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WSJ Mis-Warns on Gold ETF

On November 25, 2010, The Wall Street Journal Printed “Behind Gold’s New Glister: Miners’ Big Bet on a Fund,”  by Liam Pleven and Carolyn Cui.

We have to say, this article must be a very sophisticated piece of propaganda (either that or it is clueless to a fault, but this being the WSJ, my money is on the former). It attempts to peg the gold “rally” of the last decade on the introduction of the `GLD’ exchange-traded fund (or ETF), then slyly warn investors away from gold with a combination of faint praise salted with inaccurate innuendo about the ETF and hysterics about “volatility”.

In specific, the article misses the point, suggesting that the problem is that the ETF has somehow made the gold market “more volatile”, not that the Wall Street operators of the fund run it with a questionable amount of accountability and transparency.

To wit (emphasis mine):

… skeptics argue GLD could become a Godzilla-like beast if the gold rally reverses sharply. They say its buying has already turbo-charged gold prices, exposing the market, and legions of small investors, to a rapid fall. Smaller copycat funds add to the risk.

Wow, that sounds scary!  What evidence do you have for that, Wall Street Journal? As it turns out, none — they simply hide behind quoted hearsay from industry toadies like the CPM Group’s Jeffrey Christian, time and time again throughout the article.

Next up:

The questions come as ETFs in general are coming under heightened scrutiny about whether they distort markets. ETFs are wildly popular and growing fast, spanning stocks, bonds and hard assets. But they have made it possible for far more money to rush in and out of previously illiquid markets.

Again, this is not clear at all — and investigations of this boogeyman-like phenomenon dating back to the 2008 commodities mini-bubble have all turned up nothing. Well, not quite — they have turned up some manipulation, typically in the futures markets directly, but this has nothing to do with ETFs.

We suspect that is because ETFs do not inherently do much to change the capabilities of the large operators (banks and hedge funds) that would hyper-trade securities or manipulate commodities. What it is clear they do is attract long-term, small-scale investors who do not hyperactively trade.

So it’s beginning to look suspiciously like the WSJ is simply parroting the partyline of industry persons who are basically against large-scale, grassroots ownership of gold.

Moving right along…

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.

Wait, it “takes in the necessary gold to back” new shares? BEFORE it issues them? How quaint.  I don’t think so.  In fact the fund’s own legal governance materials say it will issue its new shares Bernanke-style: by creating them out of thin air.  This is known as naked shorting — a Wall Street pestilence of the past decade that has well-earned its horrible reputation (a regulatory crackdown finally began in 2008 when the banks themselves were worried about their stocks being naked-shorted) .

Oh, sure, the fund almost certainly eventually buys the gold to back those shares, but that is probably cold comfort to GLD holders who discover their shares are to some extent (how much?) unbacked by gold.

That seems like the real problem with the GLD ETF, if any, and it has garnered plenty of exposure online by independent researchers — but apparently none of that is noteworthy to the industry-rolodex-addicted WSJ.

Then we have:

… many GLD investors aren’t experienced in gold investing. Between 60% and 80% of GLD investors had never bought gold before, estimates Jason Toussaint, managing director of the council. No one knows how those newcomers might react in a sharp downturn.

Putting aside the 60-80% “newbie” estimate (what methodology was used?), how about we try to actually answer this question by looking at, oh, I don’t know, evidence.  For example, the way investors reacted in the acute phase of the financial crisis in September 2008?  Indeed, we find gold, and GLD fell sharply — but at the worst, were priced at about the same levels as the year before (gold went from about $800/oz to $800/oz over that time). Meanwhile, the stock market was down nearly 50% over the same period.

So why the special warning about GLD rather than equities in general (or even better, bank stocks)?

Further, it is pretty clear from that episode that the major liquidators were hedge funds and banks in acute need of immediate cash, not “first-time investors”.   As evidenced by higher bullion premiums around that time, those people were probably buying more — a counter-cyclical move which actually suggests stability, not volatility.

So it isn’t clear at all GLD per se has brought about volatility (again, the article is devoid of any sort of methodical analysis, so don’t go looking for one).   But it is pretty obvious from a glance at the gold bull market of the late 1970s through 1980 that volatility in gold during a time of great financial chaos is not unusual. Given that we are arguably having more such chaos than ever today, the price of gold has been relatively steady — even with the GLD and its brethren around.

As we have long maintained around here, the truth is probably the exact opposite and “stranger than fiction” — since, as above, we know the fund grows by shorting its own shares (selling new shares it does not have metal to back), it in essence bets against its own shareholders and suppresses rises in the underlying metal’s price.  To the extent this counter-trend action holds, it means GLD is actually a “price management” tool which keeps the fund (and gold) price rises subdued — the exact opposite of what the Wall Street Journal article’s innuendo implies.

If anything, the “unwashed” masses should be buying more gold and silver, and if physical is too much hassle, they might try (instead of the big Wall Street-managed ETFs) closed-end funds like CEF or the Sprott Trusts. This would take into account worries about being exposed to rapid trading and wild swings, and inherently stabilize the market by avoiding naked shorting.

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