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An ETF is basically a share that trades on the stock exchange. A company share represents the assets

and liabilities of the company. An ETF China has just assets that could be mal aysia | may23,2011 THEEDGE gold anything - shares India has a number of gold ETFs and share represents introduced its firstalmostETF this year. In Mala of companies, bonds, commodities or currencies. The main attraction of ETFs to investors is that it there has been a proposal to introduce an Islamic Gold ETF, the Cydinar. allows them to gain exposure to a variety of assets with minimum capital.

Gold ETFs and derivatives

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Gold ETFs

Gold ETFs trade on the principal concept that the fund is backed by physical gold. However, som Gold ETFs concerns have emerged in the market about the authenticity of this statement. There are worri gold ETF will purchase a large that neither maintaining the physical metal in storage. The ETF thatAsome ETF prospectus stateamount of gold,the Custodian or Trustee independently confirms th fund manager will then issue ETF units to market intermediaries or brokers (called Authorised fineness of the gold held in the ETF fund. Other issues linger around the extent of freedom given Participants) who are usually investment banks. The intermediaries will trade the ETF units which are the now broken down into smaller units called ETF shares with theby the Custodian. Also there has been Trustee to audit the physical appearance of gold held investor. Refer Chart 1. about the gold not being insured at all times. There has also been criticism that the SPDR gold tr As gold increases in price, the value with JP units and shares representing the gold have large short may have conflict of interest issuesof the ETFMorgan and HSBC in the U.S. who will also increase gold. Chart positions inin1 value.

mid the craze of investors wanting to gain exposure to gold, various instruments have been introduced in the market. One of the popular ones is the gold exchange traded fund (ETFs). This article will first explain the mechanics of an ETF and then introduce the exchange traded note (ETN) which is often thought to be similar to an ETF but is actually is different in many ways, mainly because of the use of derivatives in the latter.

by Jasvin Josen
units which are now broken down into smaller units called ETF shares with the investor. Refer Chart 1. As gold increases in price, the value of the ETF units and shares representing the gold will also increase in value.

What is an ETF

An ETF is basically a share that trades on the stock exchange. A company share represents the assets and liabilities of the company.An ETF share could represent almost any asset shares of companies, bonds, commodities or currencies. The main attraction of an ETF is that it allows investors to gain exposure to a variety of assets with minimum capital. A gold ETF will purchase a large amount of gold, maintaining the physical metal in storage. The ETF fund manager will then issue ETF units to market intermediaries or brokers (called Authorised Participants) which are usually investment banks. The intermediaries will trade the ETF

Gold ETFs trade on the principal concept that the fund is backed by physical gold. However, some concerns have emerged regarding the authenticity of this statement
Other than retailers, ETF investors include mutual funds and hedge funds that use ETFs in portfolio-trading strategies. Gold ETFs are traded all over the globe.The most popular one is the SPDR Gold shares, introduced in 2004 and now traded in the US, Singapore, Japan and Hong Kong. It has been claimed that the SPDR Gold Trusts holding of gold is so large that it stands on a par with the top six central banks in the world, measured solely by gold holdings. India has a number of gold ETFs and China introduced its first gold ETF

