Playing the gold card

Gold exchange-traded funds (ETFs) saw explosive growth in 2009, but this year has so far seen net outflows of investor capital. However, with inflation fears and sovereign risk high on investors’ agendas, ETF providers expect interest to pick up once again.

Gold is commonly regarded as a bad news metal, the asset that investors flock to in times of economic uncertainty when plunging stock markets, depreciating currencies and rising inflation combine to make precious metals the ideal portfolio hedge.

While the appeal of gold during times of economic turmoil has long been recognised, the spectacular performance of bullion last year took even some seasoned precious metal veterans by surprise and delighted investors who bought early in 2009.

On January 15, 2009, the spot price for gold stood at $811.70 an ounce, having dropped from $879.45 an ounce on January 1. From that mid-month low, the market never looked back for the rest of the year. By February 20, the spot price had reached $992.90 an ounce as huge volumes of investor capital poured into the asset class. While a tail-off in those flows and a rally in equity markets slowed investment from the second quarter onward, the yellow metal had breached the $1,000 threshold by September 11, before ultimately hitting its peak for the year at $1,215.70 an ounce on December 2.

Of particular note during this rally were the large inflows into the metal through gold exchange-traded funds (ETFs) rather than through the more established over-the-counter and gold futures markets. According to data from the Chicago-based National Stock Exchange, total assets under management at the three largest US gold ETFs listed on the exchange grew from $26.9 billion to $43.35 billion between January and December 2009.

In fact, strong investor flows caused a radical shake-up in the dynamics of the gold market last year. In the past, the jewellery industry has accounted for about four-fifths of annual gold consumption, with investment comprising just 10%. Last year, however, investment flows accounted for around a third of gold consumption, with jewellery representing around half.

Despite the surge in investor activity, a single ETF continues to dominate the market. Data from gold market advisory and research firm Goldessential shows Delaware-registered SPDR Gold Shares, an ETF sponsored by New York-based World Gold Trust Services and marketed by Boston-based State Street Global Advisors, represented 62% of gold assets under management among the 14 gold ETFs it monitors globally.

According to data from SPDR Gold Shares, the fund had 1,107.6 tonnes in physical gold assets under management, with a value of $39.6 billion as of February 19 (see table A).

“SPDR Gold Shares had significant investment last year, and between the soaring price of gold and large investor inflows, the size of the fund jumped substantially. Inflows were 353 tonnes, representing a $13.8 billion cash investment compared with $5.4 billion inflows for 2008. Much of that came in during the first quarter of 2009, and I don’t think flows could have kept up at that pace. Many of us thought those inflows were so significant we would see large-scale outflows later in the year, but that did not happen,” says James Ross, senior managing director for SPDR ETFs at State Street Global Advisors in Boston.

The next largest gold ETF in the US – the iShares Comex Gold Trust, offered by asset management company BlackRock – saw its assets under management grow by almost a third last year, albeit from a more modest base. At the end of January 2010, the ETF had 77.44 tonnes of bullion under management worth $2.76 billion, up significantly on the $2.05 billion it held in January 2009.

It is a similar story in Europe where the market is led by Zurich-based Zürcher Kantonalbank with its Physical Gold ETF, which held 147 tonnes of gold worth $5.3 billion as of February 11, according to Goldessential. Meanwhile, the Gold Bullion Securities (GBS) ETF, run by London-based provider ETF Securities, had 120 tonnes under management.

“GBS is one of the largest ETFs in Europe, with $4 billion of investor assets. GBS’s sister fund, ETFS Physical Gold, is only a little smaller, meaning we have more gold than the UK government. SPDR Gold Shares, the GBS, and ETFS Physical Gold account for more than $50 billion in gold assets, which makes up a market share of 80–90% of all gold ETFs,” says Hector McNeil, head of sales and marketing at ETF Securities in London.

While ETFs have long had a reputation as a retail-focused product, fund providers say a growing number of institutional investors have opted to take exposure to gold through the product. On October 2, 2009, the Texas Teachers Retirement System announced it had invested $250 million in its own internally managed gold fund, investing in precious metal mining stocks and exchange-traded funds. This was followed by the disclosure last month that China Investment Corporation, one of the world’s largest sovereign wealth funds, had taken a 0.4% stake in SPDR Gold Shares worth $155.6 million, according to a filing with the US Securities and Exchange Commission (SEC).

