What's driving the gold price?
What are ETFs? The ETFs, or Exchange-Traded Funds, are funds that track indices, commodities or securities.
The ETF shares are securities that closely resemble the yield and return of its native index, but – unlike mutual funds units – can be traded just like common stocks. The gold ETFs are a special type of ETFs that track the price of gold. The ETFs are backed by physical bullion (or gold derivative contracts), but investors do not own any gold and they cannot even redeem their shares in gold (only authorized participants can do that, thus private investors liquidate their holdings by selling their ETF shares on the open market). The two largest gold ETFs by assets are the SPDR Gold Trust (GLD) and the iShares COMEX Gold Trust (IAU).
We can think of several reasons for investing in securities which merely replicate the performance of the yellow metal. The gold ETFs are quoted on stock exchanges, so they are very convenient to trade and liquid. Since they are not actively managed and they are associated with minimal expenses. ETFs also often enjoy tax advantages.
But perhaps the most important feature of the EFTs is the fact that one share usually corresponds to one tenth of one ounce of gold. Therefore, it is relatively easy to buy ETFs even for individual investors. Some analysts even say that introduction of gold ETFs in the 2000s made the gold market finally accessible for private, retail investors. According to them, this revolution contributed to the 2000s bull market.
Is that true? What is the relationship between the ETF flows and the gold price? Let’s analyze the chart below, which shows the net inflows of gold bullion into ETFs and the price of gold. As one can see, there is a visible positive (but not always strict) correlation between gold prices and the net inflows into ETFs. When the price of gold rises, we see inflows to ETFs. Conversely, during the last bear market, we witnessed huge outflows from ETFs. Consequently, the cumulative holdings of ETFs track the price of gold.
Figure 1: The price of gold (yellow line, right axis, P.M. London fixing, in the U.S. dollars per ounce), the net demand for ETFs and similar products (red line, left axis, in tons) and the cumulative ETFs holdings (green line, right axis, in tons) from 2003 to 2015.