this year. In Malaysia, there has Chart 1: Mechanics of the ETF been a proposal to introduce ansummary, all the above concerns point to one thing does the physical gold represent the tru In mechanicsoftheETF Islamic gold ETF, the Cydinar.value of the ETF shares at all times? Analysed another way, if there were to be a gold run, woul Gold ETFs trade on the prin- be adequate physical gold to be redeemed. there cipal concept that the fund is backed by physical gold.However, Gold ETNs some concerns have emerged regarding the authenticity of this stateGold ment. There are worries that some ETNs do more than just buying the physical gold. Two of the more fashionable ETNs are be ETF prospectus state that neither the custodian or trustee independently Double long gold (e.g. PowerShares DB Gold Double Long ETN ) confirms the fineness of the gold held Double short gold ((e.g. PowerShares DB Gold Double Short ETN ) in the ETF fund. Other issues linger around the extent of freedom given Chart 2: The ETN structure to the trustee to audit the physical Chart 2 appearance of gold held by the cus- Other than retailers, ETF investors include mutual funds and hedge funds that use ETFs in portfolio todian. Also there has been talk that trading strategies. Gold ETFs are existent all over the globe. The most popular one is the SPDR Gold TheETNstructure the gold not being insured at all times. shares, introduced in 2004 and now trade in the U.S , Singapore, Japan and Hong Kong. It has been There has also been criticism that the claimed that the SPDR Gold Trusts holding of gold is so large that it stands in par amongst the top six SPDR Gold Trust may have conflicts central banks in the world, measured solely by gold holdings. of interest with JP Morgan and HSBC in the US who have large short positions in gold. In summary, all the above concerns point to one thing does the physical gold represent the true value of the ETF shares at all times? Put another way, if there were to be a gold run, would there be adequate physical gold to be redeemed? 2. Double short gold (for example, US$1,000.The ETN issuer can afford to PowerShares DB Gold Double Short give investors this privilege by leverGold ETNs ETN ) aging like in the above example.The Gold ETNs do more than just buy the actual return he made was US$5,000 Double long gold ETNs physical gold. Two of the more fash- (i) DoublE lonG GolD ETns 1. for a capital of US$10,000. That is a ionable ETNs are: Here, the issuer of the fund issues 50% return on his capital. Here, the issuer investors. The an Exchange 1. Double long gold (for example, an ETN toof the fund issues ETN func- Traded Note (ETN) to investors. backed by Note that the ETN is not The ETN functio like ations security or asecurity or a bond. By any physical gold, only futures money, ba debt like a debt bond. By holding the ETN, the investor will get returns on his conPowerShares DB Gold Double Long on the performance of certain gold futuresget tracts thatthe issuer. ETN) holding the ETN, the investor will index, created by speculates on the price returns on his money, based on the of gold. If the future contracts loses performance of certain gold futures money, the investor will not get back indices, created by the issuer. his full investment. If the ETN issuer The issuer uses the proceeds from collapses for some reason, the investhe investors to buy forwards and fu- tor will not get back his money. tures in gold. If the price of gold rises, the derivatives will be profitable, and 2. DoublE shorT GolD ETns the fund makes a profit. Spot gold Here the issuer goes short the futures prices are closely linked to future contract and profits if the price of the prices and in most cases they have gold goes down. If an investor invests a positive correlation. So the futures US$1,000, his returns will be based on index will also rise, warranting a fa- the price of gold moving downwards. vourable return to the investors. In the double short case, if gold loses For example, one futures contract 5% of its value, the investor will get for gold controls 100 troy ounces. If 10% from his investment. the market is trading at US$1,500 per ounce, the value of the contract is ETNs are not ETFs US$ 150,000 (US$ 1,500 x 100 ounces). ETNs are just a promise to pay back If the tenor of the futures contract investors their money, with returns is six months, this means that in if gold prices move in a certain direcsix months time, the buyer will pay tion. In addition to the price risk of US$150,000 and take delivery of 100 gold, the investor is heavily exposed ounces of gold. to the credibility of the ETN issuer. Say after four months the spot In 2008, when Lehman Brothers colprice of gold is US$1,550, the issuer lapsed, its Opta Commodity ETNs sufnow will only have to pay US$150,000, fered great losses when ETN holders take delivery of the gold and sell the scrambled to dispose of the notes in gold in the physical market for a to- the market. tal of US$155,000 to make a US$5,000 profit. But in practices, the issuer Conclusion almost always offsets the long posi- There could be still other varieties of tion with an opposite trade (short the gold ETNs structured in a more acsame futures) before the delivery date tive manner, where the ETN issuer is to achieve the same profit. free to invest in swaps and options to Leverage plays an important part take a speculative position in gold. It in ETNs and derivatives. With fu- is important for the investor to diftures, the issuer pays a small sum ferentiate between holding physical to get exposure to a large fraction gold, holding a gold ETF and holding E of gold. In the above example of one a gold ETN. gold futures contract, the issuer is required to pay an initial margin of Jasvin Josen is a specialist in just a fraction of around US$10,000. developing methodologies for This gives the issuer the ability to lev- valuation of various derivative erage US$1 to control roughly US$15 products. She has over 10 years worth of gold. experience in investment banking In the double long case, the inves- and the financial industry in tor gets to make double returns on the Europe and Asia. Comments: note. If the investor invests US$1,000 jasvin@gmail.com. Readers and the gold price increases by 5%, may also follow her at http:// the investor will make 10% on his derivativetimes.blogspot.com