Fasten your seatbelts

Exchange-traded funds add to gold's gyrations

Exchange-traded funds (ETFs) have added to gold's gyrations this week. The yellow metal's swift decline - a 13 per cent sell-off over two trading days - left investors breathless. Though it is still not clear what sparked the slide on Friday and Monday, stock-like ETFs added to the selling pressure. It's a reminder there's a dark side to making illiquid assets easier to trade.

Physical gold is difficult and expensive to move. But ETFs can be bought and sold like any other stock on an exchange while a fund's sponsor and its designated market makers manage the actual collateral.

As a result, retail investors and hedge fund managers like John Paulson have plowed into paper gold. Last year, ETFs sucked up 279 tonnes of the stuff, a 51 per cent increase over the prior year, according to the World Gold Council.

Notably, this demand didn't square with sentiment elsewhere. Jewellers and those who prefer their gold stacked neatly in a vault, not in a stock portfolio, bought significantly less last year than in 2011. That could suggest macro hedge funds and other investors were buying ETFs thinking central banks' ultra-low interest rates would bring inflation or, worse, destabilise the financial system. But that hasn't happened. And, the same investors may now be bailing.

Though ETFs represent only a sliver of the overall gold market, their liquidity and transparency make them an obvious benchmark for sentiment.

Moreover, the ability to add and shed holdings quickly - unlike, say, storing bullion in undisclosed locations - can exacerbate price swings. The largest US gold ETF, State Street's, for example, sold nearly 23 tonnes on Friday alone. That's double the amount of gold held by the central bank of Cyprus, which panicked investors after saying it may sell its reserves last week.

Such quick-fire trading comes with an additional cost. GLD shares traded at a 3 percent discount to the fund's underlying collateral on Friday and Monday, according to State Street's website. That's unusual for the ETF, which mostly tracks the value of its holdings closely. If such a discount were to persist, it could encourage more selling.

For the moment, calm has returned, with prices recovering slightly on Tuesday. But with more than $70 billion of assets in gold ETFs, investors should be ready for the next bout of volatility.