Gold at $1225 an ounce: a good investment?

surging gold price

The gold price has risen by almost 20% so far this year.  The advance is an unusual one, however, in two respects:

1.  Historically, the gold price has typically been stable in strong currency terms.  Much of the apparent strength has been related to depreciation of weaker currencies.  In practice, this has meant the dollar price vs. the euro (or its predecessor, the d-mark).  This year, in contrast, the dollar has been relatively strong.  Nevertheless, the dollar price of gold is up sharply.

2.  The advance is being driven not by demand for jewelry, which is usually the case, but by investment demand.  Last year, investment demand worldwide actually exceeded jewelry demand.  It may do so again in 2010.  Government mints are doing a land office business minting gold coins.  The SPDR Gold Trust ETF has over $50 billion in assets. And the Financial Times reports that commercial banks are considering expanding their vault space for storing physical gold for the first time in thirty years.

two big changes in the market

During the almost thirty years I’ve been watching (often from afar) the gold market, it has undergone two significant changes:

1.  The first is a product of the past seven years..  Thanks to the rise of ETFs, gold is much easier to buy today than it once was.  The SPDR Gold Trust ETF alone holds 1300 tons of the yellow metal, or close to half of the world’s gold production in a year.  It is traded not only in New York but also in Hong Kong, Singapore and Tokyo.  Vehicles like this eliminate the need to have a commodities account and solve the problems of physical storage, potentially high bid-asked spreads and the need to assay the gold on sale.

2.  Gold was money thirty years ago, but has been gradually losing that role since.  In developing countries, many citizens would use gold as a substitute for bank deposits.  Some had to little to be able to afford a bank.  Some worried about currency devaluation.  But many also feared either government seizure of their wealth, or attracting unfavorable attention (think:  China) from the authorities as being budding capitalists.

Wealthy individuals around the world have long since replaced gold holdings with financial instruments.  And greater political stability in large markets for gold like China or India has meant less fear-motivated demand for gold.  Jewelry demand (and not simply near-pure gold jewelry) has become the main driver of gold consumption.

why a price surge now?

Not now, though.  What are the main factors in increasing investment demand?

I think the main reason is that gold is the default choice for people who are worried about the current weakness in developed countries’ economies and don’t see what else they can buy.  Cash provides safety but almost no return.  Government bond yields are extremely low–and in the case of the euro have not delivered anticipated safety.  Stocks, after having come close to doubling since the lows in March 2009, are wobbling.  They also do best in times of strong economic growth–so they depend on conviction in economic expansion that investors don’t currently have.

What’s left?  a gold ETF plus …?

the risks

I’ve never been a real fan of gold.  As I’ve argued in other posts on this blog, I think gold price movements are ultimately driven by the ebb and flow of gold mining projects.  When prices are low, mining companies stop exploring.  When prices are high, they reopen shuttered mines and develop new deposits.

I think the case today is different.  I think investor demand is being driven by aversion to other liquid investments.  My worry about gold is what happens as/when sentiment about the course of the economies of the developing world improves.  To a great degree, generation-ago demand from the developing world for gold as money is no longer present.  The fact that gold has been very easy to buy through ETFs also means it is very easy to sell.  Remember, too, that there’s no assurance that the price you get in selling an ETF in times of distress will come close to net asset value.  Like any stock, your price will depend on where buyers are willing to make a bid.

what to buy instead?

From me, the answer should come as no surprise–stocks.

What caused the “Crash of 2:45”?

The short answer is that anyone who knows the details isn’t telling.

what happened

Last Thursday, May 6th, was a generally bad day on Wall Street.  What makes this session worthy of not, however, is the Tower of Terror-like plunge that the market took at about 2:45 pm, followed by an equally swift rebound several minutes later.

visiting the SEC

Representatives of the major exchanges met with the SEC yesterday to discuss the situation.  All reportedly professed to have no idea what caused the sudden decline and rebound.  That’s not really much of a surprise.  On the one hand, no one wants to take the risk of becoming Congress’s latest whipping boy if they admit to having had even an innocent hand in the debacle.  On the other, its track record in cases like Madoff suggest that the SEC doesn’t have the knowledge or interest to pursue the issue by itself.  So anyone involved would likely be calculating that, absent a public declaration of repsonsibility, they will never be found out.

rumors

There have been two persistent stories about the trigger for the mid-afternoon drop.  One, offered by CNBC, is that a trader from Citigroup made an input error that generated a sell order that was 1000x the amount intended.  Citi denies this.  The second, more detailed–and therefore, I think, initially more plausible–comes from the Wall Street Journal. According to the newspaper, the initial trigger was a relatively small sell order placed in the Chicago options market by hedge fund Universa Investments.   However, the Journal may have been attracted to this trade as much by the fact that Universa is linked to Nassim Taleb, who popularized the idea that disruptive “black swan” events are much more numerous than academic theories allow for.

what we do know

Several things are clear:

–as the computer-to-computer selling got more intense, the NYSE turned its machines off and reverted to manual processing of trades.  Apparently, although I wasn’t aware that this was the case, this is the NYSE’s publicly stated policy.  This action effectively eliminated one of the main ways derivative holders could hedge their positions with offsetting exposure in physical stocks.  It caused trades to be redirected to other middlemen, who buckled under the added pressure.  It isn’t clear whether the others took defensive measures similar to the NYSE’s or whether they were simply overwhelmed by volume.

