Precious Metal ETFs: Physical vs. Equity Exposure

by on December 21, 2010 | ETFs Mentioned:

ETFs in the commodity space have had an incredible run in 2010, with some funds gaining over 80% on the year and becoming some of the year’s top performers. Commodities across the board have enjoyed big gains this year due to a number of factors, including a shaky dollar, strong emerging markets demand, and various supply shortages around the world. Despite the impressive returns delivered recently (and in fact for much of the decade), there are still those who are hesitant to embrace commodities as an investable asset. For the majority of natural resources, it isn’t practical for investors to establish exposure to spot prices; storing crude oil in your basement of live cattle in your backyard isn’t exactly a recipe for investing success. That means that futures-based strategies are the next best choice, exposing investors to the nuances associated with rolling holdings as they approach expiration (i.e., contango and backwardation). The disconnect between hypothetical spot returns and the returns to a futures-based strategy have frustrated some investors who believe they made the right call on commodity prices but failed to realize the gains they expected [see Four ETF Strategies For Fighting Contango].

Physically-backed commodity ETFs–those whose underlying holdings consist of physical commodities–obviously aren’t plagued by contango, and generally move in lock step with the spot price of the related resource. But there are still some who don’t like the idea of investing in physical commodities, an objection that relates to a broader investing strategy. Gold will never make a coupon payments to those who store physical bullion, just as a silver coin or block of platinum will never may a dividend. The lack of any sort of associated cash flow means that investors will achieve all of their returns through price appreciation. And it also means that valuation is a tricky task; the market price of gold, for example, is often impacted by changes in investor sentiment. The price drivers of precious metals in particular can be nebulous; while certain of these commodities have industrial applications, their appeal to investors and use as “safe havens” makes determining a fair valuation especially challenging.

Enter another way to bet on precious metals prices: through equity-based mining funds. These ETFs gain exposure to the precious metals by investing in companies that are involved in the extraction and mining of the elusive commodities. Like any other company that sells a physical product, the profitability of mining firms depends on the current market price for the goods that it sells. Because a certain portion of mining companies’ cost structure is fixed, higher prices for the commodities they extract and sell translates into higher profit margins, and declining prices translate into diminished profitability. As such, mining ETFs often trade as a leveraged play on spot prices, exhibiting increased sensitivity to commodity markets. Below we outline several physically-backed and mining ETFs linked to popular precious metals, and compare the returns to these strategies in 2010 [see also Beyond GLD: Three Alternative Precious Metal ETFs].

Gold

Gold has long been a safe haven for investors worried about inflation, a weak dollar, or a generally dismal economic conditions. Some add gold exposure to their portfolio to hedge against equity drops, while others swear by it as a “buy-and-hold” investment, believing that its value will only increase over the long run. Anyone with exposure to the yellow metal has been handsomely rewarded this year, as gold set new all time highs several times in the latter half of 2010, thriving off of global uncertainty caused by foreign debt crises and other unfortunate events.

Predictions for where gold goes next are all across the board; some believe it to be in a bubble and poised for a plummet, yet others feel it can only go up. Despite how gold prices act, it continues to be one of the most popular commodities on the market with many options to gain exposure to the shiny metal [see also Gold ETF Investing: Closer Look At All The Options].

SPDR Gold Trust (GLD): This ETF stores gold bullion in secure vaults, thereby offering exposure to spot gold. A share of GLD represents close to 1/10th ounce of gold, and GLD is the second largest ETF by market cap and the 18th most popular by trading volume in the exchange traded industry. In 2010, GLD has returned over 25%, while exhibiting almost no correlation to stock markets.

Market Vectors Gold Miners ETF (GDX): This equity ETF tracks the NYSE Arca Gold Miners Index, which provides exposure to publicly traded companies worldwide involved primarily in the mining for gold, representing a diversified blend of small-, mid- and large- capitalization stocks. Top holdings of this fund include Barrick Gold (16.2%), Goldcorp (11.5%), and Newmont Mining Corporation (11%). GDX holds over four fifths of its assets in international funds, with a major focus on Canada (57.4%). GDX has gained more than 30% this year, exhibiting a beta 0.62 and a very strong correlation to spot gold prices.

