Gold ETFs: Factors To Consider

Published on August 18, 2011 | Updated July 18, 2012

Investing in gold is a formidable strategy that has stood the test of time as this precious metal has rightfully earned the title of “safe haven,” appreciating in times of uncertainty and providing an effective hedge against dollar devaluation. Unfortunately, this investment strategy hasn’t always been available to all walks of investors given the significant upfront costs associated with purchasing and safely storing physical gold bullion. Recent innovations in the exchange traded product space, however, have made it possible for the average investors to quickly and easily establish exposure to the precious metal. Gold ETFs have seen a surge in popularity as these investment vehicles gives investors cost-efficient access to gold prices, without the hassle of acquiring and storing the metal itself.

Developments in the ETF industry have spawned a handful of products that serve to provide exposure to gold. And while more choices are usually a favorable development for individual investors, it can be quite a daunting task to navigate through all the options and pick the most appropriate one. Below, we highlight six factors to consider when trying to the gold ETF that is right for your portfolio:

Physical vs. Futures

Gaining exposure to gold can be achieved in a variety of ways and one of the most basic questions that ought to be considered first is whether you desire a physically-backed fund or a futures-based product. Investors who opt for a physically-backed instrument should note that the underlying holdings are generally gold bullion, essentially bars of gold stored in a secure vault location. Futures-based products on the other hand achieve exposure through a more indirect approach, by investing in gold futures contracts as opposed to directly purchasing and storing the metal.

Physically-backed ETFs are designed to move in unison with the spot price of gold and while futures-based products have the same purpose in mind, their approach is more complex, which introduces additional factors that can potentially impact bottom line returns. Three factors that impact performance of futures-based products are spot price of gold, roll yield related to the slope of the futures curve, and interest earned on non-invested cash.

Given the nature of futures-based products, they must sell the gold contracts as they approach expiration and buy futures for a further date down the line. This “roll” process certainly affects overall returns; when markets are contangoed—longer-dated futures are more expensive than those approaching expiration—the roll yield will have an adverse impact on returns. When the opposite is true—markets are backwardated—the futures-based approach will put the wind at your back. Since gold markets are generally contangoed, physically-backed products will tend to deliver more attractive returns since they can track the spot price of gold more closely.

Vault Location

Investors who choose a physically-backed ETF will likely never come in physical contact with the metal they maintain an ownership interest in, but they still may have preferences as to where that gold is actually stored. All exchange-traded products store gold in secure vaults, and there are countless safeguards in place to ensure that there is no unauthorized access. Most gold bars to which physically-backed ETFs are linked are stored in the U.S. or in London.

Many gold bugs will point to the historic gold confiscation of 1933—in which the government ordered U.S. citizens to turn over any gold coins, bullion, or certificates—as justification for concerns about owning gold stored in U.S. vaults. Others may be wary of the increased risk for terrorist acts in Western countries such as the U.S. or the U.K., concerned that locations that are home to billions of dollars worth of gold could make for a prime target.

Investors who place a high degree of importance on where the underlying asset is actually stored can choose amongst several options. ETF Securities offers a number of Swiss Gold ETFs in multiple countries, including the ETFS Physical Swiss Gold Shares (SGOL) listed on the NYSE. The gold bars backing this fund are stored in Switzerland, while another option is Physical Asian Gold Shares (AGOL), which vaults its gold in Singapore.

It’s worth noting that there is no significant premium for storing gold in Singapore or Switzerland, and for many the peace of mind provided is well worth any additional fees.

Gold Bars vs. Gold Stocks

Investors who are interested in gold exposure ought to also consider investing in gold mining companies in addition to funds that track the spot price of the precious metal. Like any company, the profitability of gold miners is impacted by the prevailing market price for the goods sold. And since gold miners often maintain significant fixed costs that remain stable regardless of gold prices, these securities often trade as a leveraged play on spot prices.

