What happens if gold explodes to the upside

[rickb]

rickb, GLD is an open ended fund. It is supposed to get larger and smaller. Its just like TLT in that regard. Just as TLT adds bonds  when money flows in (and vice versa) so GLD adds gold when money flows in. The difference seems to be that with GLD sometimes rather than it being investors taking money out and so causing shares to be annuled, it is sometimes AP taking gold out and so causing shares to be annuled. The gold that is taken out in that way never need be returned. Because the GLD shares have been annuled, it is not owed to the fund. It can be turned into wedding rings etc and never seen again. I'm certain that is how it is supposed to work??
Your scenario seems to revolve around AP being short GLD. I completely agree that if AP were ever short GLD then that would be a massive hazard BUT is there any evidence that they ever have been? I thought they bought (not borrowed) GLD to annul it in return for getting gold.  The are apparently massively short gold futures but that doesn't seem relavent to me. I hope I'm not in too much of a muddle.

GLD and TLT are ETFs, not open ended funds.  When investor money "flows in" it doesn't go to the fund causing the fund to buy gold.  It goes to someone else who already owned the shares.  When an investor sells shares she doesn't get money from the fund causing the fund to sell gold, she gets the money from another investor who buys the shares. The ONLY reason the amount of gold GLD holds changes is because of the activity of the authorized participants.

I'm simply an investor, not a professional in the industry.  I don't have any first hand knowledge that APs borrow shares to redeem for actual gold, but I'd be truly shocked if this didn't at least occasionally happen and I wouldn't be surprised if it was common.  As to whether any APs are short GLD (as distinct from short gold futures), I again don't have any first hand knowledge but I'd be truly shocked if they weren't.

If Larshus or anyone else who knows more about this could comment, that'd be great.

I suspect this question is meant for Larshus:

So, excluding tax treatment, are you saying that it is preferable to hold GTU over GLD/IAU because the way the fund is set up is more straightforward and less prone to manipulation?

but my answer is yes, although another difference is you have to pay attention to the premium when you buy GTU.  If it's ever negative, load up the truck.  Below about 5% I wouldn't have any qualms about buying it.  It's debatable whether you should buy it if the premium is between 5%-10%.  Above 10% I definitely wouldn't.  Also note in a taxable account in the US, GTU currently has better tax treatment than either physical coins or the ETFs (long term capital gains vs. collectibles tax - as long as you file the right forms every year you own GTU).

[stone]

rickb, I think we agree on how ETFs work and it is simply a matter of whether what they do should be termed open ended or not. To my mind intra-day they act closed ended but multi-day they in effect are open ended via the AP mechanism you describe.
If AP were allowed to short GLD then that would make a mockery of everything. They could run GLD into the ground. It would be remarkable if they were allowed to be short GLD.

[moda0306]

I think the usual point of "when someone buys shares another person is selling them, and there is no fund activity" deserves a bit of clarification, but unfortunately I'm simply asking the question rather than actually knowing the answer here...

It seems to me that when I go buy TLT, I'm probably buying it from some sort of exchange that holds a certain number of shares for trading purposes... but I don't know... it just seems ridiculous to me that there's no middle man between me and someone else, and that someone else just happens to be selling the exact same number of shares as I am at the same time and it's just captured by Vanguard.

More likely, I'd imagine that some sort of exchange holds an "inventory" of this fund, and if people buy it, the inventory has to be replenished, and if there aren't enough sellers, eventually TLT will issue new shares after buying treasuries due to demand for their product.

I know most of the discussion here isn't necessarily disagreeing with this, but the visualization that when I buy shares there's another willing seller out there selling shares and therefore demand for the product hasn't gone up is a bit of a mischaracterization... the "willing seller" is most likely holding TLT as inventory (right??), and will eventually need to replenish that, much like your grocery store is a "willing seller" of produce, and purchasing of that produce has an indirect effect on their next order from the food suppliers.

If I'm correct, then who is this middle-man... your brokerage firm (Vanguard or Fidelity)?

