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A Gold Fund’s Debacle Highlights Risks

Investor-Update

Any time a fund invests in something more esoteric than exchange-listed stocks from a developed country or widely traded high-quality bonds, the potential for something to go wrong increases. We saw this happen in December when the Third Avenue Focused Credit Fund—a mutual fund—suddenly shut its doors in response to junk bond losses. Last week new problems emerged in fund land, this time involving a popular gold exchange-traded fund.

BlackRock’s iShares unit was caught off guard by demand for its Gold Trust ETF (IAU). The company had more requests for creation units (blocks of 50,000 shares) than it could handle. IShares literally hit the limits of its ability to issue new shares. Simply put, there were more requests for shares than there were shares outstanding or could be created. As a result, iShares had to stop issuing creation units until it filed new paperwork with the Securities and Exchange Commission. (ETFs issue and redeem shares by trading with institutional traders using creation units, either baskets of the securities or commodities those creation units represent or, in some cases, monetary amounts equivalent to the value of the creation units.)

If this has you saying “Huh?!,” then welcome to the back-end side of the ETF industry. While the perception is that ETFs can scale up or down in response to demand by issuing or redeeming shares, things don’t always go as planned. More importantly, just because an ETF is supposed to be adjusted to its net asset value by market forces on an intraday basis, this is not always the case. The iShares website says that there were 55 days last quarter when IAU traded above or below its net asset value by a margin of greater than 0.5%. Not big discounts or premiums as neither exceeded 2%, but an indication that investors weren’t always getting a dollar’s worth of the underlying gold trust for every dollar they spent on the ETF.

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The Week Ahead

AAII’s senior financial analyst, Wayne A. Thorp, CFA, will speak to our Dallas/Fort Worth Chapter on Wednesday and our Houston chapter on Saturday.

Right on the heels of fourth-quarter earnings season ending, we’ll start to see results from the first quarter’s early reports. Oracle Corp. (ORCL) will report on Tuesday, FedEx Corp. (FDX) will report on Wednesday and Adobe Systems (ADBE), Cintas Corp. (CTAS) and Lennar Corp. (LEN) will report on Thursday. All of these companies are in the S&P 500.

The Federal Open Market Committee (FOMC) will hold a two-day meeting starting on Tuesday. The meeting statement and updated forecasts from committee members will be released Wednesday at 2:00 p.m. ET. Fed Chair Janet Yellen will hold her quarterly press conference starting at 2:30. The CME’s 30-day Fed fund futures are currently pricing in a 98.1% chance of a quarter-point rate hike.

Elsewhere on the economic calendar, the February Producer Price Index (PPI), February retail sales, the March Empire State manufacturing survey, January business inventories and the National Association of Home Builders’ March housing index will be released on Tuesday. Wednesday will feature the February Consumer Price Index, February housing starts and building permits and February industrial production and capacity utilization. The March Philadelphia Fed survey and the January Job Openings and Labor Turnover (JOLTS) Survey will be released on Thursday. Friday will feature the University of Michigan’s preliminary consumer sentiment survey.

The Treasury Department will auction $11 billion of inflation-adjusted Treasuries (TIPS) on Thursday.

Friday will be a quadruple witching day, meaning both options and futures contracts will expire.

Thursday is St. Patrick’s Day; be sure to wear something green!

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One thought on “A Gold Fund’s Debacle Highlights Risks”

  1. I have to disagree that Blackrock’s back office SNAFU with regard to IAU is any sort of risk to an investor willing to bet on the on the direction of price of gold–whether making such a bet is a good idea or not I do not take a position on–and the only entity or person potentially hurt by this error is Blackrock (“BLK”) itself, not any market participant. As you note, IAU continued to trade within the expected band of variance from fair value and it is highly unlikely that BLK’s back office mistake had any impact on the trading price of IAU or the price of gold. The problem was a technical issue that arose because, as a physical gold fund, IAU is not in fact an ETF but rather a gold trust that buys physical gold that is registered under the ’33 Act, not as a ’34 Act (open-ended-able-to-issue-shares-anytime-it-wants) fund. That means that just like a follow-on offering of equity shares from a listed company new units have to be registered, typically through a shelf registration. The BLK back office simply failed to keep track of the new units being created and the number left available on the old shelf. All BLK had to do to remedy the problem was to file a new shelf for more units (which they did, but that took some time). The result was the noted SNAFU and BLK can be bitten by some fines from the SEC and potentially some shareholder lawsuits for just not paying attention, but it’s not credible that this added risk or harmed any IAU investor.

    In no way is this a risk like that of the Third Avenue Focused Credit fund (“TAFC”), an open-ended (and therefore theoretically liquid) fund whose assets were high yield credits that inherently experience periods of far less liquidity. This mismatch between the liquidity of the ETF and the underlying securities held is a very real risk and why funds with this risk characteristic I believe should not be permitted by the SEC. The same exposure to junk bonds as TAFC offered can be had through a closed end fund owning such bonds, but the mismatch in liquidity would not cause the fund to halt redemptions (because, of course closed end funds don’t redeem shares but have a set number that trade in the after market). In a closed end fund, a change in the number of shareholders wanting to own shares results in merely a widening or narrowing of the fund’s shares spread to net asset value.

     

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