Silver

Silver has been used as a form of currency for over four thousand years, but has lost popularity since the majority of the world dropped silver standards over one hundred years ago. Now, silver is used as an investment similar to gold, in that it acts as an inflation hedge, and gives a portfolio security against uncertain markets. Silver is also much cheaper than gold; an ounce costs only a fraction of a similar quantity of gold. Unlike gold, demand for silver is driven by industrial uses, as the metal is used in everything from dentistry to photography.

Silver prices are currently at the highest that they have been in nearly three decades, and some believe this metal will climb further thanks to the continuation of the Bush era tax cuts [see also ETFs To Play White Hot Silver]. The proposed extension will add to the already massive U.S. government deficit, which could devalue the dollar and increase the appeal of all precious metals. “The currencies of all the major countries, including ours, are under severe pressure because of massive government deficits,” says Joe Foster, a manager of the Van Eck International Gold Fund. “The more money that is pumped into these economies – the printing of money basically – then the less valuable the currencies become.”

iShares Silver Trust (SLV): This fund holds silver bullion, allowing it to mimic changes in the spot price of silver. SLV has been one of the top performing exchange traded products this year, and total assets now top the $10 billion mark. This fund is also traded an average of 21 million times a day, making it among the most heavily-traded ETFs in the U.S. (currently ranking 11th overall by average daily volume). With 2010 returns coming in at a jaw-dropping 70%, this ETF is among the ten or so best performing ETFs for 2010 [see all Explaining The Wacky Discounts For The Silver ETF (SLV)].

Silver Miners ETF (SIL): This ETF tracks the Solactive Global Silver Miners Index, which is comprised of companies that are actively engaged in some aspect of the silver mining industry such as the mining, refining or exploration of the shiny metal. Top holdings in the ETF include Silver Wheaton Corporation (14.6%), Fresnillo PLC (14.6%), and Pan American Silver Corporation (11%). SIL’s assets lie primarily overseas, with international exposure straddling the 90% line. From a country perspective, this fund focuses on Canada (42%) and Mexico (40%). SIL has also turned in some huge gains in 2010, gaining about 70% since its debut in April.

Platinum

Platinum is among the rarest metals in the world, and is certainly a less popular investable asset compared to gold. An average of 5 million ounces of platinum are mined each year, compared to 82 million ounces and 547 million ounces of gold and silver, respectively. Because it is so hard to come by, platinum is more expensive than both gold and silver, and can make for a unique investment opportunity (platinum’s price is currently sitting around the $1,650/ounce level)

While it may seem like just another rare commodity, platinum offers advantages that gold and silver do not. In periods of market instability, platinum will be outperformed by gold, but during periods of economic growth, platinum tends to outperform gold, making it a useful tool if acquired at the right times. The reason for this trend is because platinum has more practical uses than does gold or silver, as it is a popular metal in industrials. So while economies are growing, more platinum will be demanded and used, driving up the price, and in a weaker economy the price will drop as the expensive precious metal is overlooked [see also Playing Precious Metals Through Equity ETFs].

ETFS Physical Platinum Shares (PPLT): This ETF simply measure the spot price of platinum by physically holding platinum bullion. PPLT is relatively young, as it will not celebrate its one year anniversary until January of 2011. This ETF has returned just over 6% on the year.

ISE Global Platinum Index Fund (PLTM): This fund measures the ISE Global Platinum Index, which is designed to track public companies that are active in platinum group metals (PGMs) mining based on revenue analysis of those companies. PLTM, offered by First Trust, features names like Johnson Matthey, Impala Platinum, and Northam platinum in its top holdings. Like the two previous metals, the platinum miners fund outperformed its physical competitor, as PLTM has gained close to 8% in 2010.

Verdict

When looking at the performance of these two different strategies, a clear trend emerges; the mining based-funds have outperformed the physically-backed commodity across the board in 2010–in some cases by a fairly wide margin. There are a number of reasons that could contribute the noticeable difference between these two investment methodologies. For starters, mining ETFs offer a sort of leverage; for every one percent rise in the commodity prices, mining companies tend to rise higher than one percent (the same will hold true for negative movements). Moreover, mining ETFs have benefited from relatively strong performances out of equity markets this year; while these funds exhibit strong correlations to commodities, at the end of the day they are stocks that also are impacted by the outlook for the global economy [see also ETFs For The Forgotten Asset Classes].

Disclosure: No positions at time of writing.