If I'm wrong in my assumption, then how are these transactions negotiated within the system?  When I buy TLT, I buy it, more or less, without any delay... the computer doesn't have to go out and find someone trying to sell it... or at least I'd assume that's the case.

It would seem to me that there has to be some kind of "warehousing" that goes on.

[stone]

moda those middlemen are market makers. They promise to always buy or sell.

[moda0306]

stone could you expand on that?  Who are these middle-men?  They must hold inventory, correct, if they promise to do both?  When they get low, do they ask TLT to issue more shares?

[stone]

moda, TLT like GLD only once a day gets bonds (or gold for GLD) added. During the day it trades just like any security (eg a bond or share). Every security on the exchange has to have two or more market makers who agree to always buy or sell so as to meet any transaction up to a certain amount. Above that amount you have to put a limit order on and just hope that gets filled. Basically there is a huge amount of demand both for selling and buying TLT or GLD at any one time. People will stand by to purchase at a price a bit below the midprice and to sell at a price a bit above the midprice. Competition between such traders drives the price you can sell at to being close to the price you can buy at. The micro-capital gain such market makers make when they buy and then sell two seconds later is how they make a living. What moves markets is whether people will only buy at a price lower than was previously the case (or higher) It is highly computorized nowadays. I hope my explanation isn't too muddled/obvious.

[rickb]

moda, TLT like GLD only once a day gets bonds (or gold for GLD) added. During the day it trades just like any security (eg a bond or share).

I agree with the "during the day" part of this, but I wouldn't say TLT or GLD get bonds or gold once a day - because this is how open ended mutual funds work.  For an open ended fund any shares ordered during the day aren't really bought until the end of that day - and they're bought at that day's closing price (open ended funds are valued once a day).  The shares corresponding to the orders are created, and the net assets of the fund increases by the amount paid for the shares.  Most funds maintain a cash buffer into which the money paid for the new shares goes.  When the fund manager feels like, she buys or sells whatever the fund invests in - and both the underlying assets and cash buffer contribute to the total value of the fund.  If more investors are buying shares than selling shares, the cash buffer builds up and the manager presumably buys more "stuff".  If more investors are selling than buying, the cash buffer drains and the manager has to sell "stuff" to meet the redemptions.

ETFs are completely different.  There is no direct linkage between investors buying and selling and the fund's assets.  If investors are more interested in buying than selling (unlike an open ended fund, there can't be more buyers than sellers), the only thing that directly happens is the price presumably goes up (just like a stock).  If investors are more interested in selling, the price presumably goes down.  The market value of the ETF reflects only this (market driven) buying and selling - not the price of the underlying assets.  In particular, the closing price of an ETF is the last price someone bought/sold it at (just like a stock) - not the NAV calculated using the closing price of its assets.  Completely independently of this market activity, the APs can trade baskets of whatever the ETF owns for new shares (which they can then sell on the market) or vice versa.  The fund manager has no (alright, little) control over when or why the APs do this but the APs have a financial incentive to create shares if the ETF trades above its NAV and to destroy shares if the ETF trades below its NAV (because they can make money on the deal).  ETFs report the number of shares created/destroyed each day, but I think this activity happens during the day (not at the end of the day) and the ETF only reports the net (so if AP #1 creates 1,000,000 shares and AP #2 destroys 400,000 shares they report the net increase of 600,000 shares).

[smurff]

About market makers:

There are thousands of market makers for the NYSE and NASDAQ.  You can find an old list of some of them, arranged alphabetically, here:  http://www.level2stockquotes.com/market ... -list.html

I say it's an old list because it still has Lehman Brothers and Bear Stearns included in the list.  Here's another list http://www.alphatrade.com/techSupport/m ... tml?page=m that shows MF Global, which just filed for bankruptcy today, as a market maker.

The lists give you a general idea of who these firms are.

Market makers do this to ensure smooth operations of the exchange, and also to make money, as they earn some on the bid/ask spread, as well as receive liquidity rebates and other trading privileges on the exchange.