Saturday, June 18, 2011

Gold ETFs and Derivatives

This article appeared in The Edge, Malaysia, May 23, 2011

Gold ETFs and Derivatives

In the midst of the craze of investors wanting to gain exposure to gold, various instruments have been introduced in the market. One of the popular ones is the gold exchange traded fund (“ETFs”). This article will first explain the mechanics of an ETF and then introduce the Exchange Traded Note (ETN) which is often thought to be similar to an ETF but is actually is different in many ways, mainly because of the use of derivatives in the latter.

What is an ETF
An ETF is basically a share that trades on the stock exchange. A company share represents the assets and liabilities of the company. An ETF share represents assets that could be almost anything - shares of companies, bonds, commodities or currencies. The main attraction of ETFs to investors is that it allows them to gain exposure to a variety of assets with minimum capital.

Gold ETFs
A gold ETF will purchase a large amount of gold, maintaining the physical metal in storage. The ETF fund manager will then issue ETF units to market intermediaries or brokers (called Authorised Participants) who are usually investment banks. The intermediaries will trade the ETF units which are now broken down into smaller units called ETF shares with the investor. Refer Chart 1.
As gold increases in price, the value of the ETF units and shares representing the gold will also increase in value.

Chart 1: Mechanics of the ETF

Other than retailers, ETF investors include mutual funds and hedge funds that use ETFs in portfolio trading strategies. Gold ETFs are existent all over the globe. The most popular one is the SPDR Gold shares, introduced in 2004 and now trade in the U.S , Singapore, Japan and Hong Kong. It has been claimed that the SPDR Gold Trust’s holding of gold is so large that it stands in par amongst the top six central banks in the world, measured solely by gold holdings. India has a number of gold ETFs and China has just introduced its first gold ETF this year. In Malaysia, there has been a proposal to introduce an Islamic Gold ETF, the Cydinar. 

Gold ETFs trade on the principal concept that the fund is backed by physical gold. However, some concerns have emerged in the market about the authenticity of this statement. There are worries that some ETF prospectus state that neither the Custodian or Trustee independently confirms the fineness of the gold held in the ETF fund. Other issues linger around the extent of freedom given to the Trustee to audit the physical appearance of gold held by the Custodian. Also there has been buzz about the gold not being insured at all times. There has also been criticism that the SPDR gold trust may have conflict of interest issues with JP Morgan and HSBC in the U.S. who have large short positions in gold.

In summary, all the above concerns point to one thing – does the physical gold represent the true value of the ETF shares at all times?  Analysed another way, if there were to be a gold run, would there be adequate physical gold to be redeemed.

Gold ETNs
Gold ETNs do more than just buying the physical gold. Two of the more fashionable ETNs are below:
§  Double long gold (e.g. PowerShares DB Gold Double Long ETN )
§  Double short gold ((e.g. PowerShares DB Gold Double Short ETN )

Chart 2: The ETN structure

(i)                 Double long gold ETNs

Here, the issuer of the fund issues an Exchange Traded Note (ETN) to investors. The ETN functions like a debt security or a bond. By holding the ETN, the investor will get returns on his money, based on the performance of certain gold futures index, created by the issuer. 

The issuer uses the proceeds from the investors to buy forwards and futures in gold. If the price of gold rises, the derivatives will be profitable, and the fund makes a profit. Spot gold prices are closely linked to future prices and in most cases they have a positive correlation. So the future index will also rise, warranting a favourable return to the investors.

For example, one futures contract for gold controls 100 troy ounces. If the market is trading at USD 1500 per ounce, the value of the contract is USD 150,000 (USD 1500 x 100 ounces). If the tenor of the futures contract is six months, this means that in 6 months time, the buyer will pay USD 150,000 and take delivery of 100 ounces of gold. 

Say after 4 months the spot price of gold is USD 1550, the issuer now will only have to pay USD 150,000, take delivery of the gold and sell the gold in the physical market for a total of USD155,000 to make a $5,000 profit. But in practices, the issuer almost always offsets the long position with an opposite trade (short the same future) before the delivery date to achieve the same profit.

Leverage plays an important part in ETNs and derivatives. With futures, the issuer gets to pay a small sum to get exposure to a large fraction of gold. In the above example of one gold futures contract, the issuer is required to pay an initial margin of just a fraction of around USD10,000. This gives the issuer the ability to leverage $1 to control roughly $15 worth of gold. 

In the double long case, the investor gets to make double returns on the note. If the investor invests $1000 and the gold increases in price by 5%, the investor will make 10% on his $1000. The ETN issuer can afford to give investors this privilege by taking leverage like in the above example. The actual return he made was $5,000 for a capital of $10,000. That is a 50% return on his capital. 

Note that that the ETN  is not backed by any physical gold, only futures contracts that speculates on the price of gold. If the future contracts loses money, the investor will not get back their full investment. If the ETN issuer collapses for some reason, the investors will not get back their money.

(ii)               Double short gold ETFs

Here the issuer goes short the futures contract and profits if the price of the gold goes down. For the investor, if he invests $1000, his returns will be based on the price of gold moving downwards. In the double short case, if gold loses 5% of its value, investors will get 10% from their investment.  

ETNs are not ETFs
ETNs are just a promise to pay back investors their money, with returns if gold prices move in a certain direction. In addition to the price risk of gold, the investor is heavily exposed to the credibility of the ETN issuer. In 2008, when Lehman collapsed, its Opta Commodity ETNs suffered great losses when ETN holders were scrambling to dispose the notes in the market.

There could be still other varieties of gold ETNs structured in a more active manner, where the ETN issuer is free to invest in swaps and options to take a speculative position in gold. It is important for the investor to differentiate between holding the physical gold, holding a gold ETF and holding a gold


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