On the global stage, exchange-traded funds (ETFs) still play a pretty small role—even though the industry recently topped $2 trillion in assets under management, that number is still a drop in the ocean compared to the behemoth $23.8-trillion mutual fund industry. But just because the ETF industry is relatively small, it doesn’t mean it’s not making a significant splash in global markets, especially when it comes to commodities. Economists Ke Tang from China’s Renmin University and Wei Xiong from Princeton argue in this paper that “commodities” have become increasingly “financialized” through products such as ETFs, which have democratized access by allowing investors to trade easily in and out on the secondary market. This has had a profound effect on how commodities behave in a portfolio.

For big investors such as pension funds, this is a key problem—commodities have traditionally been used in a portfolio to hedge against equity market volatility. Commodity-backed ETFs have driven up correlations between commodities and stocks, severely diminishing the diversification benefits. So while investors might be pouring money into commodity-backed ETFs (or dumping their shares), demand for the underlying commodity could be stronger than ever.

Call it the price of mass popularity.

ETFs are now making waves for another asset class—gold. It’s well known that not everyone views gold as a commodity—and it has always been subject to the whims of the larger investing public. But, as with other commodities, the advent of gold-based ETFs has taken investment in the precious metal to a whole new level. Inflows into gold ETFs have surged in recent years, as prices for bullion climbed to record highs in the midst of global economic and political instability.

Lately, however, investors are turning away from gold ETFs in droves—and that has veteran gold investors worried. Last week, the largest gold ETF just had its largest one-day outflow in 18 months—the SPDR Gold Trust fell 2.5% last Wednesday on speculation that the Federal Reserve may pull back economic stimulus. The question is, Will outflows from ETFs crash gold prices? Investors are waiting anxiously to see what will happen.

The main message here is ETFs are beginning to shape prices for key asset classes in ways no one thought possible just a few years ago. What’s important for pension funds is the way some asset classes (such as commodities) might now behave in totally different ways as a result of money moving in and out of ETFs. So whether or not they hold ETFs, plan sponsors should closely watch their impact on the markets.

Copyright © 2017 Transcontinental Media G.P. Originally published on benefitscanada.com

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