Friday, November 26, 2010

Why Is GLD So Hard For People To Understand? An ETF Lesson: Part III

Isn't the Wall Street Journal supposed to be the premier source for financial information (ok, maybe they're number 2, behind the Financial Times)?  Somehow, even their authors can't understand that an ETF like GLD is not a mutual fund.    I've been through this twice already (please read my prior two pieces if you are still confused), but let's do it one more time. 

The WSJ article states: 

"GLD shares trade on the New York Stock Exchange, as well as in Tokyo, Hong Kong, Singapore and Mexico City. Each share represents one-tenth of an ounce of gold. That, in effect, gives shareholders the right to their share of proceeds from selling a full bar, minus fees. Before GLD issues new shares, it takes in the necessary gold to back them. On days when there are more sellers than buyers of GLD shares, the fund offloads some of its gold."

Ouch.  There's a whole lotta WRONG in that paragraph, which is too bad, because the piece is otherwise a decent history of the GLD ETF.

First, the "you've gotta own physical gold" crowd will correctly have a cow about the claim "That, in effect, gives shareholders the right to their share of proceeds from selling a full bar, minus fees."  As regular readers already know, GLD tracks the price of roughly 1/10th of an ounce of gold (slightly less, since they have to sell some gold to pay for their expenses) - but it doesn't give common shareholders the right to much of anything.  Large shareholders can, with the assistance of Authorized Participants (ie; big broker dealers), redeem their GLD shares for gold bullion - but apart from that redemption feature (which is done in minimum increments of 100,000 shares), shareholders have no "right" to any gold or to the proceeds from the sale of any gold (unless the Trust is wound down and liquidated for some reason).

The statement "Before GLD issues new shares, it takes in the necessary gold to back them," is correct! That's exactly how it works!  Authorized Participants deliver gold to the GLD Trust, and the APs receive newly issued GLD shares in return - that's called creation.  But the next sentence gets into the Land of Confusion again: "On days when there are more sellers than buyers of GLD shares, the fund offloads some of its gold."  As I've explained previously, the GLD Trust does not buy and sell gold.  It issues new GLD shares in exchange for APs delivering gold (creation) and takes back GLD shares from APs while delivering gold to the APs (redemption).    Ah hah - but the WSJ didn't actually say that GLD sold gold, right?  It said that GLD "offloads" some of its gold - maybe the WSJ meant that the Trust offloads gold to the Authorized Participants as part of redemptions which occur naturally as a result of supply and demand imbalances which cause arbitrage opportunities (if that sentence scared you, read down a few paragraphs, I'll explain)?   Although I wish I could give the WSJ the benefit of the doubt and pretend that they understood this creation/redemption process, it's clear from further down the article that they don't:

"If GLD shareholders get spooked by drops in the gold price and sell en masse, the fund would have to dump metal to meet redemptions, possibly accelerating declines by prompting others to sell even more."

Ugggh. No. Wrong - it doesn't work like that.  Let's review this one more time, because it's such a simple concept:  that's' how MUTUAL FUNDS work:  when you buy a mutual fund, the money goes to the fund itself, and they use it to purchase more of all of the stocks that they own.  When you want your money back from a mutual fund, they have to raise funds by selling little bits of the stocks in their portfolio and they then return the cash to you.   ETFs like GLD do not work like this.  When you buy GLD, you buy it from other people in the market, just like when you buy IBM, AAPL, NFLX, or GE.  When you buy GLD, you don't send money to the GLD Trust so that they can buy more gold.  It simply doesn't work like that.    How do the assets in the trust change then?  Via the creation/redemption mechanism.  I'll quote myself from the ETF Lesson Part I:

"If "the market" is lacking GLD sellers, and the price of GLD rises so that it is in excess of it's NAV (net asset value)  there are arbitrageurs standing by ready to short you shares of GLD while they simultaneously buy gold bullion as a hedge.  Since they are selling GLD "rich" to its fair value, they will make a profit when they eventually collapse their position.  How do they collapse it?  Well, they take their gold and "create" GLD by delivering the gold to the trust, receive newly created GLD and use that to cover their GLD short position.  Voila - they're now flat, and the GLD's assets have increased, as have the shares outstanding. 

Of course, if everyone wants to sell GLD, the opposite happens - the arbitrageurs, if GLD is trading "cheap" to its NAV, will buy GLD while simultaneously shorting gold bullion.  Then, they'll take their GLD shares, deliver them to the trust, redeeming them for gold which they use to close out their short position.  In this case, the assets held by the trust decrease, as do the shares outstanding (after all, the arbs have taken GLD shares out of circulation, and given them back to the trust, effectively "retiring" the shares temporarily.)"

