Gold Buyers Ride Rally While Pumping Physical Demand

NEW YORK (MainStreet) — A politically unsettled world is once again motivating investors to turn to gold and the precious metal responded with a gain of more than 6% in August, rising to a three-month high. But while the bulls are back in the commodity's corner, gold is still down more than 25% from its peak two years ago.

Investors are especially flocking to physical gold in the form of bars, jewelry and coins, according to the World Gold Council. Globally, the council reports gold jewelry demand was up 37% through the second quarter, reaching its highest level since the third quarter of 2008. In China alone, demand was up 54% compared to a year ago; while in India demand increased by 51%. Bar and coin investment grew by 78% globally compared to the same quarter last year, with Chinese demand surging 157% for the period. Combining jewelry demand with bar and coin investments, global consumer demand was up 53% from a year ago.

But the same period saw a net outflow from gold exchange traded funds (ETFs). And that may be with good reason, according to a recent study.

Dirk G. Baur of the University of Technology in Sydney, Australia studied the historic price and volatility of more than 80 physical and synthetic gold ETFs and found that the strong rise in gold prices beginning in the early 2000s coincided with the introduction of gold ETFs. And with high prices came higher volatility.

"The pooling of gold investments via the introduction of ETFs lowers the cost of storage and the costs of trading," Baur writes in his study. "As a consequence of lower trading costs, the volume which is traded increases. Higher volumes, in principle, imply higher volatility."

Baur says ETFs represent a financial claim on gold, and while that may have advantages in normal times it may not necessarily be a benefit in unsettled periods or in times of disaster when gold is expected to be a hedge against extreme and rare conditions.

"It is well possible that investors lose trust in the ability of ETF providers to redeem ETFs shares for gold precisely in situations in which such trust is most important," he says. "In other words, in extreme market conditions in which investors fear a financial meltdown they may reassess liquidity risks and counterparty risks which are clearly present in gold ETFs while the latter is absent in direct, physical investments in coins and bars."

Baur's study concludes that not only have ETFs impacted volatility, but also the underlying market price of gold.

"The introduction of ETFs is at least partially responsible for the strong increase of the price of gold between 2002 and 2011," Baur says. "It is often argued that the introduction of ETFs on gold and commodities in general do not affect the price of the underlying. This paper provides some evidence against this argument. Commodity ETFs do not turn an illiquid asset into a liquid asset without any costs. The risks represented by changes in the price and volatility of the underlying as well as counterparty risks are the price investors have to pay for the 'free lunch.'"

--Written by Hal M. Bundrick for MainStreet

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