All that glitters is not gold

19th May 2010

Yes, it's bullion time again.

The blogs and bulletin boards are resounding with the merry clang of conflict between intelligent people who maintain either that gold is either regaining its rightful place in the investment constellation – or, conversely, that it's getting quite bizarrely overvalued, thanks to a slew of new investment vehicles, especially exchange-traded funds.

And that apocalypse is surely nigh….

In the optimists' camp are all the gold bugs who remind us that bullion is nowhere near its all-time high of $887.50 per ounce in 1980 – or about $2,300 in today's money.

And that, in a time when the political and economic environment is throwing so many worries at us, the advantages of having a gold bar under the floorboards have never seemed so obvious.

In the pessimistic camp, meanwhile, are a growing number of people who are getting spooked by the distorting influence that ETFs are having on the gold market.

ETFs, they say, are feeding a bullion bubble by making it possible to have five dollars' worth of investments hanging on every dollar's worth of gold.

And this, they say, is creating a gigantic inverted pyramid of investment which could topple without warning. The risk is simply hideous.

Who's right? Well, let's look at the three main ways you might buy gold these days. Firstly, of course, you can simply go out and buy a gold bar or a coin.

Secondly, you can buy a gold certificate, which means that somebody keeps your gold in his own vault and gives you a tradeable ‘deed of ownership'.

And thirdly, there are gold ETFs.

The ETF tail that wags the bullion dog?

Now, everybody loves commodity ETFs, because they're as easy to trade as shares but you can back a whole sector in one go.

The ETF provider simply buys an interest in the gold that underlies the investment, and the price of your ETF rises and falls with the bullion price.


Fat chance. There are certainly some gold ETFs that do buy physical bullion, but most are ‘structured products' that never touch the stuff. Instead, they trade gold derivatives – mostly futures, which are just bets on the future price of gold.

By balancing their derivative holdings carefully, the ETFs can ensure that their portfolio values always allow them to match the bullion price. (Or some bullion-related index of their own choosing.)

The problem is, anybody can issue a gold futures contract. There's no technical need for the investment to be underpinned by any physical gold.

So there's effectively no limit to the amount of money that might be riding on a tonne of gold.

Derivatives, and the ETFs that hold them, are already causing headaches for oil markets, where the crude price is frequently kicked around by naked speculation.

And now the bullion bears are worrying that the gold price is being similarly distorted by this uncontrolled ‘gearing', to the point where the ETF tail is wagging the bullion dog.

On golden Ponzi…

That's dangerous for two reasons.

Firstly, if the world's gold ETF bugs were ever to sell out all at once, many of them would find out for the first time that their investment were based on promises, not gold bars. The pressure on gold prices might cause a complete collapse.

Secondly, we'd start to rediscover the Ponzi principle.

At present, with the volume of cash invested in gold ETFs rising in this geared way, each new investor is effectively trusting that all the others have done their sums properly.

If they haven't, everything may crash and burn once the bankruptcies start. And a lot of us are going to look very silly indeed.

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