Many people think the introduction of the gold exchange-traded funds (ETFs) will increase demand for gold and push up its price. But Andy Smith of London-based Mitsui Global Precious Metals thinks the price of gold will fall once the ETFs go live. Here's his reasoning:
- The London-traded gold ETF (Bullion Security) generated disappointingly low demand for gold. For example, Smith writes that "Some 97% of the gold accumulated in the [second] London gold bullion security was gobbled in the first month of its existence".
- Smith estimates that the State Street and Barclays gold ETFs will together generate maximum demand of 230 tonnes of gold, assuming similar per capita demand in the U.S.
- If each of the two ETF sponsors assumes that their ETF will hit that volume, it's possible that Barclays and State Street have already been in the market buying as much as 460 tonnes of gold in preparation for the ETFs' launch.
- It would also make sense for the two sponsors to hedge their risk by buying short-term puts (Smith speculates on December $400 puts). But if they have high expectations for the ETFs, they would also likely have been buying longer-term call options on gold.
- The purchase of gold bullion and long-dated call options by the sponsors would explain why the price of gold has been so strong recently, despite the swift resolution of the U.S. presidential election and strong employment numbers.
- If the price of gold then falls for any reason, the sponsors will try to sell their call options, and that would further depress the price of gold. And if investors don't buy the gold ETFs due to a decline in the gold price, the sponsors would then have to sell gold bullion that they had purchased on the assumption that the ETFs would be popular.
- Smith also estimates that speculators hold the equivalent of 716 tonnes of gold; if the price began to fall, they would attempt to sell, and that would exacerbate the price decline.
- A really sharp decline in the gold price would further frighten away retail investors. And then demand for the gold ETFs would fall further, requiring further sales of gold bullion by the ETF sponsors.
Smith's argument should be carefully considered by investors. However, perhaps he's misled by the U.K experience. Sure, gold securities in the U.K and Australia haven't generated surprisingly large demand for gold. But there are two key differences between those countries and the U.S.:
- Americans are much more enthusiastic about self-directed investing than Brits and Australians, who mainly invest via pension plans.
- The weak dollar has resulted in a greater increase in the gold price in dollar terms than in sterling terms, and there's considerable concern in the U.S. that the dollar is in for further declines. Gold therefore seems to many U.S. investors to be a good way to benefit from a dollar decline.
The combination of those two factors is potent: lots of U.S. retail investors and financial advisors buying the gold ETFs to protect their portfolios from a declining dollar. Plus the possiblity that many U.S. investors and money managers will buy the gold ETFs to add a distinct asset class to their portfolios, irrespective of the near-term outlook for the gold price.
So it's likely that demand for the U.S. ETFs will be considerably higher than in the U.K. It's then worth considering what would happen if demand for the U.S. gold ETFs is even higher than Smith's optimistic scenario of 460 tonnes.
In that case, Barclays and State Street would be forced to buy more bullion. Their purchase of long-dated call-options would then look smart (they certainly wouldn't be in the market trying to sell them), and the price of gold could actually rise. Particularly if the dollar continues to decline.
Which outcome is most likely? I've no idea. Andy Smith is almost certainly correct that at least some of the bullion buying has been completed by the sponsors ahead of the launch of the ETFs. But U.S. investor demand for the gold ETFs is still an open question.
The debate, however, illustrates one important point about gold:
Gold is an essentially speculative investment.Gold is only worth what investors are prepared to pay for
it, unlike other commodities whose demand is largely determined by consumption. If the price of gold begins to fall and is expected to
continue falling, there's no reason for most people (excluding
jewelers) to buy gold.
In that respect, investing in precious metals is fundamentally riskier than investing in stocks or industrial commodities. And that's one reason why some people may consider gold to be an asset class unworthy of inclusion in investment portfolios.
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