Let me start this post off by saying that I own GLD – but I don’t care in the slightest if you choose not to. This is NOT a post trying to convince you to buy GLD instead of its competing instruments, or to tout the merits of gold investments. It’s simply a clarification of a horrendous misunderstanding by another very popular blog about how GLD works.
I sent out a tweet last night accusing the very popular ZeroHedge of demonstrating a thorough lack of understanding of the mechanics of the GLD exchange traded fund. A few of my followers asked me to write a rebuttal and clarify, so here we go.
If you haven’t read “An ETF Lesson: Part 1,” please go scope out the first several paragraphs of that post right now to familiarise yourself with the process of ETF creation and redemption. Summarizing, when you buy an ETF, regardless of if it’s the SPY, IWM, or GLD, the ETF manager does not receive your money and does not use it to go out and buy the underlying instruments in the ETF. When you buy SPY, the SPY trust doesn’t buy a basket of S&P 500 stocks, and when you buy GLD the GLD trust doesn’t buy gold.
Instead, you’re buying from other market participants. Whomever sells the ETF to you is the one who gets the money, just like any other stock – when you buy MSFT in the market, the money doesn’t go to Microsoft Corporation – it goes to whomever sold the stock to you. A great feature of many ETFs (including GLD and SPY) is the creation and redemption mechanism, which allows authorised participants (ie, big broker dealers) to arbitrage price anomalies in the ETFs.
Taking GLD as an example: GLD, like every other ETF, has an NAV: net asset value – this is the value of the underlying gold in the trust corresponding to each share outstanding. If tons of people want to buy GLD and no one wants to sell it, the price of GLD might rise above the NAV, and at some point authorised participants will come in and short GLD to you, while simultaneously buying gold. They’ll then take the gold they bought, deliver it to the GLD trust, and “create” new shares of GLD which are backed by this newly delivered gold. The authorised participant will use these newly created shares to cover the shares they shorted to you and close out their position. The authorised participant profits because they shorted the GLD shares to you at a slight premium to NAV.
Which brings us to the ZeroHedge post:
“One of the completely unmentioned side effects of the recent surge in gold prices, has been the fact that one of the biggest holders of gold, the GLD ETF (presumably physical, even though it is kept in the cellars of HSBC in London, one of the two banks recently charged with a RICO suit for precious metal price manipulation) which as of close today held 1,294 tonnes, has not really bought any gold in over 5 months. The issue is that GLD’s gold actual holdings, which feed right into its NAV, have been flat since June, peaking at 1,320.44 tonnes on June 29, and flat-lining and even declining through today. Since then, however, gold spot has risen by 14%. As the chart below shows, GLD tends to reindex its NAV in spurts, buying up gold during specific periods when gold goes up, notably in March of 2009, and between May and June of 2010. As of today, the trust’s NAV per GLD in gold is at an all time low of 97.67. The bottom line is that GLD is now long overdue to replenish its actual gold holdings, net of redemptions. Assuming that GLD will increase its holdings in line with prior accumulations, when gold price surged, the ETF may soon be due to buy about 200 tonnes of gold. Should that happen, GLD will further increase its distance to 6th sovereign holder of gold, China, which as of September 2010 held “just” 1,040 tonnes. As to what would happen to the price gold if it is made known that there is a buyer for 200 tonnes of gold, we leave to our readers’ imagination.”
So, let’s count the errors and misunderstandings here.
1) Of course the GLD hasn’t bought any gold in the last 5 months – GLD NEVER buys any gold, unless of course they decide to do a secondary offering.
2) GLD does not “re-index its NAV in spurts,” – I don’t even know what Tyler is attempting to say here. He provides a useful chart based on publicly available data from a spreadsheet that GLD provides on its website. As you can see from his chart, there is usually some correlation between the price of gold and the number of tons of gold held by the GLD – this makes perfect sense: it illustrates that it’s likely that investors are using GLD as a way to gain exposure to gold. As we talked about above, investors go out and try to buy GLD, APs arb the NAV premium and create new shares of GLD, the price of gold rises and the amount of gold held by GLD increases.
