ETFs Helped Fuel Gold's Boom -- and Could Worsen a Bust

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Gold barsInvestors tend to treat financial markets as if they're timeless. Technical analysts, for instance, compare recent market patterns with those that occurred generations ago, and come up with historical ratios that are assumed to apply perpetually.

But markets have changed dramatically over time. The rise of computerized trading and virtual baskets of assets are leading stocks to trade in tandem and vexing professional investors who follow traditional approaches like value investing, for example. Investors would be particularly wise to look under the hood at the mechanisms that drive prices when it comes to gold, an investment that proponents ironically often push as a pure store of value.

However, a good deal of gold's meteoric gains over the last five years can be attributed to the gargantuan success of an exchange-traded fund (ETF) that made it easier than ever for investors to pile into the precious metal, The Wall Street Journal reports.

Launched in November 2004, the GLD (GLD) ETF is adding $100 to $150 per ounce to gold prices, experts tell the Journal. Industry body the World Gold Council (WGC) helped launch the ETF in a moment of "desperation," according to the Journal. Council backers that include gold and gold-mining companies were threatening to pull their funding because of the WGC's inability to boost gold prices, which had slumped for two decades prior to the recent rally.

"A Godzilla-Like Beast"

But GLD is now the fastest-growing major investment ever and has ballooned to $57 billion. GLD was created in part to help boost the demand for gold and attract new buyers. The investment vehicle has succeeded wildly in that pursuit. Between 60% and 80% of GLD investors are buying gold for the first time, according to WGC Managing Director Jason Toussaint.

But the Journal notes that "skeptics argue GLD could become a Godzilla-like beast if the gold rally reverses sharply." New gold investors, accustomed to nothing but rising prices, could flee if the momentum turns. And unlike assets such as stocks and bonds, gold has no income stream associated with it. And that makes valuing the precious metal almost impossible. Gold prices have rallied to about $1,400 this year. But they could just as easily be $140 or $14,000.

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So far, the difficulty in determining prices has worked to the advantage of gold bulls. The precious metal can be hawked in anticipation of inflationary or deflationary conditions alike.

But while investors are told rising prices signal a recognition of gold's true value compared to fungible paper currencies, they should take a closer look at the dynamics of this market. The shady endorsements from paranoid media personalities and gold companies that push coins of questionable quality onto customers have already raised some eyebrows.

The rise of gold ETFs has also clearly helped boost prices. And if the momentum turns, that same ease of trading could lead to quick liquidation -- and prove to be a double-edged sword.

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