The Impact of ETFs on the Gold Market

Vladimir Nedeljkovic
Structured Products, Capital and Debt Markets
Absa Corporate and Merchant Bank

Good morning ladies and gentlemen. The title says it all. I am here today to give
you a couple of thoughts on a new trend in the gold investment, the gold-linked
exchange rated funds, or ETFs, and their current and potential impact on the gold
market. I will first set the scene and show you some well-known facts about gold
demand, then zoom in onto the gold investments and zoom in again on the gold
ETFs. I will specifically concentrate on the market penetration of the gold ETFs by
looking at them in the context of the worldwide investment market. Finally, I will
talk about the potential for growth for these products.

You have basically seen the gold supply and

demand graph multiple times. Above ground World investment demand

stocks are approximately 150,000 tonnes, and I Identifiable investment demand, 1995-2004
will come back to that number later. Supply and
Bar hoarding
the largest 600 450.00

component

demand flow is about 4,000 tonnes per annum.

500 400.00

“Other retail 350.00

400
investment”
On the demand side, the investment is about quite volatile
300
300.00
Tonnes

250.00

US$/oz
13% of the total; to compare, 69% of the ETFs and
related
products as a
200

100
200.00

demand is in jewellery. new form of

demand 0
150.00

100.00

-100 50.00

Source data: GFMS Ltd.

-200 -
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Gold supply and demand

Bar hoarding Official coin Medals/imitation coin
Above-ground stocks Other retail investment ETFs and related products Gold price - London PM, US$/oz
Data: GFMS Ltd.
(end 2004 - 152,964 tonnes)

Supply and
demand only a 2%

16% 19%
small portion of Central banks
the overall above- 5
ground stocks Jewellery

12% Industrial
Stocks in the
form of jewellery, Investment
industrial scrap
and net central Mine production
bank sales
provide close to 51%
one third of the Supply flows Demand flows
total supply figure (five-year average: 2000-2004; 3,979 tonnes) (five-year average: 2000-2004; 3,979 tonnes)

Investment
13%
7%
If we look at year-on-year demand for the
investments, we see that it more or less bound in
demand, a small
share of annual 13%

demand, exerts a
disproportionate
influence on price
because of its
15%

11%
the range of 300-500 tonnes. We’ve seen, of
volatility
66%
4%

2%
course, some growth in the recent years, and I
would like to attribute some of it to the advent of
69%

the gold-linked exchange-traded funds.

Interestingly enough, in the survey we took
yesterday, 62% of the participants said that they
believe that investment demand is going to drive
If we go into gold investment, most of it is in
the gold price going forward. Still investment
gold bars and coins, as well as other retail
demand is only 13% of the overall demand for
investment. Securitised gold in the form of gold-
gold. Why not 50%?
linked ETFs is a relatively new development,
and this is the one that we will be concentrating There are obstacles to investing in gold. Gold is
on today. traded over the counter, which excludes it from
the investment universe of certain classes of
investors. It is a physical transaction, so one
basically has the issues regarding custody
arrangements, insurance, settlement, and so on.
It is specifically difficult for the retail investors.
They do not really have much choice.

The LBMA Precious Metals Conference 2005, Johannesburg Page 127

The Impact of ETFs on the Gold Market Vladimir Nedeljkovic

Most people cannot buy big bars, costs are So we see that there are some good reasons to
significant, liquidity is low, et cetera. Of course, invest in gold through gold-linked securities.
investors can buy gold coins, but there are issues These securities have been around for a few
related to that as well. years now, and it is a fair question to ask: have
they made any impact? Consider the asset
One important factor is the regulatory
growth of gold ETFs worldwide. You can
environment. For example, in South Africa gold
immediately see some positives and some
is considered to be a foreign currency and falls
negatives. The positive is that we have
under the Exchange Control regulations. In some
experienced a rapid growth in assets over a
countries, pension funds are not allowed to
relatively short period of time. At the moment,
invest in gold.
there is about 300 tonnes of gold in all the ETFs
Add to that the relatively lacklustre performance worldwide. That is significant by any standard.
of gold price over a period of years and, as a The one negative is a trend that is similar to all
consequence, we get an asset that is really gold ETFs. Initially, there a relatively sharp
outside of the institution investors’ benchmarks growth, followed by a plateau. The question that
and as such not being followed and researched people ask is, is this it? Has the demand already
by them. We market our gold ETF and we talk to been satisfied?
a lot of institution investors that invest in gold
equities but do not really know about the Contribution to gold ETF market capitalisation
properties of gold as an asset.
In order to address those issues, we had the Based on this
graph, only the
US products
Contribution to market capitalisation of gold ETFs
0.04, 1%

