The Hidden Risk in Gold

Since their introduction a little over a decade ago, gold-backed exchange-traded funds (ETFs) have accumulated more than $500 billion in assets. Investors’ most common rationale for owning gold is that it acts as a hedge against financial instability or a sudden shock to the markets, such as the 9/11 attacks. But what if the flow of assets into gold ETFs plays a greater role in the price of gold than do investors’ fears of instability? Is gold the hedge investors believe it to be?

A just-released academic study, Exchange-Traded Funds on Gold – A Free Lunch?, provides some valuable clues to the answers to those questions. It was written by Dirk Baur, a professor at the University of Technology in Sydney, Australia.

Baur looked at data from 84 physical and synthetic ETFs (including exchange-traded notes and exchange-traded commodities) since the first one was introduced in 2002. His most interesting finding is revealed in the graph below:

Gold Price and Market Cap of Gold ETFs

The price of gold has increased almost lockstep with the assets held in ETFs, particularly in the last three years. The question investors must answer is whether gold prices are being driven by the liquidity and other advantages (such as reduced storage costs) that ETFs provide, rather than by fear of systemic risk.

Baur did not answer that question, nor can he. Indeed, gold cannot be valued by traditional analytical techniques using cash-flow forecasts and discount rates. Investors must look for clues in the historical data, assess whether it has behaved in a manner consistent with a given model and forecast whether that model will be viable in the future.