The introduction of gold ETFs, and the ease with which the average investor can now invest in gold, has made gold much more accessible – and, in turn, much more speculative than ever before.

The more widespread an investment becomes, the greater its chances of forming a bubble. Perhaps nothing has helped gold prices soar more than the introduction of Gold Exchange-Traded Funds (ETFs). Before ETFs, the main ways to invest in gold were limited to buying physical gold, jewelry, or through real commodity trading. The introduction of gold ETFs, most notably the GLD (the largest gold holding ETF in the US), has made it much easier, more accessible, and liquid to invest in gold. With gold now traded similarly to stocks, the number of investors and degree of speculation has increased exponentially. With the proper tools for investment now at the disposal of gold investors, a speculative bubble has become drastically more likely.

The first gold ETF to be launched was Gold Bullion Securities, listed on the Australian Stock Exchange on March 28, 2003. The largest and most well-known gold ETF, the SPDR Gold ETF (NYSEARCA:GLD), was launched in November 2004. Now holding over $60 billion in gold, the GLD holds more gold than China. A multitude of gold ETFs have since emerged, and continue to ignite speculative interest in the precious metal.

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Though the speculative interest in gold has coincided with the growth of the gold ETF industry, and is not necessarily caused by the ETF, it is still easy to see how the introduction and availability of the gold ETFs has tremendously supported the rise in gold prices, and may have even acted as a multiplier.

Just take a look at how far gold prices have gone since the introduction of gold ETFs:

In describing the precipitating structural factors that had led to irrational exuberance and the market bubbles of the late 1990's and 2000's, Shiller points to the “proliferation of equity mutual funds with the effect of encouraging speculative price movements in stock market aggregates, rather than in individual stocks”. Furthermore, the psychological aspect of new investment vehicles led to “the emerging popular concept that mutual fund investing is sound, convenient, and safe” and “has encouraged many investors who were once afraid of the market to want to enter it, thereby contributing to an upward thrust in the market" (Shiller, Irrational Exuberance 50).

The eerie similarity between the mutual funds that led to the bubbles of the late 1900s and the ETFs that have led to the gold bubble of the past decade is uncanny. The introduction of the gold ETFs has increased awareness, created the illusion that investing in gold through ETFs is sound and safe, and has encouraged many investors who were once afraid of gold investing to buy gold and thereby contribute to the “upward thrust” of the gold bubble.

The price of gold is up nearly $1300 since the introduction of the gold ETFs. And though it is hard, if not impossible, to truly measure the effect of ETFs on investment demand it could very well be argued that ETFs have sparked a lot of interest in gold. Both by allowing new investors a way to invest in gold and by involving a multitude of market participants who would otherwise never come across gold as an investment idea.

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Further ETF Risks: Proper Storage and Physical Backing?

Although the GLD ETF is supposedly backed by gold bullion in London, there has been concern over the questionable assurance of quantity, quality, and safety of the fund’s holdings. One example of questionable and potentially fraudulent practices: according to the SPDR Gold Trust prospectus, “Gold bars allocated to the Trust in connection with the creation of a basket may not meet the London Good Delivery Standards.” Other questionable provisions in the prospectus that should send out red flags are ones that limit the liability of custodians and sub-custodians responsible for the safekeeping of the gold in cases of fraud, damage or theft.

The accusations and potential fraud have not been proven, but the ambiguous prospectus might be showing signs of speculation and questionable practices normally associated with risky asset bubbles. Furthermore, if such fraud does turn out to be true one day, the gold market will tumble. This is just another reason to watch out with gold.

Disclosure: I am short GDX through put options.