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By Jeremy Glaser | 12-20-2010 03:38 PM

What Could Pop the Gold Bubble?

Morningstar's Scott Burns discusses the state of precious-metal ETFs and what could bring the price of gold down.

Jeremy Glaser: For, I am Jeremy Glaser. Commodity ETFs have been particularly hot this year. I am here today with Scott Burns, he is a Director of ETF Research, to see what the future holds for these products.

Scott, thanks for joining me today.

Scott Burns: Jeremy, thanks for having me.

Glaser: So, it's no big secret that GLD is one of those popular commodity funds. It's one of the most requested on, I think it's the second largest ETF. Are investors getting into this, are they're buying and holding it? Are they trading gold? Why has this been so popular?

Burns: Yeah, you know, gold is always very popular in times of uncertainty. That's the one thing that we know about gold. We have 3,000 years of history with gold, which we don't have with any other security or investment type out there. Gold has been really viewed as a way to protect against inflation. It's also a great way to historically protect against deflation. People will ask, why is that? And I'd say well, because the only way out of deflation is inflation. So that's kind of the answer to that.

We saw a lot of money flow into gold, but it wasn't just gold that we saw. Actually, two of the largest and most successful new launches in 2010 were Physical Platinum and Physical Palladium from ETF Securities. So, physical metals of all sorts, gold, platinum, palladium, silver have been drawing a lot of interest.

The one thing – we were recently looking at some numbers just around SPDR Gold and yes, I think everybody knows that it's a second biggest ETF and iShares Gold is a very solid, although in distance, it's multiples smaller than GLD but it's still a multi-billion fund in and of its own right. It was just how much trading happens in the GLD. Actually, the average holding period is about 20 days. So, that doesn't mean that everybody holds it for just 20 days, but that a fund that size is turning over its assets every 20 days was kind of surprising to me actually. It means that there is quite a bit of people moving in and out of a gold investment.

Glaser: With all of that, speculation happening in the market, there has been a lot of talk of possibly being in a gold bubble. I don't know if you have a view on the level of gold right now, but what do you think would happen if we did see a pretty serious decline in prices?

Burns: Yeah, I generally stay away from making predictions on the gold price. We have a commodities analysts; I'll let that person handle that. But, I will say, I do get asked this question a lot. What's going to happen with the GLD if we are in a gold bubble and it bursts? There is a lot of curiosity around that. What I think is going to happen is that like all bubbles when they burst, it's going to be terrible and calamitous. You'll have a lot of very steep downward jags to the price of gold.

Again, with the one thing with gold, we have 3,000 years of history. I mean, that's exactly when the gold bubble burst in the early 80s what it looked like when it burst. Throughout recorded history, it's always very steep, very jagged. So the question I get a lot is, what's going to happen to a gold trust like the GLD or even IAU, the iShares product? The answer is that it will reflect the price of gold. So it will drop very steeply and you should expect that.

While what I don't think will happen is that you'll see huge discounts or premiums swinging around for that. I think there is really a widespread misinformation about how a grantor trust like SPDR Gold operates. You know the SPDR gold fund is never out in the market buying gold. I think that's people think that it's this, like corporation or entity out there purchasing. It's really a trust, it's a bank valut, and the way it works is that, gold shares come at – a large bank or government delivers a truck load of gold to the trust and the trust delivers shares back, and then the shares are sold in the secondary market. That's how the arbitrage works.

Vice versa, if gold prices star to drop and we start to see a lot redemptions, shares come in and trucks of gold go out, and then people have to do it like that. So even if we do get discounts, that could get into the 3% to 5% range; one, it will be temporary. And two, I'd also like to remind viewers that managing the kind of discounts you'll see if you take your suitcase of gold to Wabash Avenue and try to turn it in, you won't be getting discounts at 3%, you'll be looking at 30% to 50%. Because that's what happened in the 80s and that's how those folks get rich in those kind of downturn.

I always hear stories about people saying, well, I still have my suitcase of gold from the 80s because when I went to sell it, I couldn't get a fair price, so I just held on to it. So I think the GLD is still going to be a much better mechanism than that kind of inefficient one-off transaction.

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