Are The World's Biggest Gold Bulls Hoping To Blow A Fast Bubble, While Hedging Against A Collapse?

John Paulson

A lot of hedge funds have become very interested in gold over the last few years, but perhaps many are buying gold for different reasons than the average investor.

John Paulson, for example, has publicly amassed vast amounts of gold. The thing is, at the same time he seems remarkably interested in gold’s SPDR Gold Trust ETF (‘GLD, which represents physical gold), rather than buying gold the old fashioned way, which he as a large hedge fund should be able to easily manage.


…gold is the firm’s largest single position. The $3.4bn stake in the SPDR Gold Trust, a listed US instrument backed by physical gold, equates to a greater tonnage of the metal than Australia holds.

One explanation for his fondness of GLD could be that he’s taking part in gold’s contango arbitrage, rather than simply investing in gold.

Contango happens for an asset when longer-dated futures prices are higher than shorter-dated futures and the spot price. Gold sits in contango since markets expect it to rise in value over time. Alphaville describes the arbitrage mechanism as follows:

In a nutshell, you buy GLD (perfect proxy for gold, but with no storage costs) you create a hedge by selling front month gold futures. You then lock in the spread further down the curve, and sit and collect the contango premium.

As long as the premium covers your financing costs to hold the futures, it’s happy days. You’ve put your potential $3.4bn worth of GLD shares into constant yield generation.

No wonder then that there has been some demand for an exchange-for-physical into GLD over the CME.

So basically you buy gold as GLD now, and you hedge yourself with gold futures, collecting the difference between the future price for gold and the GLD price you paid.

In this fashion, you aren’t betting on gold to go up, and you are also hedged vs. a decline in gold price. That’s because you’ve already locked in the spread with a short position in gold futures vs. your long gold position in GLD. You are simply earning the difference between the two. You can keep rolling over this trade and earning a yield every time your futures position matures, as long as the market’s future expected gold price remains higher than spot.

But these kind of trades should be triggering alarm bells for investors in the relatively small gold market. That’s because these kind of spread trades suit themselves towards high volume and leverage, since you are locking in small-but-sure percentage gains each time. This could explain the rapidly growing interest in gold ETFs we’ve seen recently, especially for GLD, and how gold prices have begun to mimick asset flows into gold ETFs, as we’ve discussed on this site before.

High volume and market-neutral positions means that, if this trade is being widely followed, then things could get ugly when it unwinds:

The convergence makes sense, because the more shares that are issued the more gold bars are locked up idly in the fund. So even though the assets are going up, and gold is theoretically being bid, the fact that that gold is being locked away for the purposes of the contango trade is the potential equivalent to a mass pool of oversupply in the market – just like in oil. [in reference to what happened with traders trading oil contango using idle supertankers]

Furthermore, if GLD suddenly becomes less sought after than gold itself — because the contango trade can’t be financed easily anymore– that creates a very real liquidation risk for the commodity.

Yet here’s a final thought:

The yield you earn in this trade will be higher if futures prices reflect increased amounts of optimism for gold’s appreciation potential, since you earn the difference between this future price and the current price. Basically, you earn 2% a year if markets think gold will go up 2% in a year, but you earn 10% if markets suddenly think gold can rise 10% in a year. (Here we’ve simplified the calculation of contango arbitrage profit for simplicity)

This means that hedge funds engaged in such a trade would have a large vested interest in promoting the notion that gold can rise in price very quickly, over a short period of time, rather than slowly over the long-haul.

This is how some gold bulls might be a bit tricky when they say they’ve invested in gold and are massively bullish. Since they could be hedged vs. downside via the short position in futures described above, it doesn’t matter if gold goes up or down for them. They just want a large difference in price between the current gold price and the expected price in the future, the larger the better. They want the market to expect rapid price appreciation, because then they will collect larger percentages every time they roll over their contango trade. If the market takes things too far, and then a ‘bubble’ pops, they won’t lose much since they should be hedged. A collapse will just mean that their game is over, but they will have collected substantial profits in the meantime.

(Note that we are NOT saying John Paulson is doing this, this is broad speculation on our part and we have no proof of any fund doing this.)

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