Hedge Funds Are Buying Up Gold ETFs, Should You?

by on August 19, 2010 | Updated August 24, 2010 | ETFs Mentioned:

Despite a relatively solid earnings season, anxiety continues to run high on Wall Street as elevated unemployment and sagging confidence stand as major obstacles to a continued economic recovery. As equity markets trend sideways and potential pitfalls materialize, many investors have moved slowly towards safe havens, preferring to watch from the sidelines until the storm clouds clear [see Five Safe Haven ETFs]. Government bonds have been a popular choice, but record demand for these securities has driven prices up and yields down to near-historic lows. The combination of these paltry yields have and record budget deficit levels have sent many investors into precious metals, traditionally a calm harbor during rocky economic times.

It isn’t just the cooky conspiracy theorists who are flocking to precious metals; investments in gold are a popular choice for some of the world’s most famous fund managers. According to recent 13F filings, demand for gold ETFs, particularly the SPDR Gold Trust (GLD), has soared in recent months among top hedge fund firms. Eton Park Capital Management revealed that it has about $800 million in GLD, while the legendary George Soros has a position of about $600 million. Not to be outdone, John Paulson’s fund maintains a $4 billion allocation in GLD, making his fund the single largest holder of State Street’s gold trust. That means that Paulson’s stake in GLD is as almost as large as the other two physically-backed gold ETFs (IAU and SGOL) combines. “I can’t remember in 20 years so many respected investors focused on a single strategy,” said Bradley Alford of Alpha Capital Management, which invests in hedge funds. “Some of these people are icons of the industry with at least 15-year track records. It’s a losing proposition to bet against guys like that. They aren’t billionaires because they make bad bets.” [also read Three ETFs To Protect Against A "Hindenburg Omen" Sighting]

Despite having a higher expense ratio than other gold ETFs, GLD remains a popular choice for hedge funds and other large traders due to its immense size and impressive liquidity. The fund has over $51 billion in assets and an average daily volume of close to 15 million shares. This allows the hedge funds to increase or decrease their holdings without drastically impacting the market, a perceived risk in smaller ETFs (although the arbitrage mechanisms underlying ETFs make it possible to execute trades near NAV regardless of trading volume). So far, these big stakes in GLD have paid off for hedge funds; the gold ETF is up about 12% to date in 2010 while most equity markets are in the red [see Is A Cheaper Gold ETF A Better Gold ETF?].

Investment Banks: Favoring Gold Mining Equities

While star hedge fund managers are building up positions in the physical commodity, some investment banks have embraced another ETF-based strategy for establishing gold exposure: investing in gold miner stocks through the the Market Vectors Gold Miners ETF (GDX) and Junior Gold Miners ETF (GDXJ). Goldman Sachs and Morgan Stanley both have significant holdings in the junior gold miners ETF, with Morgan Stanley currently standing as the top holder of the fund.

ETFs made up of gold miner equities tend to trade as a leveraged play on gold prices. Because the profitability of gold miners depends on the prevailing market price for their product (i.e., gold bullion), their outlooks tend to move in unison with spot prices. Some investors prefer to establish exposure to gold through GDX and GDXJ since the underlying holdings generate cash flow and have a positive expected real return over the long-term. By contrast, it’s a certainty that the underlying holdings of GLD–bars of gold stored in secure vaults–will never make a dividend or coupon payment. Putting a price on an asset that is impacted by changes in investor psychology and has no cash flow is obviously a tricky task; valuing a stock is much more straightforward.

The downside of playing gold through mining stocks is that the underlying holdings are, well, stocks. Investors interested in gold exposure generally have a negative outlook on equity markets, and are looking for an asset that will thrive during periods of economic uncertainty. Although the correlation between broader markets is relatively low, GDX and GDXJ are equities just like SPY and EEM, and as such are subject to some similar risk factors.

Both GDX and GDXJ are enjoying sustained runs higher in 2010; the junior miners ETF is up about 16% while GDX has gained 13% on the year [read GDX vs. GDXJ for a closer look at the similarities and differences between these two funds].

Where Next?

The massive bets on gold from legendary hedge fund managers and Wall Street institutions should be comforting for those with exposure to the yellow metal, but it also creates the potential for a massive sell-off if sentiments change. If other big investors follow in the footsteps of Soros, Paulson, and Morgan Stanley, the momentum behind gold prices could continue to build. However, this demand by institutional investors could end up having devastating consequences as well; should the companies decide to sell their holdings all at once it could create a herd-effect in the market and result in a plunge in gold ETF prices. So while the massive buying of gold ETFs is certainly bullish, a continued run higher is no sure thing [also see Gold ETFs: Where Do They Go From Here?].

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Disclosure: Eric is long gold bullion and IAU.