What is behind the ETF gold rush?

This article originally appeared in Morningstar ETFInvestor December 2019 edition, available to Morningstar Premium members

The US-China trade war, never ending Brexit uncertainty, low interest rates, and fears of slowing global economic growth have seen investors flocking to the so-called safe haven assets, including gold.

Indeed, ETF Securities' ETFS Physical Gold (ASX: GOLD) exchange-traded fund (ETF) broke the AUD 1 billion barrier in September 2019. Moreover, GOLD almost doubled its funds under management, or FUM, over the 12 months to 30 Sept 2019.

Exhibit 1 shows the spike in trading volume of GOLD in April 2018 (announcement of the first tranche of US tariffs on Chinese imports), December 2018 (large spike in equity markets), and August 2019 (further trade war escalation).

Exhibit 1: GOLD ETF FUM (LHS) and monthly trading volume (RHS) Jan 2018–Sep 2019

Source: Morningstar Direct

Many investors see gold as a safe harbour during times of economic uncertainty. This is because it can act as a diversifier in a multi-asset portfolio due to a common perception that its returns are negatively correlated to equities.

Exhibit 2 shows the correlation of London Bullion Market Association (LBMA) Gold Price PM USD index, which GOLD ETF aims to track, with equities and bonds over the 15-year period.

Exhibit 2: Correlation of LBMA Gold Price PM USD index with equities and bonds, Oct 2004–Sep 2019

Source: Morningstar Direct

We see gold having a near zero correlation to equities during that time; however, correlations between asset classes change over time.

This is evident from Exhibit 3 which shows gold's correlation to equities significantly higher during the global financial crisis, or GFC, showing that its status as a safe harbour asset is questionable during that time of market stress.

Investors should note that correlations will change under various market conditions.

Exhibit 3: Correlation of LBMA Gold Price PM USD index with equities and bonds, Jan 2008–Mar 2009

Source: Morningstar Direct

Gold’s value as an inflation hedge is also in question. Historically, gold acted as a hedge against inflation as its price tends to increase when the cost of living is rising.

Exhibit 4 shows that the price of gold kept up with the rising US inflation during 1976-1979. However, the opposite can be seen in 1987-1989 when the inflation was rising and the price of gold fell exposing gold holders to purchasing power risk.

Exhibit 4: US inflation (RHS) (US BLS CPI All Urban NSA 1982–1984) & LBMA Gold Price PM USD Index (LHS) cumulative returns (USD) Jan 1976–Dec 1988

Source: Morningstar Direct

Gold’s ability to hedge against inflation will change over time depending on which drivers are having the greatest influence on its price. Those drivers are monetary policy, supply, demand, and economic growth.

We observe that gold ETFs are often used by speculators to bet on macro, political, and economic events. And with a growing number of gold-related products on the market, we think it creates more opportunities for short-term traders and speculators.

Long duration government bonds typically act as a better defensive asset as seen in Exhibits 2 and 3. While inflation-linked bonds can provide protection against rising inflation environment.

Not all that glitters is gold

There are three ways investors can access gold exposure via exchange-traded products, or ETPs, in the Australian market. Though the exposure, risk and returns will differ depending on the product.

The first are ETFs that invest in listed gold mining companies. The second are ETFs backed by physical gold that buy and store gold bullion in a vault with a custodian and aim to track spot price of gold. And the third are ETFs that invest in futures contracts and derivatives leading to a more complex and opaque structure.

For example, US listed iShares Gold Strategy ETF (IAUF US), invests in gold futures, derivatives, as well as gold ETPs, to synthetically replicate the returns of gold.

While there are no synthetic gold ETFs trading on the ASX today, the US and European exchanges have a range of such products and are more prevalent by number than physically backed ones. 

Exhibit 5: Gold ETPs listed on the ASX as of Sep 2019

Source: ASX. Data as of 30 September 2019

Launched in 2003, ETFS Physical Gold was the first gold ETF on the ASX. GOLD is backed by physical gold which is held by the custodian (HSBC) in vaults with each bullion bar segregated and individually numbered.

BetaShares Gold Bullion ETF (ASX: QAU) is another physically backed gold ETF that store their gold bars in the vault of JP Morgan Chase, or with its authorised subcustodians.

Each participant from gold vendors to custodians and subcustodians increase counterparty risk due to increased opacity in the operational chain of custody.

Custodians like HSBC and JP Morgan Chase are unlikely to allow investors into their vaults to confirm the presence of their bullion.

Some physical gold ETFs (GOLD) are designed as structured products (exchange-traded commodities, or ETCs) where investors rely on the issuer's promise to pay them.

While GOLD is a secured ETC, generally structured products are unsecured representing additional layer of risk. We believe that assessment of counterparty risk in these products can be challenging especially for retail investors. 

Perth Mint Gold (ASX: PMGOLD) is another physically backed gold ETF available on the ASX. Each unit of PMGOLD purchased by investors represents ownership of 1/100th of a troy ounce (slightly heavier than a regular ounce) of gold.

Since PMGOLD is issued by the Perth Mint, the gold stored on investors' behalf is guaranteed by the Government of Western Australia, hence the counterparty risk here is different, arguably reduced. Another feature that differentiates PMGOLD is that investors can redeem the units of this ETC for physical gold while others will give back cash.

What about the “gold-diggers”?

Other investors might prefer to own a basket of gold miners instead of owning a claim on the metal. There are currently two ETFs trading on ASX that invest into shares of global gold miners, VanEck Vectors Gold Miners ETF (ASX: GDX) and BetaShares Global Gold Miners ETF (ASX: MNRS).

While the share prices of the gold miners tend to be highly correlated with the underlying gold price, there are additional risks to consider. As with any business, these companies have operational risks which can impact their earnings and cashflow. Valuations can be impacted by exploration success or failure. Finally, operational and financial leverage can result in additional downside risk when the gold price falls.

There are also more technical factors to consider. Depending on the liquidity of the underlying holdings, there is the potential for large ETF flows to distort the price of underlying stocks. There is a limited pool of gold mining stocks globally, and as the gold miner ETFs attract inflows they buy more of the same names. For example, GDX saw inflows of AUD 48 million in the third quarter of 2019.

Following aggressive inflows into ETFs like GDX, the providers can quickly reach large holdings in smaller gold miners. For example, VanEck’s holdings in some Australian-listed gold miners include Regis Resources and Saracen Mineral Holdings both at 12%.

Trading in smaller gold miners tend to be illiquid and shifting significant blocks of shares during the index rebalancing potentially causes outsize price movements. Investors in those names bear the risk that shares can surge on inclusion and dive on dilution or exclusion from an index without any changes in the fundamentals of these stocks.

VanEck apply several proprietary algorithmic techniques to avoid potential price distorting. One technique is to stagger the volume of the constituents over a certain period. Another is to use volume-weighted average price strategy which breaks up a large order and releases smaller chunks to the market. Another risk is those ETFs that follow an index will have exposure to the speculative end of gold miners which may introduce increased price volatility.

Conclusion

Although a well-priced and well-managed gold ETF can be a reasonable way for investors to get exposure to this commodity, at Morningstar, we currently don’t cover any of these products.

Before investors take up exposure to gold via bars of gold, a physically backed gold ETF, a synthetic gold ETF or an ETF holding stocks of gold miners, they need to consider the risks.

The lack of transparency to assess counterparty and credit risks plus the difficulty in forecasting the price of gold makes them challenging to incorporate in a diversified portfolio.

Morningstar currently publishes qualitative analyst research for 71 Australian ETPs, accounting for about 80 per cent of invested assets.