Tuesday, February 24, 2009

The Wall Street Journal is Wrong

In poker, there's a saying, "don't tap on the glass." When someone is being an idiot - a fish, you don't educate them - you let them be an idiot and you take their money.

However, when I read something that I know is blatantly false in a paper with as much clout as the Wall Street Journal, it bugs me. WSJ reporter John Jannarone wrote an article on the GLD trust on Sunday that fundamentally misunderstands how the trust works, and since he's not the only one (I read some "GLD IS A SCAM!" articles which posed similar questions), I felt the need to explain it here.

First, let's review his claims:

"ETFs such as SPDR Gold Shares -- ticker GLD -- are a direct bet on bullion prices. The trusts have to buy physical gold to match investment levels. Having doubled the gold in their vaults in a year, the stash is worth $45 billion.That's tiny in the context of big asset classes like stocks. But gold's scarcity keeps the market small. If ETFs continue to grow fast, they could start to create a real squeeze in gold, with its limited supply."

and then in his conclusion:

"If, and when, investors decide the game is up, ETFs will have to liquidate holdings as people sell. Just as they are squeezing the market now, they could flood it when the frenzy ends."

OK - Mr. Jannarone has one thing right that a lot of people fail to understand - GLD is indeed a direct bet on bullion prices - they own gold bullion, not futures or options. You can read all about the details of the GLD Trust here.

However, when an investor goes out and buys GLD, there is no resulting effect causing the trust to "buy physical gold to match investment levels." That's simply not how it works. When you buy shares of GE, the money doesn't go to GE - it goes to whomever sold the shares to you. When you buy shares of SPY, the money doesn't go to the SPY trust in order to buy a basket of S&P 500 stocks. Similarly, when you buy GLD, the money doesn't go to the GLD trust - it goes to the seller of the GLD on the exchange. The trust has nothing to do with it.

Now, you are able to create shares of GLD (in 100,000 share increments) if you go out and buy the corresponding amount of gold bullion. You can take your bullion, deliver it to the trust, and get shares - but the trust doesn't have to go out and buy any bullion. Similarly, if you have 100k shares of GLD, you can give them back to the trust (aka, "Redeem") and they will give you gold bullion in return.

The reason the shares outstanding of the GLD are increasing is because someone is creating GLD shares. Even though GLD frequently trades very close to its net asset value, (you can get the data here) I'd guess that someone has been shorting GLD when it trades rich (above NAV), and buying bullion. This arbitrageur then takes his bullion and delivers it to the trust, and received GLD shares to cover his short.

There has been a lot of talk lately about the USO Oil ETF, and its impact on the oil market. The USO is structured differently from the GLD in that it owns oil FUTURES, which must be rolled each month. The assets of the USO are a huge percentage of the outstanding open interest in oil futures, and thus it ends up costing the trust a great deal each month when they roll their futures position, because everyone in the market knows they are coming and rips their eyes out. GLD, on the other hand, doesn't have to roll anything - they just hold their gold bullion in their vault.

This is neither a recommendation to buy or sell GLD - just an attempt to correct a common misunderstanding out there in the market.

Thus concludes today's lesson.



The Bracelet said...

To me, trying to understand anything related to financial markets is literally like listening to two Mexicans speak their native tongue. Every so often I understand some tiny, inconsequential component of the overall discussion, but absolutely nothing else gets absorbed.

One of these days, over a couple beers, I'm going to have you give me the Wall Street For Retarded Grade Schoolers explanation so that maybe I can finally follow along with the rest of the adults.

I'm an idiot.

For me it's like that person you can never recall the name of no matter how many times someone tells you it. Two seconds later it's gone again. I go, "Ok, a guy buys stock in a company. Alright. He has stock now. Ok, so...FUCK! Who has what now?"

Patton said...

You're far too kind.

The article's not just wrong, its fundamentally stupid.

Mark Herpel said...

From where did all the gold claimed to be owned by all the gold ETFs come from? Where did funds such as GLD get their additional 45 tons in the last month? We certainly can forget about that gold coming from the Comex. 12 deliveries would stand out like a sore thumb. This concept and record keeping eliminates all exchanges around the globe as the source of bullion delivery in any size to all Gold ETFs. The physical market is so tight that coin minting has all but closed down compared to what it was one year ago. It is hard to accept that the Gold EFTs can buy what the mints can’t.
That probability is that the claimed gold can only be OTC derivative long positions. If that is so then the financial reliability of the paper stands on the foundation of the balance sheet of the granting counter party to the OTC derivative. This is true regardless of whether it is a mine or naked speculator.
I think you own an ETF of derivatives, not of gold!


Kid Dynamite said...

Thanks for that comment, Mark, it's a point i wanted to address, as I read the article you quoted it from.

The point is that the article again completely misunderstands: the Gold ETF DID NOT GO OUT AND BUY 45 TONS OF GOLD! that's exactly my point.

My guess is that gold dealers delivered gold into the trust to create shares to cover GLD shorts they had established thru arb (when they could buy bullion cheaper than GLD was trading).

the GLD has a great website with all sorts of data - i downloaded their spreadsheet last night to confirm that they never had a point where the amount of gold in the trust gapped up overnight - and the data confirmed this.

The prospectus claims that the trust owns only gold bullion - physyical gold - not futures or derivs. I believe them.

Kid Dynamite said...

oh, by the way, i just went back and looked at the ETF data again - from Jan 12, 2009 to Feb 13, 2009 the assets in the trust increased by nearly TWO HUNDRED tons, not 45 tons. (787 tons --> 985 tons)

Anonymous said...



Anonymous said...

I agree the idea that GLD is a Scam ;
if there is no fixed number of GLD shares then anybody can create a share by selling a non existing GLD share then buy the actual gold bullion and give back to the trust and get back their actual GLD shares. The trust works like a manipulation room.
To stop SCAM simply the total number of GLD shares and corresponding actual total Tons of gold should be fixed.