Exchange Traded Funds

Exchange traded funds may just be the most important invention in the gold market since shovels.

Essentially, these funds are ways for investors to gain direct exposure to gold in their portfolios via the stock market.

Exchange traded funds are listed on major exchanges, and perhaps the easiest way to understand them is to think of them as companies that do nothing but own gold. Their share price is also generally at a fixed ratio against the price of gold, so that if the gold price goes up, their share values go up, and if the price goes down, the inverse happens.

When investors buy shares in these funds, more gold is added to the ETF vault, and when investors sell shares, gold flows out of the vault.

Prior to ETFs, investors could only get access to gold exposure through indirect means, such as through the futures market or by owning mining shares – which thus had inherent counter-party risks and diluted the correlation with the gold price – or by owning physical gold – which involved self-funding the storage and security.

In exchange traded funds, the storage is taken care of by the fund manager, and the security cost passed on as part of the share price, and the exposure has a much closer correlation to the gold price than, for instance mining stock.

The fact that it is accessible via the stock market, as opposed to the futures market, also means that it has democratised investment to less sophisticated investors who may not have the knowledge, inclination or risk appetite to speculate on futures contracts – which carry with them a deeper level of complexity.

However, ETFs are not the exclusive domain of the small-time investor. Many large funds have substantial holdings in gold ETFs. They particularly like these products because of the high level of liquidity.

Nevertheless, exchange traded products are not for everyone. Many investors still prefer to invest in mining stocks because these are sometimes seen as providing the opportunity to outperform the moves in the price of the metal. And mining stock also pays dividend, and thus provides yield – something that neither ETFs, nor physical gold does (except when the physical is, for instance, lent out at a fee).

There also remains a core of investors who believe that it is better to own physical gold than invest in ETFs – which they sometimes describe as paper gold. These investors for one reason or another – be it because they are armageddonists or whether they just prefer the security of having the gold where they can see it, rather than trusting a counter-party to hold it for them – still prefer to buy bars, coins and ingots and arrange storage and security themselves.

But these investors notwithstanding, the growth in the importance of gold in exchange traded funds have been remarkable since their invention more than a decade ago, with flows into and out of these funds often front-running – perhaps even causing – directional changes in the gold price.