Since we're talking about an ETF, there's no chance that "the fund will have to dump metal to meet redemptions."  ETFs simply do not do that.  Will GLD (and gold) go down if everyone wants to sell it?  Of course - if selling pressure in GLD mounts, the natural tendency is for arbs to buy GLD slightly "cheap" to it's Net Asset Value, while hedging themselves by selling actual gold.  A surplus of selling (aka, supply), results in lower prices.  But note that by the time the actual "redemption" happens - where the AP delivers GLD shares to the trust in exchange for gold - the selling has already occurred (they've hedged themselves by shorting gold, in response to investors selling GLD to a price below its NAV).  Again, this is the opposite of a mutual fund, where "redemptions" - aka "I want my money back,"  require selling to raise the funds.

The mechanics of ETFs with easy create/redeem mechanisms like GLD are not rocket science, yet that doesn't seem to stop the media, even professionally targeted sources like the Wall Street Journal, from continually demonstrating a lack of comprehension of the product.


disclosure: long GLD

As usual, comments of the nature "GLD doesn't actually own any gold" will be deleted unless they are wicked intelligent.


Beth Leonard said...

Is there a cut-and-paste typo in there? Did you really mean SPY near the end?

Kid Dynamite said...

thanks beth - it was a c&p typo

Manshu said...

I read that article, and I thought it sounded incorrect based on your earlier posts.

Thanks for explaining this once again :-)

Anonymous said...

My firm recently helped underwrite this gold ETF: Sprott Physical Silver Trust but I don't pretend to understand it that much.

What do you think will be the long-term effect these types of ETF's on the market (for whatever the ETF's hold)? Do these ETF's merely further influence mania's? I don't think we have ever had an ETF that tracks a phyisical product implode so I wonder what the effect would be if the parabolic increases stop.

Kid Dynamite said...

VegasKev - as many people have pointed out, by allowing a broader range of investors to access your product (which is what ETFs like GLD do), it can certainly result in higher prices. For things like commodities, a lot of people don't like this idea.

I think it's better to have the products open to everyone - if I want to buy palladium, I should be able to buy palladium, as a retail investor - it shouldn't be just professional futures traders who should be able to access the product (which is basically how it used to be)

wcw said...

ETFs are '40-Act mutual funds. Sponsors have to apply to the SEC for exemptive relief in order to launch them. Let us just repeat the important words: ETFs are mutual funds. So shareholders of ETFs indeed have rights that exactly parallel those of the shareholders of open-end mutual funds, because legally they are the same vehicle.

I don't think the WSJ fails to understand creation and redemption, I think it failed to dumb-down the concept accurately for a short article.

Kid Dynamite said...

WCW - I have no interest in arguing what the WSJ did or did not understand. It's quite evident that, like almost all journalists writing about the topic, they positively do not understand the redemption mechanism, which I went through lengths to explain in the post already, so I will not do it again here.

Saying things like "ETFs are mutual funds" doesn't help at all, and only guarantees that people will continue to misunderstand, because ETF cash flows and redemptions ARE NOT AT ALL LIKE mutual fund cash flows and redemptions.

As for the similar rights to open ended mutual funds - would you care to elaborate? what rights? I'm not an expert on the rights of mutual fund holders, although I'm pretty sure they don't have things like voting rights in the underlying (the fund votes for them). So what rights to GLD holders have?

from the prospectus:

"Upon the termination of the Trust, the Trustee will, within a reasonable time after the termination of the Trust, sell the Trust’s gold bars and, after paying or making provision for the Trust’s liabilities, distribute the proceeds to the Shareholders,"

as I stated in the article.

also, "Shareholders have no voting rights except in limited circumstances. Shareholders holding at least 66-2/3% of the Shares outstanding may vote to remove the Trustee. The Trustee, in turn, may terminate the Trust with the agreement of Shareholders owning at least 66-2/3% of the outstanding Shares. In addition, certain amendments to the Trust Indenture require 51% or unanimous consent of the Shareholders."

then there's also this, referencing the same '40 act which you referenced:

"Shareholders do not have the protections associated with ownership of shares in an investment company registered under the Investment Company Act of 1940 or the protections afforded by the CEA. The Trust is not registered as an investment company under the Investment Company Act of 1940 and is not
required to register under such act. Consequently, Shareholders do not have the regulatory protections
provided to investors in investment companies."

wcw said...

Apologies -- I forgot these things (GLD, AU, and friends) generally aren't structured as '40-Act funds. Most successful ETFs, with the notable exception of SPY, are. Mea culpa. I war wrong.

Kid Dynamite said...

WCW - cool. But still, what was your point about the rights that shareholders get? is MDY structured like that? QQQQ? DIA? what rights are shareholders accorded thusly under the '40 act?

they still can't vote, right? they can't redeem their ETFS for the underlying basket (unless they are an AP), right? (the Merrill Lynch HOLDERS are an exception: SMH, HHH, BBH, etc)