When peeling back the layers of the ETF industry, one quickly realizes that certain corners of the market have expanded more quickly than others over the last several years. While many of the largest ETFs by total assets track equity indexes, those that have driven growth in both the number of products and total assets in recent years have focused on benchmarks linked to other asset classes, such as commodities.
The commodity ETF boom is relatively easy to explain. Prior to the rise of the ETF industry, many investors were limited in their ability to gain exposure to prices of natural resources. With a handful of diversified commodity and resource-specific funds now available, any investor with an online brokerage account can make a play on everything from agriculture to sugar.
One of the most popular commodities accessed through ETFs has been gold, a safe haven investment that many U.S. and international investors see as a preferred alternative to the U.S. dollar. When most investors discuss gold ETFs, they are referring to physically-backed products that store gold bullion in secure vaults, such as GLD, IAU, and SGOL. The gold SPDR’s $40 billion in assets dwarfs its competitors, but the competing products from iShares and ETF Securities aren’t exactly small; assets in IAU and SGOL stood at $2.8 billion and $360 billion, respectively, at the end of the first quarter. That puts total assets in physically-backed gold ETFs at approximately $45 billion, more than all but a handful of sovereign wealth funds.
In addition to these physically-backed products, there are a few other gold ETFs that take a different approach to providing exposure to bullion prices. One of these is the PowerShares DB Gold Fund (DGL), which seeks to replicate the performance of the Deutsche Bank Liquid Commodity Index-Optimum Yield Gold Excess Return. Unlike GLD, the underlying assets of this product are not gold bars, but rather futures contracts on gold (see DGL’s fact sheet). So while the returns generated will be similar to changes in the spot price of gold, they won’t be identical.
As most investors know, the returns generated by a futures-based strategy are generally dependent on three factors: 1) changes in the spot price of the underlying asset, 2) interest earned on uninvested cash, and 3) the “roll yield” incurred when expiring contracts are sold and the proceeds are used to purchase longer-dated futures. Whereas shares of GLD are only impacted by the first factor, movements in the price of DGL depend on all three.
After seeing funds like UNG and VXX incur big losses in contangoed markets (see How UNG Lost 20% In March), some investors are wary of any product that uses a futures-based strategy. Many futures-based exchange-traded products roll their holdings at predetermined dates, a habit that makes some uncomfortable. The index underlying DGL, however, is somewhat unique. The “Optimum Yield” in the index name refers to the fact that the index manager will seek to minimize the negative effects of rolling futures contracts when a market is in contango and try to maximize the effects of rolling futures when a market is in backwardation. The calculations for determining exactly when and how to roll contracts are somewhat complex, but the ultimate objective is relatively easy to grasp; either minimizing the negative delta between spot prices and the index performance or maximizing the positive delta.
So how do the historical returns of GLD and DGL compare? As one might expect, they’re pretty close. Since its inception in January 2007, DGL has delivered an average annual return of about 18.2%, while GLD has returned 20.7% annually over the same period. As the chart below shows, the majority of this disconnect arose since gold prices started soaring in late 2008 amidst overwhelming economic uncertainty and a flight to safe havens.
Because gold bullion classifies as a collectible, it’s taxed at a rate of 28%, significantly higher than the 15% rate that applies to equity ETFs held for more than a year. The tax treatment of futures-based ETFs can be complex (it’s important to note that tax circumstances can vary from investor to investor and ETF Database is by no means a tax expert). Generally, gains and losses on futures within an ETF are treated for tax purposes as 60% long-term and 40% short-term, regardless of how long the contracts were held by the ETF.
So which is the better exchange-traded product for achieving exposure to gold prices? For investors looking for an ETF that will move in lock step with spot prices, physically-backed like GLD and IAU are the way to go. For those who think a futures-based strategy might outperform spot prices or hesitant to invest in physical bullion, DGL could offer an interesting option.
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Disclosure: No positions at time of writing.