Why the Gold Price Falls According to US Labor Market Data

For some time now, ETFs have been the standard tip for equity investments. In most cases, these exchange-traded funds passively track an index or commodity. This means that the fund manager generally does not make any decisions of its own, but rather purchases the underlying shown. Since the fund manager does not conduct its own research, these exchange-traded funds are particularly cheap. In addition, the exchange trading of the share certificates enables quick and also inexpensive entries and exits from the fund during the usual exchange trading hours. Most banks offer the inexpensive purchase in savings plans. The sum of the benefits has resulted in trillions of dollars being bundled in ETFs. But this also has some serious, unavoidable disadvantages.

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I still remember the time before, during and shortly after the 2008 financial crisis. Back then, at least 25 years after the start of the first ETF, ETFs were the best seller when it came to investing as simply and safely as possible. When risk was discussed, it was usually about the replication method and the counterparty risk. So the risk that arises from the choice of the ETF provider and from the trading partner of the ETF. It was the time when AIG was on the edge of the abyss. AIG was also an important player in the swap market. And then and now swaps were used by numerous ETFs to track the underlying.

Back then, investors were startled to find that their gold ETF contained no gold at all, but, for example, Japanese government bonds. The fund company had only entered into a swap transaction with a trading partner, for example AIG, in which the fund exchanged the yield on Japanese government bonds for the yield on gold. Stupid if the swap partner slips into bankruptcy during the crisis, in which investors wanted to benefit from the gold performance.

Stocks are now tracking ETFs, but it should be the other way around

ETFs that physically replicate the underlying have therefore been recommended. That means an oil fund should buy oil and not government bonds, a gold ETF and a DAX ETF would like the shares of the leading German index. For a decade, investors thought they were safe when they bought physically replicating ETFs. Thanks to the physical representation of the underlying, the return is secure and the fund can be sold on the stock exchange at any time thanks to its large liquidity.

That was a deceptive security, as the current crisis shows. For years, individual voices have warned that the market power of the ETFs has become so great that the underlyings reflect the ETF and not the ETF. The current situation is by no means comparable to 2008. In 2007, ETFs went to 2008 with only $ 807 billion in fund assets worldwide. In 2019, it was $ 6,181 billion, an increase of a good third within a year. A good 2/3 of this wealth is invested in ETFs for US stocks. It’s not just that ETFs now have larger inflows than actively managed portfolios. No, investors even withdraw capital from active management and switch to passive management.

The market power of the ETFs now means that mass purchases of the S&P 500 ETFs, for example, cause the prices of all 500 stocks in the S&P 500 to rise equally. And with fund outflows, all stocks fall equally. The CBOE has been publishing the S&P 500 Implied Correlation Index for a decade. It indicates the extent to which the yield distribution of the 500 stocks in the S&P 500 index is correlated with one another. What is striking is a low of only 13% in January 2017. That was the month in which the S&P 500 ETFs recorded essentially no inflows or outflows, i.e. they were market neutral.

Massive ETF investments reinforce boom & bust cycles

Buying stocks using index ETFs means that scrap companies also experience considerable price increases. While an active manager would avoid a company with poor balance sheets or a history of losses, passively managed ETFs buy these stocks without considering whether they are fundamentally worth buying or not. Passive investing thus reduces the pricing mechanism of the exchange. What is more relevant is whether a share is included in a frequently bought index and less whether the company is doing well.

In boom phases, passive investing means that practically all stocks contained in large indices rise regardless of the course of business. And corrections include almost all stocks regardless of the course of business. The constant high demand for shares in scrap companies in good stock market times is aggravating the crisis. Because thanks to access to the capital market, these companies stay on the market longer than they would if people still took over stock selection. In the crisis, the market is then faced with a whole host of zombie companies, all of which suddenly lose access to the capital market because ETFs record cash outflows instead of inflows.

ETFs also act to reinforce trends. Active portfolio managers would most likely refrain from buying stocks and even selling stocks in the final stages of a boom, according to their analysis, as overvalued. These first sales are dampening prices. Conversely, active portfolio managers buy what they think are cheap stocks in a crash, which compensates for the price crash. In a world in which more than 50% of the capital flowing into the market is invested passively, this corrective is missing. An ETF doesn’t buy in a crash. And an ETF is not selling in the bull market. The ETFs’ savings plan buyers don’t either – after all, they opted for passive savings plan investments. However, what passive ETF buyers do in many cases is panic sales in the crisis.

The liquidity of ETFs may be lacking in times of crisis

But it gets worse. The high trading volume of ETFs suggests investors liquidity that could be lost when it is most needed: during the crisis. If liquidity dries up because market participants withdraw during the crisis and stop trading, there can be significant differences between the trading value of an ETF and its NAV, the net asset value. The NAV is the intrinsic value of each share certificate, i.e. the combined trade values ​​of the shares or commodities represented by the share certificate. Theoretically, the commercial value of an ETF share certificate should always reflect the intrinsic value.

If the demand for an ETF increases, authorized participants, i.e. banks and brokerages, would create ETF shares on behalf of the fund providers. For example, if an investor buys shares in the S&P 500, the authorized participant would buy the 500 shares of the S&P 500, create the desired shares, sell them to the investor and transfer the shares to the fund companies. In the crisis, when investors sell shares, the opposite would happen. The Authorized Participants buy the unit certificates, pass them on to the fund company, receive the shares in exchange and sell them. The supply and demand for the share certificates would always be in harmony. If there were any discrepancies between the price of the share certificate and the NAV, the authorized participants would be rewarded for carrying out this process more intensively. Because then risk-free profits would be achieved for them.

The prices of ETFs no longer reflect the underlyings

However, in the recent crisis, a number of ETFs saw notable differences between the share price and the NAV. The ETFs no longer replicated the performance of the underlyings. Sometimes they were significantly cheaper than the NAV, sometimes they were significantly more expensive. The best example of this is the USO ETF, which is intended to represent the price of the next due futures contract for crude oil of the WTI variety. On April 20, investors paid a 7.8% surcharge on the NAV. The reason was that so many ETF shares were in demand that the pre-registered share certificates had been used up and as long as no new ones could be created until a new registration was completed.

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