advent a couple of years ago of securitised gold are a success,

all the rest are
failures.
0.34, 8%
0.12, 3%

in the form of gold ETFs. Gold ETFs, compared

to some other structured products, are very Is that really
the case?
0.69, 15%

United States

simple structures. There is a vehicle that holds

UK
Canada
Australia

gold in a trust, usually fully allocated, so there is

South Africa

no credit risk. On the basis of that, gold 3.29, 73%

securities are issued, listed on an exchange and

traded in the same manner as equities. Source: WGC

As a consequence, this type of investment is 9

accessible and simple. It is listed on a stock

exchange, quoted in local currency, with no
If you look at the contribution of different
minimum investment. It is very secure because
countries to market capitalisation, the situation is
the gold is, as I said, held in an allocated form.
quite skewed, in that quite a large percentage of
It is very cost effective. Depending on the
the investments in gold ETFs is basically in one
investment size, it can be more cost effective to
country, the United States. Based on this, one
invest in gold through this channel than by
could say that one should not really be bothered
actually buying physical gold. Finally, it is very
by any other country, that US gold ETFs are a
liquid. Because gold ETFs are open-ended, i.e.,
success story and that the other ETFs are
their size can vary with supply and demand
irrelevant and failures. The problem with that
conditions, the liquidity of the securitised gold
kind of reasoning is that it does not take into
is exactly the same as the liquidity of the
account the relative sizes of the corresponding
underlying spot market, which is actually quite
markets.
high.
World investment demand
Growth of gold ETFs worldwide
Although it % Investment market penetration
does not look
Positives: ETF and similar products' gold holdings like it, average 0.01800%
market
penetration of
Rapid growth 500
0.01600%
Central Fund of Canada (CEF) Gold Bullion Securities (Australia) gold ETFs in
300.00
Central Gold Trust (GTU) Gold Bullion Securities (UK) different
Attracting NewGold (GLD JSE) StreetTRACKS Gold Shares (GLD NYSE) markets is 0.01400%
450
new investors iShares (IAU AMEX) London PM Fix similar
250.00
who previously 0.01200%

did not have 400

And very,
access (cost, 200.00
very small. 0.01000%

convenience,
security) What would
US$/oz.
Tonnes

0.00800%
350
150.00 happen if we
managed to 0.00600%
Gold is in raise the
allocated form 100.00
300
market
0.00400%
penetration of
gold ETFs to
50.00
250 the levels 0.00200%
Negatives: required by
asset allocation 0.00000%
United States UK Canada Australia South Africa AVERAGE
Rapid initial - 200 models? …
% penetration 0.00842% 0.01289% 0.01532% 0.00830% 0.00738% 0.00921%
01/2003 04/2003 07/2003 10/2003 01/2004 04/2004 07/2004 10/2004 01/2005 04/2005 07/2005
growth not
sustained
Source: World Gold Council Source: WGC, International Federation of Exchanges, BIS

10

The LBMA Precious Metals Conference 2005, Johannesburg Page 128

The Impact of ETFs on the Gold Market Vladimir Nedeljkovic

Taking the market size data from the We can get a good visual representation of the
International Federation of exchanges and the possible impact if we overlay 2,500 additional
BIS, and expressing the assets in the gold ETFs tones of demand per annum for the next six
as a percentage of the overall assets, the years over the current demand figures. The topic
penetration of the gold ETFs in different of my speech is ‘What happens to the gold
markets is quite similar. price?’ Well, I ask you: what happens to the gold
price? We cannot exactly say what would
Excluding two Canadian close-ended funds,
happen because we do not really have the proper
which are not real ETFs, the biggest market
gold demand elasticity models, but judging by
penetration is in the UK, followed closely by the
this simple graph, I would think the gold price
US, Australia and South Africa. The worrying
would react quite positively.
thing is that in all markets, penetration of gold
ETFs is minuscule. Overall, average penetration
is just 0.009%. Even this is an overestimate, What if?

because the analysis could not include all the

different investment assets available for the lack
How to get What if?
there? - How to
3,500 450.00
add 2,600 tonnes ?

of relevant data. of demand per

annum for the
next six years to
3,000 400.00

350.00
2,500
increase

I worked with the World Gold Council on asset

penetration of 300.00
2,000
gold as an

Tonnes
250.00

US$/oz
investment to 1,500

allocation studies for different markets, and they 0.5% of total

market? Is it
feasible? Why or
1,000
200.00

150.00

show orders of magnitude higher optimal why not? 500

100.00

allocations to gold than we have at the moment.

