Gold ETFs: Boom Or Bust?

by on October 15, 2010 | ETFs Mentioned:

With the end of 2010 rapidly approaching, much of the uncertainty that investors had expected to lift this year remains firmly in place. Equity markets have staged an impressive rally in recent months, but significant hurdles remain in the form of persistently-high unemployment, regulatory uncertainty, and fiscal instability throughout much of the developed world [see Seven ETFs Peter Schiff Might Not Hate].

Likewise, bonds have endured an eventful 2010 but face an uncertain future. Despite predictions of a dismal year for fixed income, many bonds–particularly longer-dated securities–have surged this year. Yet to many, fixed income is a ticking time bomb; the next rate hike may still be some ways off, but with key benchmark rates at record lows there is nowhere to go but up. Moreover, concerns over the prospect of inflation have been revived in recent weeks, dealing another strike against bonds. Fed meetings seem likely to drive this asset class in coming weeks and months, as plans to implement additional easing could extend a rally.

With these murky outlooks for both bonds and equities, more and more investors have been turning to precious metals, sending gold and silver sharply higher in recent sessions. The “smart money” has been beefing up exposure to gold for the last several months, and with big names such George Soros and John Paulson holding considerable stakes in gold ETFs, smaller investors have clearly begun hopping on the bandwagon. Gold is often perceived as a safe haven investment, bu the recent rally in the precious metal has corresponded to a run-up in global equity markets as well. Despite tame CPI readings in recent months, inflationary concerns have helped to push up gold prices as investors consider the ramifications of additional stimulus measures. Spot gold prices have jumped nearly 25% this year, and the metal has consistently set new record highs [see also Three Legendary Investors With Huge Positions In GLD].

Opinions on what the next six months holds for gold prices are all over the board. Some believe that a major bubble has formed, while others argue that the rally is only in its infancy. If equities continue to show strength and the Fed holds off on additional QE, some of the air could come rushing out of the bubble. But if stocks stumble and inflation finally does rear its head, gold could continue its meteoric rise. Below, we take a look at the factors likely to drive gold prices in coming months, highlighting some of the popular options for establishing precious metals exposure through ETFs as well [see also Beyond GLD: Three Alternative Precious Metal ETFs].

The Bull Case

Because gold does not entitle owners to any sort of cash flow–rather through a dividend payment or coupon–valuation of this asset is inherently difficult. Predicting demand for gold is a challenging task, arguably more art than science. Still, there are plenty of investors with an opinion on where prices are headed [see ETF Plays For $3,000 Gold].

Gold prices have repeatedly closed at new highs in recent weeks, but many investors believe that the precious metals rally is still in its infancy. Among the arguments for a continued surge in gold prices:

  • Inflation: The last year has seen investor anxiety oscillate between inflation and deflation, but recent overtures from the Federal Reserve have caused some to stock up on assets that perform well when prices rise. The market is bracing for another round of quantitative easing, and the Fed has stated that it may even attempt to push inflation through the high end of its “comfort zone.” Although Bernanke and Co. have historically sought to keep inflation in check, it is seen as a more preferable outcome than the alternative; deflation which could quickly erode economic confidence and send stocks into a tailspin [see Inside Five Surging Commodity ETFs].
  • Dollar Weakness: Gold also acts as a hedge against the dollar, and the greenback’s slide against almost all of its major rivals has further fueled gold’s climb. As a number of countries have become more active and more vocal regarding currency policies, investor interest in a hard currency (i.e., gold) has skyrocketed.
  • Safe Haven: Although gold is often perceived as a safe haven–an asset class that performs well during turbulent economic stretches–the recent run-up in prices has corresponded to a rally in equity markets as well. Although investors have been buying up risky assets recently, the global economy isn’t out of the woods just yet. The developed world is on uneasy fiscal footing, and rising unemployment remains a major concern. If equities falter in coming months, a wave of risk aversion could spur yet another round of gold buying, pushing precious metals up even further.
  • ETF Boost: The introduction of physically-backed gold ETFs has democratized this asset class, expanding access to precious metals to countless investors. Historically, gold has been primarily an investment for large, sophisticated investors. But the ease with which shares of gold ETFs can be purchased now allows smaller retail investors to mimic the strategies used by billion dollar hedge funds, leveling the playing field a bit. While the large investors still account for the vast majority of gold held as an investment, ETFs have significantly expanded the universe of potential buyers for precious metals. That allows for rallies to pick up additional momentum, and could create more upside potential [also read The Definitive Gold ETF Guide].