3) The trust’s “NAV per GLD in gold” was, at the time he wrote this, 97.76% of its starting value of .10 ounces of gold per GLD. It’s the quantity of gold backing your GLD share. This is different from the “NAV per share” which is $135.61 (As of 11/8/10) – the value of the gold backing your GLD share. The 97.76% number represents the fact that GLD must sell a little gold to pay its bills. Originally, back at inception, the “NAV per GLD in gold” was 100% of .10 oz, which is to say that 1 GLD represented 1/10th of an ounce of gold. Currently, 1 GLD represents almost 98% of 1/10th of an ounce of gold. The 97.76% number is indeed an all time low. And the new number will match or make a new all time low every single day. That’s how it works.
4) “The bottom line is that GLD is now long overdue to replenish its actual gold holdings, net of redemptions.” Again, this is not what GLD does. You can run your own chart of NAV per GLD in gold over time – it’s a straight downward sloping line. As I explained above, this is by design – GLD is constantly selling tiny quantities of gold to pay for the costs of storage and other expenses. They don’t “replenish” this number back up to 100% of the original .10 ounces. The amount of gold delivered in creations and received in redemptions changes along with this number.
Then it just deteriorates into pure hype:
5) “Assuming that GLD will increase its holdings in line with prior accumulations, when gold price surged,” That’s a horrendous assumption, because it doesn’t happen. Maybe investors tend to buy more GLD when gold prices surge – I’ve explained that as a possible scenario above already in #2, which can lead to the end result of GLD’s assets increasing – but it’s got nothing to do with gold that the GLD trust needs to go out and buy to “replenish” or “re-index” anything.
And the coup de grace: the hyperbolic headline grabber:
6) “the ETF may soon be due to buy about 200 tonnes of gold. Should that happen, GLD will further increase its distance to 6th sovereign holder of gold, China, which as of September 2010 held “just” 1,040 tonnes. As to what would happen to the price gold if it is made known that there is a buyer for 200 tonnes of gold, we leave to our readers’ imagination.” The only way the ETF will go buy 200 tonnes of gold is if they somehow get wind that there is flat out rabidly insatiable demand for a huge chunk of gold that someone would rather hold in GLD shares than in gold bullion, in which case they would file papers with the SEC and do a secondary offering. I think the odds of a 200 ton secondary offering happening is roughly zero.
It’s scary to see a site like ZeroHedge write such a blatantly erroneous article demonstrating a gross lack of understanding of the reality of how GLD works. It’s even scarier to read the comments and see not a single reader pointing out that there are mistakes. Which is why I spend my time writing corrections to mass mis-education like this.
Now, we can even try to deduce some actual useful information from the chart that Tyler put together (and then misinterpreted) which graphs Tons of Gold held by the Trust vs Price of Gold. Back in the first quarter of 2009, the assets of the trust rose while the price of gold remained steady. What could explain this? Perhaps this was a time when investors were clamoring to own GLD as a result of the turmoil in the financial markets. Their buying interest resulted in lots of GLD demand, and thus more arbitrage and share creation. Why didn’t the price of gold increase? Again, during the turmoil, there were also ample investors who needed to raise funds, and perhaps gold was a source of funds for them (but not GLD, since if there was massive natural selling of GLD, the arb would go the other way, and result in a decrease in assets in the trust).
How about recently? We’ve seen the price of gold skyrocket, while the assets in GLD have remained relatively flat. Perhaps that means that investors are gaining exposure to gold via other methods – alternative ETFs, physical coins, gold stocks. If investors were relentlessly buying GLD shares, we’d expect arbs to short the GLD shares to them, while buying gold and creating new GLD shares with the trust. The trust tonnage data doesn’t show this.
If you take the time to understand the facts, you can actually draw some useful conclusions from data instead of relying on hype and hysteria to fabricate nonsensical headlines.
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