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The Hidden Jewel in ETFs: Bullion

For a brief moment last year, the exchange-traded fund held in greatest value by investors had nothing to do with the Standard and Poor's 500. Or stocks of publicly traded companies of any sort.

Instead, it was an ETF that took stock in a metal. Gold.

The fund was SPDR Gold Shares from State Street Global Advisors, the firm which kickstarted the entire $1 trillion ETF industry with the 1993 launch of the SPDR S and P 500, which did, in fact, have as its base holdings of stocks in that widely watched and used index.

But on Aug. 18, 2011, SPDR Gold Shares were worth more, in toto, than all shares held in the SPDR S and P 500, long the undisputed leader in overall size.

At that moment, though, shares of stocks in public companies were reeling as were the values of SPDR S and P 500. That was due to the first-ever downgrade of U.S. debt by a major ratings agency, on Aug. 5, and nervousness over the U.S. deficit, debt and economy.

At the same time, the threat of a European sovereign debt collapse sent investors looking for a safe haven. For thousands of years, that has been gold.

With gold prices up and stock prices down, $76.7 billion was held in GLD shares and $74.4 billion in SPY shares on Friday, Aug. 19. The moment didn't last. Four trading days later, SPY was back on top.

But the moment showed just how broadly accepted investing in a share of a fund that in turn holds bullion has become.

Indeed, says Kevin Quigg, Global Head of ETF Strategy and Consulting Holding at State Street, gold is on the verge of becoming a 'set piece of asset allocation' '' in the minds of institutions.

Its slice of the investing pie in a diversified set of holdings, next to stocks and bonds and other alternatives? Somewhere between 3% and 5%.

Gold, in the form of shares in an exchange-traded fund such as GLD, "is increasingly becoming part of a diversified investment portfolio,'' said Greg King, head of Exchange Traded Products at Credit Suisse.

The 3% to 5% slice?

It's been higher. When inflation was roaring in double digits in the late '70s and early '80s, some institutions kept as much as 20% of their holdings, overall, in gold. Back then, in bars or other physical forms.

In many investing quarters, in the past, gold also has been viewed almost interchangeably with other commodities, from oil to corn to coffee to copper, by many institutions.

But now, Quigg contends, it's becoming regarded as a separate asset class, almost if by groundswell. A store of value. A hedge against risk. A bet on the metal itself. A hedge against inflation.

"It's all of those things,'' he said.

GLD, for many institutions and individuals, has been better than holding gold.

Because it's quicker to buy and sell as needed. And no special housing is required.

For instance, State Street Global Advisors holds 40.3 million ounces or 1,254 tons of gold in a vault. And it sells shares in the GLD fund at the rate of one-tenth of an ounce a share.

So, in practicality, the "index" for the fund is the price of gold and rises or falls accordingly.

And even though gold has fallen from its record high of $1,895 an ounce in early September, the returns have been far better than stocks for far longer.

Since inception of the fund in November 2004, the average annual return has been 18.72%. By comparison, the Standard and Poor's 500 index has risen from 1,211.92 on the last day of 2004 to 1,257.60 on the last trading day of 2011. That's a return of 3.7%. Over seven years. Or half of 1% a year.

Investors were so enthusiastic about the chance to invest in gold through the indirect mechanism of exchange-traded fund shares that State Street pulled in $1 billion to GLD in its first three days of operation.

And even with a pullback, as European Union nations moved toward approving the European Stability Mechanism rescue fund, the 420.3 million shares in the fund were worth a total of $70.5 billion at the end of trading on Jan. 27.

The fund is not alone in capitalizing on gold. Nor is it the lowest cost fund. The expense ratio for GLD is 0.40% of assets over the course of a year. By contrast, the second largest fund, BlackRock's iShares Gold Trust, has an expense ratio of 0.25%, King notes. It has total assets of approximately $9.7 billion.

Partly because of the rise of exchange-traded funds, demand for gold-the bullion-is increasing. In the third quarter of 2011, demand for gold increased 6% from the same period a year earlier. Demand was 1,054 tons, worth $57.7 billion.

And the reason for the growth? Investors, according to the World Gold Council.