Rock Beats Paper: Why the Volatility Can't Beat a Solid Foundation

By Jason Sampognaro, Hard Assets Alliance Analyst

It's easy to get caught up in the frenzy of the gold market. When prices are skyrocketing to new highs, everyone is scrambling to buy. When prices are falling, it's as if they've run out of lifeboats on the Titanic. Like lemmings, many investors walk off their own personal fiscal cliff by buying high and selling low. To avoid flocking with the herd, it's key to remember that gold is not an investment at all. It is a rock-solid savings account that beats any fiat paper governments can dish out.

Last week, we went in-depth on why the US Federal Reserve will be printing much more fiat paper in the months and years to come and the effect this will have on the price of gold. The Fed's actions should be a red flag to anyone who is not currently holding a portion of their wealth in physical hard assets. In case you missed it, you can read it here.

We believe gold will continue to climb higher in the future – a belief you may share. However, it can be difficult to swallow the volatility of the gold market. It's said that we often fear what we do not understand, so building on what we started in last week's article, let's continue to explore other drivers in gold's price.

In this piece we'll dig into paper gold, discuss its two most common forms, and demystify how these instruments can cause swings in the price of gold.

What Is Paper Gold?

Commodities like gold are traded in many forms. We at Hard Assets Alliance recommend the physical kind. However, the physical market is tiny compared to the paper market. It's been said the ratio of paper gold to physical gold could be as high as 100:1. Judging from this fact, you can see how much influence the paper market can have on the price of gold.

Exchange-traded funds (ETFs) and futures are two of the most common forms of paper, making up a majority of the paper market for gold. Gold ETFs, like GLD, are an easy way for inventors to gain exposure to precious metals without leaving the comfort of the stock market. Futures, on the other hand, are a much more advanced form of paper gold. They can also be quite risky. We'll discuss both of them below.

Easy ETFs

Exchange-traded funds are companies that purchase assets and sell shares on the stock market based on the value of those assets less administrative costs. Assets can be stocks, bonds, or commodities like gold. With most of the major gold ETFs, the actual gold is held in a vault; each share represents a fixed amount of that gold. For example, if an ETF owns 1 million ounces of gold and issues 10 million shares, each share would represent 1/10 of an ounce of gold. The ETF collects a fee each year to maintain the fund. For most of the gold ETFs, this fee is about 0.4%.

Since ETFs are traded in the form of shares on the stock exchange, most investors don't have to step outside their comfort zone. They can buy and sell gold from their home computer just like they would any other stock. The fee of 0.4% that most ETFs charge is about what it would cost to buy, store, and insure a small amount of gold.

ETFs bypassed many of the obstacles that regular investors faced when looking to purchase physical gold – obstacles like finding a reputable dealer, determining whether to store the gold at home or in a storage facility, and finding a buyer when the time comes to sell. It's not surprising that the easy trading of ETFs contributed to gold's meteoric climb. Since the beginning of the decade, total investment demand for gold has soared from only 4% in 2000 to a record of 45% in 2009. From 2003 to 2007 – the time when most of the major gold ETFs came into being – investment demand for gold shot up as millions of investors around the world were looking for exposure.

It's important to note that owning shares in an ETF is not the same as owning physical gold. Only hold-in-your-hand, physical gold will provide you with a hedge against out-of-control government spending, debt, and money printing. Although each share of an ETF represents a specific amount of gold, you can't just walk up to the office of the fund manager and demand your gold.

Read through the prospectus of a given gold ETF and you'll likely find that only "Authorized Participants" can redeem shares for actual physical metal. And even then, the fund usually has a minimum requirement for the amount of shares that can be redeemed. SPRD's gold ETF, GLD, requires a minimum of 100,000 shares for redemption. At today's prices, that would require a $1.6 million position in GLD – not exactly chump change for most investors. Perhaps the most unsettling aspect of GLD is that its operating agreement allows the fund to lend your gold holdings. It's almost like parking your money in a bank that doesn't allow you to make a withdrawal.

In their inception, gold ETFs offered an easy way to gain exposure to gold. Millions of investors flocked to these funds, and the price of gold responded accordingly. However, after some scrutiny we find that owning gold ETFs does not equate to owning physical metal.

Back to the Futures

Futures originated as a way for both buyers and sellers of goods to lock in a future price to gain more stability in an unstable market.

For example, let's look at the business transaction between the owner of a mint and a coin dealer. Because of the volatility of the gold market, the mint owner finds it difficult to predict what his quarterly revenues will be. The coin dealer is in the same boat, needing to model costs in order to plan finances accordingly. Therefore, the two agree to transact in the future for a fixed price and fixed quantity of gold. So, regardless of the spot price of gold on that day, the transaction will still take place and each will be able to plan more confidently.

While the futures market began as a way to aid business, the majority of the participants in today's futures market are speculators. While business owners are looking for stability, speculators bank on volatility. They make their money off of large swings in price by betting on market movements in the future.

Most often, contracts between speculators are purchased on loans from the exchange they are traded on. When the contract expires, the speculators pay back the loan and the gains from the trade are transferred from the speculator who guessed wrong to the speculator who guessed right. No actual physical metal changes hands.

You can imagine that a futures exchange, which trades millions of contracts like this per day, could generate a lot of paper gold. As each contract matures, new ones take its place. Since most traders do not actually take delivery of the gold they trade, there is always a large amount of paper gold floating between long and short positions.

With futures, all of this extra paper turns any short-term forecast in to a wild price swing in one direction or another. Imagine a multitude of traders taking a sudden short position, offering to sell gold at a price that is lower than the current spot because they're concerned about some sort of catastrophic drop. Now imagine all of these traders being able to leverage their positions by 10 times or more by taking out a loan from the exchange. Since the general trend is for the spot price to be lower than the futures contract price, we would expect the spot price to drop dramatically as all of these short positions began to mature. And as soon as the price swings downward, everyone begins to flock back into gold, causing the next spike.

Knowledge Is Power

As we already mentioned, understanding something helps conquer fears about it. We've shown how ETFs and futures – the two main players in the paper market – can drive the price of gold.

Exchange-traded funds enabled many investors to take a position in gold they may not have otherwise taken. This ease of entry gave rise to an influx of demand and a healthy bump in the price. However, ETFs are on the decline. Does this mean a decline in the gold price? Hardly. Investors are wising up to the fact that rock beats paper and are moving their wealth into coins and bars as opposed to bullion proxies. Since 2009, total coin and bar purchases are up 96%, while net additions to exchange-traded products are down 73% over the same period.

Futures serve to exacerbate the already volatile nature of gold due to the use of leverage by speculators. However, these wild swings in the short-term are mere blips on a curve that is upward and to the right in the long term. If you know why you own gold, you'll know not to get caught up in the short-term volatility.

Now that you're armed with this knowledge, you can invest in gold more confidently and sleep well at night once you do.

Leave the Paper Behind

There couldn't be a better time to get into gold. Luckily, the Hard Assets Alliance offers all the benefits of an ETF without all of the extra baggage. Buying, storing, or taking delivery of physical gold can be done from the convenience of your home computer. With storage facilities all over the globe, you gain something most ETFs do not offer: international diversification. Download your free SmartMetals Action Kit for more details on how you can get the best kind of exposure to precious metals – the physical kind.

Posted 01-30-2013 2:08 PM by Hard Assets
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