Do Gold ETFs Smooth Out Volatility?

June 1st, 2017 by

While gold has proven to be a far better store of value than any currency over any long-term time horizon, and is thus chosen by many investors as an inflation hedge, its price fluctuations are generally rather volatile in the short run. Under normal circumstances, gold’s perceived trustworthiness over riskier investments attracts a fair amount of speculation. You can almost think of gold as a trusty sponge that is always there to absorb or offset some of the risk taken on by hedge funds and large financial institutions.

Increasingly over the last three or four years, however, gold prices have been unusually stagnant much of the time. According to Bloomberg News, the drop in volatility in precious metal prices may be attributable to the rising popularity of gold exchange-traded funds.

Historically Low Volatility

There’s a general pattern that more and more traders and media pundits have been taking note of: stocks have been very calm over the past 18 months or so, with the exception of the Brexit and Trump surprises. (Both of those events proved to have only transitory influence on the markets, anyway.)

In fact, equities have been seemingly too calm, given the lack of clarity to many big looming questions for the global economy. Regardless of what triggers it, any prolonged period of calm “before the storm” does typically mean that some measure of volatility in the future becomes more likely.

That being said, volatility in the gold price has fallen all the way to a 12-year low. (See the chart below.) More broadly across the financial markets, volatility as measured by the VIX index, the popular “fear gauge” for Wall St, has hit its lowest point in more than two decades.

gold ETF volatility

Chart and data courtesy of Bloomberg

One reason that’s been suggested for this sideways trading is the increasing amount of capital toward gold investment that has been diverted into gold ETFs. These funds have become more and more popular over the past few years, roughly coinciding with the drop we’ve seen in market volatility.

© Alexmoe | Dreamstime.com

© Alexmoe | Dreamstime.com

There is a world of difference between buying a share in a gold ETF and owning physical gold. (There are important pitfalls with the former that investors should be aware of, such as how shares can be distributed and how often the fund actually redeems shares for its gold rather than simply settling in cash.) Nonetheless, gold ETFs are appealing to many investors and portfolio managers that are seeking something convenient and “securitized”—a gold-backed investment that still trades like the stocks or bonds they’re accustomed to dealing with.

This argument about gold ETFs reducing volatility has become more relevant now that these types of funds hold so much of the available gold in the market. ETFs now account for about two-thirds of the money invested in gold, excluding what central banks hold, since these reserves are essentially off the market and only offered for sale intermittently. Behind the famous over-the-counter gold market in London, which boasts the greatest concentration of gold vaults found anywhere in the world, the gold ETF market is now the next-biggest indicator of active gold trading and speculation on the yellow metal.

The connection between more money flowing into ETFs that track gold and reduced price volatility seems to hold true, at least when compared to the pre-ETF past (circa about 2004). Simpler times, indeed.

This dynamic may well be the result of the expansion of the ETF market. Nevertheless, nothing about these vehicles for gold speculation can outweigh the benefits of holding physical gold as a tangible asset in one’s portfolio.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.