–ETFs were hurt unusually badly in the selloff.  According to the Financial Times, two-thirds of the securities where exchanges subsequently cancelled trades were ETFs.  ETFs themselves represent only about 16% of the total number of securities traded on US exchanges.  I don’t think there’s any great significance to this, however.  In a “normal” stock trade, the market makers matches a third-party buyer and seller–who have already decided they want to transact–and charges a bid-asked spread.  In an ETF trade, however, the counterparty is often the market maker himself, who is constantly calculating the NASV of the underlying ETF and his hedging possibilities and deciding whether to transact at a given price or not.  To let the market know he is potentially a buyer or seller, he typically has “placeholder” bids of, say, $.01, that under normal circumstances let the world know that he may be interested in transacting.

Last Thursday, a lot of those $.01 bids were hit before the market makers could withdraw them.

–as mentioned above, the exchanges unilaterally decided to cancel transactions they considered to be anomalies.  This presumably leaves a lot of unhappy individuals who had placed low-ball limit orders.  Perhaps not by coincidence, the counterparties–that is, the losing side–to those canceled trades are the same exchange members who canceled them.

what happens next

The SEC is under political pressure to do something to prevent a recurrence of anything like the near-instantaneous decline of 5% that happened last Thursday.  Some of this pressure likely comes from proponents of having a stronger “uptick rule” (see my post on this topic).  Although the current uptick rule seems to me to invite sudden plunges in stock prices of the type we had last week, no one is publicly suggesting that this is the cause of last Thursday’s meltdown.

Whether needed or not, a new trading halt mechanism is probably the “solution” the SEC will opt for.

I have two related thoughts:

–added volatility may just be a fact of life in a modern stock market, where computer-to-computer trading and monthly performance measurement of the type hedge funds undergo are prevalent.  In other words, get used to this.

–the first time something like this happens, it’s a surprise.  Even now, I’m sure that investors are beginning to devise strategies to cope with–and take advantage of–increased volatility.  Understanding what’s going on and planning for it, investors will enter the market as buyers sooner and more aggressively. By doing so, they will temper volatility.  For their part, sellers, learning that there’s a penalty for being aggressive on the downside, will adjust their behavior as well.

That’s why I think canceling money-losing trades made by people pushing the market down is a really bad idea.

–no one so far is questioning the behavior of the NYSE (admittedly, not my favorite organization).  It’s kind of like switching from big fire hoses to small ones as soon as the fire starts.  What good is that?  In fact, if this incident isn’t the accident that I think it was, short-sellers may have been counting on the NYSE to remove liquidity from the market.

ETFs vs. Mutual Funds (III)-Actively-managed funds

Similarities between actively-managed ETFs and mutual funds

Actively-managed ETFs have been allowed by the SEC since March 2008.  Like actively-managed equity mutual funds, they fall into two types:

1.  quantitative funds–that is, the fund sponsor creates a set of decision rules that are implemented without exception, typically by computer.  The set may be simple, like:  own equal dollar amounts of each of the 100 largest-capitalization stocks in the S&P 500.  Or the rules might be more complex, with constraints on allowable book value, historical growth rates, consensus earnings estimates and other variables.  There will also doubtless be a sub-rule dealing with borderline cases, to prevent having to trade in and out of a stock that flip-flops between #100 and #101.  Otherwise, the “active” here consists in executing the rules.

2.  “traditional” actively-managed funds–which make use of the subjective judgment of portfolio managers.  These managers are supported in larger organizations by a staff of, among other possibilities, in-house securities analysts, quantitative analysts or an investment committee that creates an “approved list,”  which specifies the only securities the manager is allowed to have in his portfolio.  Discretion given to the manager in forming strategy and selecting stocks runs the gamut from the manager having total control, on the one hand, to being more or less a client relationship manager for a portfolio structured completely by computer or investment committee, on the other.

You can find the general structural similarities in my earlier posts on ETFs vs mutual funds.  The differences?

Continue reading →

ETFs vs Mutual Funds (II) index funds

Two starting comments

Why are there so many different index products, under the S&P, FT, Dow Jones, MSCI…brands, that do basically the same thing?  Index-tracking is a commodity product.  Given a certain level of technical competence in design, to make sure that the returns are in line with the appropriate index, one product is basically the same as another.  Having slightly different benchmarks with slightly different constituents, requiring slightly different holdings in the ETF/mutual fund, raises the costs for an institutional investor to switch from one provider to another.  So it takes the edge off what would otherwise be brutal price competition.

Does an S&P 500 index product have 500 stocks in it?  Maybe, maybe not.  The ETF/fund prospectus will say for sure, but all that’s usually required is that the product have a basket of stocks in it that tracks the appropriate index with a high degree of accuracy.  It’s much easier to handle inflows and outflows if you don’t have to deal with the most illiquid stocks in the index.

The ETF/fund websites should have charts or other information about “tracking error.” i.e. how closely the index product mimics its index. Continue reading →