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$4bn Swiss Gold ETF: Paranoia premium or plain expensive?

Rob Mackinlay
By Rob Mackinlay  19-May-2009

One of Europe’s largest and fastest growing physical gold ETFs is facing an industry backlash after suggesting that its higher trading costs are justified because its product is 'safer', in a case that throws the spotlight on charges paid by investors for different funds holding the same underlying asset.

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The performance of physical gold exchange traded funds (ETFs) should not deviate much as they all aim to track the same underlying commodity and many of the products charge the same 0.4 per cent annual management fee. 

This leaves investors with a handful of factors to consider when choosing a physical gold ETF, including trading costs and security. For buy and hold investors - and the many extremely risk averse investors buying these products - security is the key. For investors looking for quick returns, the trading cost will be the decider. 

Until now investors would not have seen these two issues as being in conflict. But statements by Swiss ETF provider ZKB have raised the stakes by suggesting that this is indeed the case - security versus trading costs - and the ETF industry is now embroiled in a debate over the merits of the argument.

With many physical gold ETF investors paranoid about fundamental security issues (Could owning gold be banned? Hedge fund warning) anything that eases their minds could command a premium. One of Europe's largest and fastest growing gold-backed ETFs, the Swiss  ZKB Gold ETF, has sparked a heated debate by suggesting that its product does just this, and that it is safer than its peers.

The lure of gold for UK investors versus FTSE All Share, 1yr 


The broker role

ZKB claims that its products have achieved this extra degree of safety by ditching the multi-broker model which allows lots of market makers to create ETF shares and which injects competition into trading the products. With an estimated third of ZKB's $4bn assets under management coming from outside Switzerland, Foreign investors appear to be willing to pay this paranoia premium.

ZKB's claims have infuriated a number of ETF industry participants. Open shows of deep disagreement between asset managers are rare, particularly when the assets under management are in the $billions. The debate sheds light on the issues at stake for most ETF investors, particularly as swap based ETFs do not use the multi-broker model (Will iShares sale cost investors?)  

The ZKB product does not use the conventional multi-broker model in which several market makers are able to create and redeem ETF(exchange traded funds) shares.

Shares in physical gold ETFs represent a lump of metal in a vault. If the price of the gold share rises above the price of the physical gold that backs it, a market maker can profit by buying more gold, creating more shares, and selling these shares at a higher price than the gold they bought.

If the ETF shares are cheaper than gold the process is reversed: the market maker profits by buying the cheap shares, destroying them and selling the redeemed gold at a higher price.

The process prevents ETFs from trading at a premium or a discount to net asset value ensuring that it tracks the value of the underlying commodity. The existence of more than one market maker also introduces competition to the bid/offer spreads.

ZKB says it has retained the role of sole market maker because having several market makers introduces risks. ZKB acknowledges that this may add costs for investors but claims that investors are prepared to pay to have risk removed.

Debbie Fuhr, global head of ETF research & implementation strategy at Barclays Global Investors (currently in the process of selling iShares, the world’s largest ETF provider which uses the multi-broker model) said: “Embracing a multi-broker dealer model has been one of the positive and important features of ETFs. It allows investors to request price quotes from multiple brokers and to trade with multiple brokers.”

Market makers have also expressed concern about the product. One market maker said that the wider spreads on ZKB products enabled his firm to make more money buying and selling ZKB Gold ETF but pointed out that this was a cost to investors.

Another industry participant, who did not want to be named, said that the ZKB product should not be called an ETF and claimed that it traded at a premium to its NAV.

ETF Securities, Europe’s largest provider of commodity-based ETFs has provided a full response to ZKB’s claims which can be seen below. ETFS has over $6bn assets under management in its two bullion-backed ETFs: $3.9bn AUM in its GBS physical gold backed ETF and $2.5bn AUM in its PHAU ETF. 

Trustnet asked Hugo Stalder, product manager at ZKB, if he accepted that other products were cheaper to trade. He said: “The question is what do you mean by cheaper? Our management fee is 0.4 per cent and most of the others are the same. The spread has a maximum of 0.5 per cent, sometimes narrower. Looking at other products, they may be narrower. (ETF Securities says its equivalent products have a 0.05-0.10 per cent spread)

“I know some of these criticisms. We have been asked by some foreign brokers who like to make markets – you can make money from market making – but we are not interested in having different market makers in foreign places.”

Asked why investors were prepared to pay extra, Stalder said: “They are not looking for the cheapest price but for the best security. You may say it may cost a little bit more, this may be true.

“If someone is looking for the best security he looks at our ETF with a spread of 0.5 per cent and he may look at iShares where he’s not sure he has full coverage of gold.” Stalder said that this was not his view, but the view of some of ZKB’s clients. A spokesperson for iShares would not comment on the claim.

He said: “There is no stock lending and no naked selling and the risk of this is kept to a minimum because it is all done via ZKB. That is why we don’t like to have any other formal market makers, more so we can control that we have full coverage of gold. If you have foreign market makers you don’t have full control any more.”

Hector McNeil from ETF Securities said that this system did not add security and that for larger trades the opposite may be true: “Swiss gold funds (ZKB) cannot cover the trading with gold straight away. Gold trades T plus 2 (a two day delay) Loco London, Loco Zurich is even longer potentially. If they sell the shares to a customer then the customer has counterparty risk to the Swiss fund for probably significantly longer than two days.”

“It should also be known that gold trades and clears loco in London. Loco Zurich is much less liquid and costs more money. Therefore if a client wants a large trade the likelihood is that the gold will have to be sourced in London and moved to Zurich. This has its own set of logistics, costs and risks.”

“They cannot cover all the time. If they get buyers they cannot immediately buy allocated gold. It takes several days to settle and probably one day to allocate.”

McNeil said: “ETF Securities fundamentally believes that an ETF can only be called an ETF if it has an open creation and redemption model with multi authorised participants/market makers.

“Issuers should provide a multiple market maker model which provides true liquidity and fair pricing through the ability to arbitrage mis-pricing and compete for business. There are some products, notably in Switzerland, where the issuer of the product is also the promoter, custodian and market maker with no independents.

“This is a really bad model as it has huge conflicts of interest. It is clear this model is very bad for investors as there is always the risk that the market maker prices his product at a premium. This is effectively raising the cost to investors dramatically without transparency. Looking at some of the products in question this can run into multi millions of dollars of extra costs to investors.

“We believe the exchanges have a key role here. They should have as part of their listing requirements that Issuer have open market making models allowing true competition and arbitrage. They should dictate that there are at least two independent authorised participants/market makers. The products in question do not allow that. The bank is the only one. What is really bad is most investors are unaware that this is even happening so we welcome transparency.

“Looking at the single market maker model investors need also to understand that they are hugely exposed from a counterparty basis. This is due to the fact that the only way they can buy or sell the product is through that single bank counterparty. As we know from events in September 2008 that single point of failure is no longer tenable.”

ETF roundtable: Debbie Fuhr, ETF Securities, iShares
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Silver investigation: CFTC does U-turn
Gold investigation: is it already underway?
Silver ignored by UK investors: will it all be gone by 2034?
Gold conspiracy: Can you afford to ignore it?
Could owning gold be banned? Hedge fund warning

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