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ETF Specialist

When Market Confidence Sours, Gold Soars

We are confident that there is actual gold in gold ETFs--despite the rumors.

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I recently enjoyed reading a piece by Axel Merk regarding market confidence. His insights begin with a quote from Wen Jiabao, the Chinese premier: "Confidence is the most important thing, more important than gold or currency." Merk notes that in times of extreme crisis, "Gold is the most important thing, more important than confidence or currency." While I will, for now at least, refrain from speculating as to what gold prices will do henceforth, recent asset flows and price appreciation clearly indicate that the gold bugs are having their time in the spotlight.

I see little reason why gold should not be performing as well as it has lately. Even the most fervent supporters of the government bailout admit that, while something needs to be done, the precise way to stabilize and stimulate the economy is unknown. Following the popularity of Rick Santelli's recent "Chicago Tea Party" rant, it is clear that we have not yet reached a consensus. With nine million people failing to make payments on their mortgages, 300 million of us are being asked to keep these people in "their" homes. Even though it is evident that housing prices were massively overpriced, the ever-evolving view today seems to be that keeping home prices high is good for everyone.

Last time I checked, not everyone in this country owns a home. And perhaps my graduate studies in finance were simply a waste of time, but I've always operated under the assumption that the most efficient way to make any asset more affordable to a potential buyer is to lower the price. Perhaps the best way back to the aggregate historical ratio of income/home price is to let the home values fall. However, with more voters in the home-ownership camp than not, this logic probably holds little clout in this democratic society.

Something will be done, and its impact will be pronounced in an uncertain way--possibly good, possibly not. If too little is done, we may go into a crippling deflationary spiral. Provide too much stimulus and inflation may ride roughshod over us. A viewpoint shared by many investors today is "deflation today, inflation tomorrow," and there is a term for that scenario. It's called price instability. Nothing brings market confidence to its knees like price instability.

The above views are not held by everyone and are simply used to highlight today's global lack of confidence in government, markets, and paper currencies. What hasn't been tarnished is the reputation of gold. We've seen its price respond in a pronounced and positive way. We've also seen a remarkable renaissance in investor interest that has persisted now for several years as measured by net asset flows. As we indicated back in December, we are not surprised by gold's continued strength. And no investment vehicle has benefited more from gold's interest than  SPDR Gold Shares (GLD) ETF.

Please forgive me, but, as an ETF strategist, I sometimes get a bit too geeked about some ETFs. But GLD is a beautiful product and a testament to the empowerment of individual investors by ETFs. Prior to GLD's November 2004 issuance, perhaps the best way for investors to gain exposure to gold was through Krugerrands, which sold approximately 42 million ounces from 1970 to 1985. In just more than four years, GLD has accumulated more than 33 million ounces. Per our sources at the fund's backing company, an estimated 60%-70% of those investments have been made by individual investors as opposed to institutions. With a total market value of more than $33 billion, the fund is now the second-largest ETF on the market, trailing only the world's most actively traded security--the S&P-500-tracking  SPDRs (SPY) ETF. Additionally, gold ETFs have "consumed" approximately 6% of total gold production since they were introduced five years ago. To say that this fund has filled a gap in market demand would be an understatement.

The beauty of GLD lies in its simplicity. It buys wholesale gold bullion at spot prices and stores the product in underground vaults. There is no use of futures or other derivative contracts. We repeat, there is no use of futures or other derivative contracts.

For those who don't want to pour through the fund's prospectus, here is the Reader's Digest version of how the GLD operates. First, the fund (which is actually a trust) can only hold physical bars of gold that weigh between 350 and 430 ounces. The fund is allowed to hold a market value differential in cash up to the value of a single bar of gold. The only other time that each share is not matched by physical gold in the vault is during the share creation process. Authorized Participants buy physical gold on the market and exchange with the ETF provider the commodity (not cash) for shares of GLD, and they then deliver the shares to investors. The process to then transfer the gold to the vault can take up to three days. So, the only time the gold backing the GLD is not in the trust's London vaults is when it is en route to the vault. This exchange only happens when the fund is experiencing net asset inflows, thus necessitating the creation of new ETF shares.

Two things are worth noting. First, GLD is never on the open market actually purchasing gold. Rather, Authorized Participants bring gold to GLD in exchange for shares. Second, GLD can only accept institutional-grade gold bars, which are not the same as the bullion coin to which many retail investors have access. We believe that there is a shortage of coin-minting capacity right now that has led to premium prices in the gold-coin market. The bar business, on the other hand, is quite liquid, and there are no premiums being paid at the institutional level.

Per our contact at the World Gold Council (these are not our words, and our contact means it in the nicest possible way), gold bugs are "the longest tenured and most fervent lunatic investors in the world." They've only been this way for a few thousand years. Over the past 20 years, the gold bugs have only represented a dissident minority, a bunch that has permanently strayed from the protection of the equity-investing herd. But if there is anything that we can learn from lemmings, it is that sometimes breaking from the herd is the key to survival.

Because we've identified that gold bugs are hardly conformists, it is easy to see why some are skeptical about using any exchange-traded investment vehicle, ETFs included, to gain gold exposure--they would rather be able to physically touch their stash. Some have even gone so far as to doubt the existence of the physical gold that the ETF claims it holds. These same people even doubt the presence of gold in the vault at Fort Knox. I don't subscribe to these conspiracy theories, and I cannot disprove them with my own audit. I have to rely on my faith that the governing institutions that do conduct these audits are honest. I don't think that is unreasonable (and I know that I'm going to receive a few hundred e-mails telling me otherwise).

For security reasons, none of us will be given access to see the gold held either by GLD or in Fort Knox. Furthermore, investors cannot redeem their shares of GLD for delivery of physical gold--only the Authorized Participants can. The argument for actually holding physical gold has some merit and historical precedent; governments have seized gold in the past under dire economic circumstances. And if you're holding gold to hedge against disaster, the last thing you want is to be denied access to your assets when you desire them most.

Individual investors seeking true exposure to physical gold previously had to purchase gold coins and then either purchase a safety deposit box or implement their own security system to protect their stash. If you're holding a significant sum of gold, such expenses would hardly be an afterthought to protect a nonearning store of value. GLD takes care of the handling and storage for you at the low annual expense of just 0.40%. That is considerably cheaper (and I'd argue safer) than buying guard dogs and installing a vault and motion detectors.

Investing in gold is not for everyone. As a word of caution, many investors are horrible at deciding when to invest in gold. When bullion prices are soaring, it's all too easy to jump on the gilded bandwagon. The last time gold prices soared, back in the early 1980s, many speculative investors lost their shirts after the price of gold collapsed. I have no idea how high gold will go or how long its latest heyday will last, but I'm sure that those looking to short gold will also eventually have their day. For a bit of help determining if an investment in gold is right for you, I urge you to read our Analyst Report on GLD. But if you determine that gold exposure is something you seek, you should not hesitate to use GLD or  iShares COMEX Gold Trust (IAU) as your investment vehicle of choice.


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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Paul Justice does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.