The Bear Case

Some investors are not so optimistic over the outlook for gold prices, expressing concern that a precious metals bubble may have formed.

  • Deflation: Despite the Fed’s apparent plans to push inflation higher, it’s worth noting that recent CPI readings have shown that deflation is more of an immediate concern. Gold prices have climbed on expectations for an uptick in inflation, but there is no guarantee that an inflationary environment will materialize. Heading into 2010, countless investors were bracing for runaway inflation, predicting that CPI would break into the double digits in the wake of massive stimulus plans implemented during the recession. But these fears never materialized, and a repeat of this scenario could take some wind out of gold’s sails [see Five ETFs To Own During The "Great Deflation"].
  • Bubble Fears: Whenever an unexpected rally becomes a prolonged trend, concerns about a bubble inevitably follow. Currently, there is some concern that if hedge funds and other big investors decide that their assets could be better utilized elsewhere, a sell-off in gold could sent prices tumbling. “I may not be very old, but I’ve already seen this movie three times,” writes Jason Schwarz. “During the 1999 holiday season individuals who had never bought a tech stock were buying Lucent (LU). In 2006 family and friends talking about flipping real estate at neighborhood barbecues. In 2007 I was flooded with hate mail when I suggested oil would plummet to $30 a barrel.” At the height of the tech bubble, the absurd pricing multiples for the sector should have raised a red flag. But because there are no cash flows associated with gold, detecting a bubble is a tough task. Still, some of those who have made a nice profit from gold’s surge aren’t so sure that this rally still has legs; legendary hedge fund manager George Soros recently called gold “the ultimate bubble.”
  • High Reserves + High Deficits: Many countries maintain massive gold reserves; the U.S. leads the way with over 8,000 tons of the precious metal. Many of the nations with huge gold reserves are also some of the most indebted in the world. With such high reserves, and prices spiking daily, many of these countries may be tempted to sell off some of their gold stockpile to help pay off the debt they have accumulated. If countries were to suddenly unload massive amounts of gold, the price would likely sink. Given the fiscal instability in the markets, this may not be such a far-fetched scenario.
  • Emerging Markets Strength: While the hurdles facing the developed world may strengthen the case for safe havens, the scenario playing out in emerging markets is drastically different. Many of the emerging markets are experiencing tremendous economic and population growth [see Case For Emerging Markets Consumer]. If emerging markets are able to drive global growth, the need for safe havens may be diminished, taking some of the luster off of gold [see The Definitive Guide To Inverse Gold ETF Investing].

ETFs To Play The Gold Market

There are a number of ways for investors to play gold through ETFs, including physically-backed funds, futures-based portfolios, products focusing on gold miners, and inverse and leveraged options as well [see all ETFs offering exposure to physical gold]. Below, we highlight some of the most popular gold ETFs:

  • iShares COMEX Gold Trust (IAU): This ETF is similar to GLD, but offers a couple of potential advantages: IAU charges an expense ratio of just 0.25% and offers 100% allocation on a daily basis.
  • Market Vectors Gold Miners ETF (GDX): This ETF provides exposure to publicly traded companies around that world that are primarily involved in mining for gold. Although the underlying holdings of GDX are equities, this fund is most certainly impacted by gold prices. The profitability of companies engaged in the extraction of precious metals moves with the market price of bullion, and GDX often trades as a leveraged play on gold. This mostly-international ETF focuses primarily on large cap firms, and nearly 60% of the individual securities in GDX are based out of Canada [also see Playing Precious Metals Through Equity ETFs].
  • PowerShares DB Gold Fund (DGL): Rather than track the physically backed commodity, this ETF is composed of futures contracts on gold. The fund has surged by 24.6% so far this year and may also provide great diversification benefits to investors; its beta is -0.02 suggesting that the fund moves almost completely independent of the S&P 500.
  • PowerShares DB Gold Short ETN (DGZ): This exchange-traded note presents a way for investors to bet on a decline in gold prices. This fund tracks the Deutsche Bank Liquid Commodity Index-Optimum Yield Gold (-100%) which is designed to reflect the performance of certain gold futures contracts plus the returns from investing in 3 month United States Treasury Bills.
  • ProShares Ultra Gold (UGL): This ETF seeks to deliver daily returns that correspond to twice (200%) the daily performance of gold bullion as measured by the U.S. Dollar p.m. fixing price for delivery in London. ProShares also offers a bear counterpart, the UltraShort Gold (GLL).

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Disclosure: Jared is long IAU.