“I would say 40% of the gold assets under management with SPDR Gold Shares are held by institutional investors. That’s not unusual because a direct investment in gold would be an OTC investment, while an ETF is a security fully regulated by the SEC with guaranteed two-way markets, settlement and clearing, and it avoids many of the problems involved in gold investment such as vaulting, transport and insurance that you would have to consider if you’re going in through a direct physical investment,” says Jason Toussaint, managing director of investments at the World Gold Council in New York.

But while gold ETFs saw unprecedented investor demand in 2009, the bulk of the investment came in the first three months of the year, on the back of the collapse of Lehman Brothers in September 2008 and uncertainty about the stability of other major banks. Once markets stabilised and the equity markets began to recover in the second quarter of 2009 onwards, investor inflows into gold ETFs dropped markedly.

Toussaint of the World Gold Council puts total growth for all gold ETFs in the first quarter of 2009 at 460 tonnes compared with a far more modest 30 tonnes in the fourth quarter of the year. Others report a similar trend.

“ETF holdings increased by almost 400 tonnes, from 1,200 tonnes at the start of 2009 to almost 1,600 at the end of the first quarter. Since April, though, inflows have generally been drifting sideways. There were still fresh inflows, but nothing of the same order as the start of the year,” says Walter de Wet, senior commodities analyst at Standard Bank in London.

Nonetheless, that is better than some had been expecting. With the rally in equity markets after the first quarter of last year, analysts had expected an exodus from the gold market. That did not materialise, with many investors apparently opting to maintain their holding. The situation appears to be changing in 2010, however, with several ETFs experiencing net outflows.

“We track the 18 largest physically gold-backed exchange-traded products that have assets under management of around $60 billion and we had inflows of about $17 billion into those products last year. December 2009 saw an outflow of seven tonnes and our provisional data for January 2010 shows another outflow of 24 tonnes. As of February 11, we have seen an outflow of around five tonnes. We’ve started the year off on a weak note. But since we’ve not seen massive redemptions, prices have been quite steady,” says Suki Cooper, a gold analyst at Barclays Capital in London.

According to the National Stock Exchange, SPDR Gold Shares saw gold assets under management reduced by $1.68 billion between the end of December and the end of January, with iShares Comex Gold Trust recording outflows of $32 million.

However, these outflows are not regarded as particularly significant, especially when put in the context of the net inflows in 2009. In fact, analysts believe macroeconomic fundamentals for the year ahead will mean investors are likely to retain or increase their existing holdings in gold for the remainder of 2010.

“We have seen a lot of investors shifting their reasoning for holding on to gold. A lot of people bought bullion in the first quarter of 2009 based on fear, but then sustained those positions throughout the year to retain gold as part of their portfolio as a US dollar and inflation hedge. Those are the two macro trends we have observed in addition to a broad view that gold is a good diversifier,” says Ross of State Street Global Advisors.

The prospect of rising inflation continues to worry some investors, with fears that government stimulus packages – in particular, the quantitative easing policies that had been pursued in the UK and the US – may begin to have an effect on consumer prices. In the UK, for example, the consumer price index rose by 3.5% in the 12 months to January, significantly above the Bank of England’s target of 2%.

“Quantitative easing obviously helped gold since bullion is the only currency you cannot print more of, and with inflation fears coming back, it is a very interesting time,” says McNeil of ETF Securities. “Some people believe gold will reach $1,500 or $2,000 an ounce and I wouldn’t bet against it. There are a lot of arguments to suggest circumstances are present to send it there, even if it is range-bound at the moment.”

Adding to investor fears is the perceived increase in sovereign risk, with several European countries – in particular, Greece – struggling with ballooning debt levels and gaping deficits. Combined with fears of a double-dip recession, these issues will continue to make gold an attractive flight-to-quality option, some analysts believe.

“Last year’s demand was definitely a case of nobody knowing what would happen to financial assets and credit risk being so high. The fact that physical gold has no credit risk made it a very attractive asset during that period and it’s still attractive. As the recent problems in the eurozone have shown, credit risk concerns continue, and those concerns are supporting gold. We’re fairly bullish for the remainder of 2010 and we expect the spot price to go higher as we head into the second half of the year,” says Standard Bank’s de Wet.