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What Could Pop the Gold Bubble?

Jeremy Glaser

Jeremy Glaser: For Morningstar.com, 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 Morningstar.com, 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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Glaser: You mentioned gold is something that people hold when they are uncertain and it doesn't seem like the uncertainty of the state of the economy is really going to go away any time soon even if we see a return to more normal levels of growth. What do you think could cause the price of gold to plummet then?

Burns: So, I have a, what I think is a little out of the box theory on what will burst the price of gold and I think what we've seen over the past three to five years is that gold has really started to appear in a lot of asset allocation models and gold is actually the best performing asset class for the past 25 years. A lot of people don't realize that even the fact that for 20 years it was one of the worst, how it's performed in the past five relative to everything else has really pushed it up.

So I think as gold became more popular in a lot of asset allocation models, 5%, 10% type holdings, what I think we're going to get in 2011 is people doing their natural kind of annual portfolio review on the asset allocation side and seeing that a 5% allocation has turned into an 8% or a 10% has turned into a 15% and I'm just kind of making these numbers up, and they'll do what asset allocators do and they'll start to rebalance which means selling gold and buying something else.

Well, the frothiness of gold right now, on the gold prices right now and the amount of, I think, this is what was so eye-opening about those trading stats, the amount of trading and technical trading that's happening in gold. When you get that natural kind of selling reaction of rebalancing, you may actually trigger false signals to the technical analysts that there is now a run on gold and once the people start – once the herd starts running for the gate, that's the kind of thing, especially in something as frothy as gold that could really start to trigger this downhill unwind of gold prices.

So it will be interesting to see how these long investors who have helped I think prop up the price of gold, when they start to do their natural rebalancing what kind of effects that triggers unintentionally in the secondary market. Of course that also puts a nice bottoming too because then they'll see the 5% and 10% allocation are now 3% and 8% and have to do the rebalance the other way.

Glaser: Looking at other commodity ETFs, a lot of these products that rely on the futures market have had a big issue with negative roll yield. Is this something that the ETF industry has tried to address or that they're even able to address?

Burns: Well, we've seen a lot of innovation in the commodity space around that some kind of contango-killer products as we call it. I think we want to always keep things in perspective that for 25 years contango wasn't really a problem. These were the strategies and you wanted that one month roll because it was traditionally a positive roll yield.

I think two things are going to help solve this contango issue, one innovation and I think innovation comes from some smarter rules-based yield curve optimizing type products or products that are intentionally trying to capture negative roll yield from a shorting perspective to give you a positive yield. But I also think active management will help a lot than just having somebody that the fund is 80% rules driven with just someone watching the switch to just say yes/no, I think that will go a long way to solving that.

I think the other solution to contango and negative roll yield is actually just going to be time. I think where we see the most pressing and steepest curves or the largest negative roll yield, a lot of that is really just a function of the recession right now.

So as demand for energy and demand for raw materials starts increasing and copper starting to hit all time price highs again, we'll see these curves invert back to their more normal state of backwardation and that one month roll yield strategy will go back to being actually the preferred strategy and the more optimized stuff will be less preferred. So, yeah, I think time and innovation will help bring those commodity products back into investible territory.

Glaser: Sounds great, Scott. Thanks for talking with me today.

Burns: Thanks for having me, Jeremy.

Glaser: For Morningstar.com, I am Jeremy Glaser.