0 50.00

What would Source data: GFMS Ltd.

-500 -
something like

Today, we have heard some central bankers

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
that do to the
gold price? Do
we have proper
discussing optimal allocation to gold in their demand elasticity
models?
Bar hoarding
Other retail investment
Official coin
ETFs and related products
Medals/imitation coin
Gold price - London PM, US$/oz

portfolios of 5-10%. The margin between the

current and the desirable is really wide. 12

So, the potential is here. But how do we quantify

it? Let me be very conservative and say, okay, Is it possible? I do not know. I do not see why it
not everybody wants to invest in gold, and so let would not be possible if we take seriously the
us say our aim is to try to increase the market case for gold. Everybody in this audience talks
penetration, not to 5% but to 0.5%, which is about the issues such as diversification, currency
actually quite below what the most optimal asset hedging, inflation protection. If the central banks
allocation model tells us to invest. Also think it is prudent to hold, say, 10% of their
remember, I looked at only five countries. I did assets in gold why would not other institutions
not look at European countries; I did not look at think it is prudent to hold similar amounts or
India; I did not look at China. maybe 10 times less of gold in their portfolios?
How do we get there? Currently, according to
Raising market penetration of gold ETFs the Gold Bullion Securities’ statistics, the largest
Answer: we Current assets in gold ETFs and additional amounts needed to raise
investors in gold securities are institutions:
would sell lots of
gold market penetration to 0.5%
mutual funds hold about 26%, individuals 11%,
Is it possible to
pension funds 2%, which is quite low, assurance
18,000.00
sell 0.5% strategic
asset allocation to 16,000.00
institutional
investors? After
all, asset allocation
studies talk about
much higher
14,000.00
holdings 6%, stock lending 7%. In the case of
South Africa, for our ETF, we have about 90% -
12,000.00
percentages.
10,000.00
Tonnes

As a comparison
23,600 tonnes or
approximately
$326 billion in
private investor
8,000.00
10% split between the institutions and
individuals.
6,000.00
hands, excluding
gold jewellery
purchased for 4,000.00
investment (end
2004) 2,000.00

NB: additional
amount (for these
5 countries only)
-

Additional assets
United States
12,855.02
UK
1,742.76
Canada
726.37
Australia
468.94
South Africa
191.15
TOTAL
15,984.23
What are the obstacles? I think the first one is
~10% of total
above-ground
stocks.
Current assets 220.16 46.10 22.95 7.92 2.86 299.99
lack of knowledge, again because of the fact that
institutional exposure to gold, compared to other
11
assets, is quite minor. As a consequence, there
are not too many analysts that cover gold, which
further makes the job of selling gold or gold
What do we get if we increase market
securities more difficult. Another obstacle is a
penetration to 0.5% in the five markets we are
perception held by many that gold is a marginal
considering? An additional demand of about
and speculative asset with no real intrinsic value.
16,000 tonnes of gold. Remember, the total
Finally, there are regulatory obstacles in some
above ground stocks of gold are 150,000 tonnes,
jurisdictions to be overcome.
so we are talking about 10% of the total of above
ground stocks. Also, compare it to the total
annual demand for gold of some 4,000 tonnes.

The LBMA Precious Metals Conference 2005, Johannesburg Page 129

The Impact of ETFs on the Gold Market
There is a very good investment case for gold,
dealing with topics such as diversification,
inflation protection, currency hedging. That case
needs to be aggressively promoted. Secondly,
we need to expand the investor base. We need to
go beyond traditional gold bulls (after all, they
are already invested in gold in one way or
another). We need to reach mainstream equity
investors, and position gold as another security
with all the characteristics they know and like.
Finally, we have countries like India and China
that are traditionally very big on gold as an
investment, but they currently do it in the form
of jewellery.
The LBMA Precious Metals Conference 2005, Johannesburg
Vladimir Nedeljkovic
Is there a potential? That is really a question I
would like to know the answer to. Is it possible
to sell securitised gold to investors in these
countries without cannibalising existing
jewellery demand? I suppose that is a well-posed
question that can be answered by researching the
relevant markets and taking into account
relevant demographic and development trends.
To conclude, I believe that the potential of gold
ETFs is far from fulfilled and that they can
become a significant factor fuelling demand for
gold and pushing the price of gold upward.
Thank you very much.■
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