Assessing the Liquidity of Futures Backed Gold ETFs
Treesdale Partners, portfolio manager of the AdvisorShares Gartman Gold/Euro ETF (GEUR), AdvisorShares Gartman Gold/British Pound ETF (GGBP), AdvisorShares Gartman Gold/Yen ETF (GYEN) and AdvisorShares International Gold ETF (GLDE), share their thoughts about the gold space.
Most gold ETFs that use futures to gain gold exposure will use the COMEX 100 ounce gold futures contract which is generally regarded as the most liquid gold futures contract in the world. The Commodity Exchange (COMEX) is a commodity exchange owned by the Chicago Mercantile Exchange (CME). As part of its gold exchange the COMEX offers warehousing for its members. This facilitates a key feature of the COMEX gold future which is that it can be physically settled – in other words traders can choose to settle open contract positions they hold at maturity with delivery of physical gold. The warehousing facilities that the exchange offers provides a convenient method for traders to complete physical delivery with the gold held in the exchange’s vaults being readily transferred between members accounts at low cost. In practice the way this happens is that a member that chooses to store gold at the COMEX is able to classify some or all of its gold as “registered” meaning that these bars are available for delivery to settle open futures positions. In effect “registered” gold provides backing for the futures contracts traded on the exchange and while the ratio of registered gold to futures contracts outstanding does fluctuate on a daily basis, this physical delivery mechanism that the exchange provides is a key feature for the efficient functioning of the gold futures market. From the point of view of an investor, the major implication of the physical delivery mechanism is that the price of gold on futures markets closely tracks the price of gold on spot markets.
When deciding on how to execute a trade in an ETF, an advisor has two alternative methods from which to access liquidity. (i) Execute a transaction in the secondary market on the stock exchange through a broker dealer or (ii) initiate a creation (buy) or redemption (sell) of shares through an associated person (AP) in the primary market. However the creation or redemption process is only available for advisors when they are executing trades in large enough blocks known as a creation/redemption unit (a unit consisting of a specified number of shares – for example 25,000 shares – as defined in a fund’s prospectus).
Executing in the secondary market
Many ETFs at inception have low trading volumes which unsurprisingly raise concerns from advisors about the ability to execute orders whilst minimizing potential market disruption. Another associated risk that investors face is the bid/ask spread. The bid/ask spread is the difference between the bid and ask price and is typically a function of the daily trading volume of the ETF. In general, the higher the daily trading volume the smaller the bid/ask spread. In particular for low trading volume ETFs, the bid/ask spread as a ratio of the ETF price can be high which can make execution expensive and this is why it is generally advisable to always use limit orders to trade all ETF transactions, both high and low volume alike. When executing in the secondary market, an advisor would typically also incur brokerage fees payable to the executing broker.
Creation or redemption of shares in the primary market
Creation and redemption of ETF shares occur in the primary market. Working through an AP, the advisor submits the order to the ETF who then processes the creation/redemption order. This ability of the AP to create or redeem shares in response to supply and demand from advisors is a key driver of the liquidity available for a given ETF.
There are two methods by which shares in an ETF can be created. Creation in-kind, where the AP creates the shares by acquiring the securities that match the holdings of the ETF. These shares are then delivered to the ETF which creates ETF shares for the AP in exchange. The main concern for advisors creating ETF shares in-kind is the cost of executing the basket of securities that the ETF holds. This is of most concern where the ETF holds illiquid securities as the wider bid/ask spreads incurred in acquiring the underlying assets can make the creation process costly.
Cash creation with liquid futures contracts
Gold ETFs that hold futures use a different creation process called cash creation. In this type of transaction the advisor, working through the AP, would exchange cash with the ETF for ETF shares. The ETF in creating the shares for the AP is then responsible for buying the underlying futures contracts that the fund will hold to hedge the risk exposure. In the case of COMEX 100 gold futures these contracts are both highly liquid and trade with reasonably tight bid/ask spreads. As of January 2014 the average daily turnover of the COMEX gold contract was US$22.3bn as reported by CME. Similarly the average bid/ask spread for the COMEX 100 gold contract reported by the CME in its Q4 2013 Liquidity Monitor was 9 basis points (0.09%). This compares favorably to the US$20.9bn average daily turnover in the combined allocated and unallocated gold market as reported by the London Bullion Market Association in January 2014. It is also worth noting that allocated gold (gold where the holder is allocated specific gold bars) makes up only approximately 5% of the daily turnover in the gold market; unallocated gold where the holder holds gold in the form of an IOU from the trading bank, is by far the largest component of the gold market and is more directly comparable to gold traded on futures markets.
Another feature of the COMEX gold future that facilitates efficient execution of large orders is the Trade At Settlement (TAS) facility. TAS (which is part of the electronic trading platform) matches bids and offers from market participants who wish to execute their futures trades at the exchange’s Daily Settlement Price. By using TAS, the ETF guarantees execution of a gold trade at or close to the Daily Settlement Price thereby avoiding the need to execute the transaction in the open market. Tracking error is also therefore minimized as the Daily Settlement Price is the price used to calculate the ETF’s NAV at the close.
In summary, when evaluating an ETF a primary consideration for the advisor will be the liquidity of the ETF. There are two principal methods by which ETFs can be bought or sold – in the secondary market on a stock exchange or in the primary market via a creation or redemption of shares. The primary benefit of using the primary market, particularly for ETFs that have low daily trading volumes, is that the liquidity of the ETF is no longer constrained by its own liquidity in the secondary market but by the liquidity of the underlying securities. In particular for futures backed gold ETFs, there are potential benefits to accessing the primary market as the cash creation/redemption process lends itself to the very high liquidity of the COMEX 100 gold future and the TAS execution mechanism offered by the exchange.