Although there is generally a fairly strong correlation between the price of gold and the value of a gold mining stock, there are still a number of potential drawbacks to this strategy. Investors should keep in mind that gold miners are, at the end of the day, stocks. Thus, they may exhibit stronger correlations to global equity markets than physical gold—diminishing one of the major attractions of the precious metal in the first place.

On the other hand, gold mining companies have identifiable cash flows that they generate from operations, while the value of a physical gold bar is much harder to evaluate since it doesn’t make a distribution or coupon payment of any sort.

For those interested in establishing exposure to gold through equity holdings, there are a number of different types of ETFs that provide access to the mining industry:

  • Gold Miner ETFs: These ETFs, including GDX and GGGG, offer exposure to large, multinational, gold mining companies.
  • Junior Gold Miner ETFs: Junior gold miners funds, such as GDXJ, offer exposure to smaller companies that may not maintain significant reserves and tend to be more volatile than their larger, more established counterparts.
  • Gold Explorer ETFs: Gold exploration companies, available through GLDX, often have minimal operations and negative cash flows. These are companies that are literally hoping to strike gold.

Investors should note that some of the gold mining ETFs actually hold a number of other precious metal miners as well, including but not limited to silver, platinum, and palladium.

Expenses

The ETF space has seen a tremendous inflow of investments in recent years and some of the reasons are because the exchange-traded structure offers unparalleled transparency, enhanced tax efficiency, and vast intraday liquidity. But perhaps the biggest driver of the ETF boom is related to expenses—or more accurately, the lack thereof.

Some could make the mistake however that all funds are created equal, when in fact there is a significant gap between many expense ratios amongst gold ETFs. For example, the RBS Gold TrendPilot ETN (TBAR) accrues expenses at a rate as high as 1.0% per year when invested in gold (this ETN is a bit unique, as is adjusts exposure between gold and cash depending on momentum factors). Somewhere in the middle of the cost spectrum is the ultra-popular GLD, charging 0.40%, while the iShares COMEX Gold Trust (IAU) is the cheapest option available, charging a mere 0.25%.

These differences may seem minor, and the dollar impact to short-term investors will be inconsequential. But for those seeking gold exposure for the long term, minimizing the impact of compounding costs can go a long way.

Taxes

While gold ETFs do trade just like equities, many investors will be surprised to learn that they don’t obey the same rules when it comes to taxes. According to the Internal Revenue Service, gold is classified as a collectible when held in the form of coins or bullion. That means that long-term gains are taxes at 28%, which is nearly twice the 15% rate applicable to long-term gains in stocks and bonds. And unfortunately for ETF investors, physically-backed gold ETFs are subject to taxation as collectibles—meaning any long-term gains in funds like GLD will be taxed a hefty 28%.

Futures-based products are subject to unique taxation rules as well, and incur obligations or benefits annually regardless of whether a position was liquidated. These products are taxed at a blended rate: 60% short-term capital gains and 40% long-term capital gains.

Investors should be aware of and understand the tax implications that are associated with the different gold ETFs available on the market.

Liquidity

The remarkable popularity of certain gold ETFs, and the lack of trading volume in others, simply serves to show how certain products will inevitably appeal to some traders while turning away others. From the perspective of an active trader, one who moves in and out of positions multiple times a day, liquidity is a top criteria and it’s likely the most important one next to the underlying holdings of the product itself.  Investors who desire vast liquidity and access to one of the most active options markets in the ETF space, GLD is the supreme choice. The SPDR Gold Trust is by the far the biggest and most actively traded gold ETF on the market and traders who value liquidity above all need not look further.

Investors with a longer time horizon who don’t require tight bid-ask spreads on an intraday basis may find other gold ETFs that suite their needs. Buy-and-hold investors will surely find IAU appealing, as this fund has the second highest average daily volume in the space, while also boasting the cheapest expense fee. Those who are interested in products like UBG or AGOL should exercise caution and use limit orders when opening /closing positions given the ultra-low trading volumes that these funds see on a daily basis. From the gold miners side of the field, GDX is the biggest and most popular product, while GGGG may not be as appealing to short-term traders given its low trading volume.

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