Commentary: Rise and growth of gold ETFs

The last decade has been an eventful one for gold markets. We have seen a remarkable 12-year bull market, a shift in demand from the developed West to the rising East, and global central banks as net buyers of gold for the first time since 1985. Exchange-traded funds (ETFs) and other exchange-traded products have been another key development that made it easier for investors to access gold, especially after the 2008–09 financial crisis.

Historically, investors have bought gold in a number of ways. They buy gold futures contracts or gold-mining stocks, own shares in a mutual fund with an actively managed precious metal strategy or hold physical gold (directly or indirectly) in the form of bars and coins.

Since 2003, ETFs — as well as other ETF products — were added to the list of alternatives available to investors. While other vehicles for acquiring physical gold could still suit investors, the unique characteristics of ETFs have drawn investors into the gold market for a number of reasons.

Gold ETFs help lower the overall cost of owning gold and increase the efficiency of holding gold bullion within a portfolio because they offer:

•  Lower management fees. Investors who buy an actively managed mutual fund with a precious metal strategy pay fees that range from an average of 160 basis points (bps) to more than 250 bps. 1 ETF fees are typically 40 bps or less because their structures get the benefit of economies of scale. Investors can invest in allocated gold accounts with comparable costs to gold ETFs; however, unlike ETFs, these accounts require a large minimum investment.

•  Reduced premiums. Gold-backed ETFs help democratize physical gold investment. ETFs offer investors of all sizes wholesale prices for the first time, while offering shares at fractional units of an ounce of gold, resulting in a much cheaper cost per purchase than bullion.

In contrast, investors who choose physical bars and coins may pay additional premiums over the gold price depending on the size of their investment.

•  No separate storage and vaulting costs. The management fee of exchange-trade products typically includes storage and vaulting costs for physical gold. Investors who hold gold bullion and coins bear the expense of storage and vaulting directly or through a third-party.

•  Standardized quality and security. Gold-backed ETFs generally hold a standard form of gold bullion in troy ounces, kilograms, or grams. For example, some ETFs hold exclusively London Good Delivery bars which have standardized quality and characteristics in weight (400 troy oz.), minimum fineness (99.5%), and dimensions that, in conjunction with periodical audits, reduce the cost of inconsistency and fraud. Additionally, these bars are typically stored at custodian or bullion banks that have experience, networks and facilities to properly secure the gold, helping reduce any cost of theft.

•  Added liquidity. Gold is liquid and can be easily converted into cash. Investors who hold gold via ETFs are participating in a deep and broad market that collectively trades more than US$1.1 billion a day, rivalling single stocks and many equity linked ETFs.

•  Increased operational efficiency and transparency. Gold ETFs provide transparency and security through an approved custodian, typically a bullion bank or dealer, with experience in managing gold accounts. Gold ETFs must also meet strict regulatory requirements similar to publically traded equities and publish intraday prices and reports. While a gold-backed ETF investor typically holds physical gold indirectly through a fund or trust, the ETF price closely tracks the “spot” price of gold. Its structure also reduces some of the drawbacks associated with actively managed or derivative-based products.

•  Less tracking error. ETFs are a passive implementation with no management or reinvestment decisions of the underlying holdings. Unlike futures contracts, gold-backed ETFs do not face contango and backwardation concerns, or rollover and reinvestment decisions on maturity.

•  Reduced counterparty risk. Major gold-backed ETFs hold no derivative contracts, reducing their exposure to counterparty risk. In addition, many ETFs hold gold in “allocated” accounts that shield investors from a default by the custodian.

These aspects of gold ETFs helped shape the gold market to make gold investing more accessible to all types of investors — ranging from small private investors to large institutional holders — as a hedge asset, a diversifier and a form of portfolio insurance against multiple investment risks.

WGC launches first-ever gold ETF in 2003

ETFs debuted in the late 1980s. In their early days, ETFs were used to replicate baskets of stocks. The best known — and largest — is the SPDR S&P 500 ETF Trust, launched in 1993. It was not until a decade later that this differentiated fund structure was applied to non-traditional hard assets, such as gold.

In March 2003, the World Gold Council helped launch the first-ever gold ETF — developed by what is now known as ETF Securities — on the Australian stock exchange, giving investors an easy and and cost-effective way to hold gold. Similar products were later launched worldwide.

Most major exchanges now list gold ETFs, showing the global interest in this vehicle.

SPDR Gold Shares (ticker “GLD”) — which will have its tenth anniversary this year — was the first physically backed gold-ETF launched in the U.S. Developed and sponsored by World Gold Trust Services LLC — a wholly owned subsidiary of the World Gold Council — GLD was listed on the NYSE in November 2004. It is the largest gold-backed ETF — holding approximately 800 tonnes of physical gold at press time — as well as a gold-industry benchmark.

One of the most remarkable aspects of gold ETFs since their inception is the rate of growth and investor interest. For example, GLD reached more than US$1 billion in assets under management within its first three trading days. Within a year from its launch, the fund had tripled these assets.

Despite the sizable outflows in 2013, assets in gold ETFs rival the market capitalization of major global companies, or the gold holdings of major central banks.

As of August 2014, the 1,700 tonnes of gold held collectively by the 60 gold-backed ETFs we track had a US$71-billion value. To put this in perspective, if these ETFs were a company, they would be in the top 10% of companies worldwide ranked by market capitalization.

When measured against the constituents of the S&P 500, gold ETFs listed in the U.S. fall within the top 20% of U.S. companies by size. In addition, these 60 funds hold more gold than central banks combined with the exception of the U.S., Germany, Italy and France. Unlike central bank gold holdings, however, ETF shares are divided among millions of account holders.

Perhaps the most interesting comparison of gold ETFs comes when their liquidity is compared to some of the most liquid and actively traded equities. The average daily traded value as measured by trading volume of GLD alone (the most liquid gold ETF) is comparable to top technology and financial companies alone, and to broad index equity ETFs.

— The preceding is an edited excerpt from the newly published seventh volume of Gold investor: Risk management and capital preservation, produced by the World Gold Council. The full 40-page report is available for free at www.gold.org.