Gold ETF Investing: Physical Or Futures?

Gold investing has been a popular choice for quite some time now. This elusive commodity has a long list on functional uses, including its abilities to act as an inflation hedge and the fact that it is often sought out as a safe haven in times of market turmoil. The popularity of this precious metal was cracked wide open with the widespread release of exchange traded funds, which allowed investors to gain exposure to their favorite metal with low costs, high liquidity, and a transparency that can be matched nowhere else in the financial world. There are now all kinds of ETPs that offer pure exposure to gold as well as basket shares of various precious metals, giving investors a wide range of choices when it comes time to make a gold allocation [see also Precious Metals ETFs: Finding The Best Fit].

Among the many gold ETP choices, there are two methodologies that stand out as the clear favorites: futures-based and physical-based. While both of these strategies have grown in popularity, they both come with a very different set of risks and returns that make them appropriate for some investors and a bad choice for others. Many debate over which strategy is better, but the fact remains that neither strategy is necessarily better than the other, but rather, one strategy will likely fit better with certain kinds of investors over the other.

Below, we break down the ins and outs of futures-based and physical-based gold ETPs to allow investors to decide which side of the line they fall on, and which choices would be most beneficial for adding necessary commodity exposure to an individual portfolio [see also The Ultimate Guide To Gold Investing].

Futures-Based Gold ETPs

Futures-based gold investing can vary in a number of different aspects of the portfolio maintained, but the overarching theme of this investment segment is delivering returns by investing in futures contracts on a specified commodity; in this case, gold. This style of fund will afford investors with a wealth of opportunities. For starters, one does not have to own a futures account to own a futures-based gold product; you only need to own the singular ticker of any of these respective exchange traded products. Second, trading futures contracts can be very difficult, and quite frankly, is not meant for the average investor. Futures ETPs take away the complexities by doing the tough work for investors, who can simply buy into a fund and enjoy instant exposure to futures-contracts on gold. And still, for all of its advantages, futures-based investing has a fair amount of backlash.

The most pressing issue of a futures-based products comes in the form of contango; a process where front month futures contracts are more expensive as time goes on, creating a loss of value when the ETF automatically sells the current contract and purchases the next month’s contract. Over time, contango can kill a significant amount of value in a single investment. This process can work to an investors advantage when front month futures are cheaper, adding value in the roll process between contracts. This is known as backwardation. Some funds have taken active strides to avoid contango with unique buying and selling techniques, but the fact remains that investors must be fully aware of the futures curve when buying into one of these ETPs [see also Eight Legendary Gold Investors].

Due to its shortcomings, futures-based products are not meant for the average “buy-and-hold” investor, but rather are meant to be used by only those who fully appreciate their complexities and can trade them appropriately. For those who do understand them, these can be powerful trading tools that offer an investment methodology that is unmatched in the financial world. Below, we outline two of the most popular futures-based ETP options.

  • PowerShares DB Gold Fund (DGL): This product tracks a benchmark that is composed of futures contracts on gold and is intended to reflect the performance of the precious metal.
  • E-TRACS UBS Bloomberg CMCI Gold ETN (UBG): This ETN differs its strategy from DGL by investing in futures contracts that are diversified across five constant maturities from three months up to three years. This may help alleviate contango concerns or simply fit better for investors looking to spread out their risks, as UBG is a better diversified product than DGL, though it will not reflect the changes in front-month futures as well as its competitor.

Physical-Based Gold

Prior to ETFs, the only way to physically own a metal was to simply go out and buy it, and run the risk of holding onto it yourself. But as the exchange traded world has beefed up its offerings, physical-based investing took a ride on the fast track to popularity, as investors can now own gold without shelling out the high costs for a couple measly ounces. Physical-based investing takes a different approach to gold allocation. Rather than owning futures contracts, these products seek to physically hold gold in vaults all around the world, nixing a lot of the issues that the aforementioned products exhibit. Owning physical gold gets rid of issues like contango, and allows for investors to keep their gains at a low cost. But while physical based investing avoids the major issues of futures-funds, it has its own problems to deal with [see also 50 Excellent Tools, Resources, and Blogs For Gold Bugs].

Allocation. When it comes to physical investing, it is important to note that a share of one of these ETFs represents a grantor who owns the physical gold bullion. Some funds exhibit 100% allocation, a process whereby the ownership of new gold is transferred from the custodian to the trust, reflecting in the holdings of the investor. Unfortunately, this process does not always go smoothly, and can lead to unallocated gold, which occurs when the custodian fails to deliver the specified amount of gold to the trust, or simply does not make the delivery on time. This creates unallocated gold, which can cause issues for individual investors [see also IAU vs. GLD]. While these issues seldom occur, as most funds have near 100% allocation, it is still an issue that investors should be privy to prior to purchase.

The simplicity of these products makes them ideal for a risk-averse investor looking for a long term play on gold. While these are still useful products for complex traders, they are most practical for the more hands-off investor. Below, we outline two of the most popular physical-based ETF options.

  • SPDR Gold Trust (GLD): By far the most popular gold ETF in the world, GLD offers physical exposure to this precious metal as well as supreme liquidity: the fund changes hands an average of just under 15 million times per day. GLD’s share price is designed to represent roughly 1/10th the price of an ounce of gold and has an allocation that is slightly under 100%, which may be a cause for concern for some investors. GLD charges an expense ratio of 0.40%.
  • iShares COMEX Gold Trust (IAU): IAU seeks to directly compete with GLD by offering a cheaper price (representing approximately 1/100th an ounce of gold) as well as expenses that are 15 basis point cheaper. IAU is able to boast 100% allocation and has gained 4.2% thus far in 2011.

In addition to these funds, ETF Securities offers a pair of physically-backed ETFs that store gold in some exotic locations:

  • Physical Swiss Gold Shares (SGOL)
  • Physical Asian Gold Shares (AGOL)

While the exact location of the vault doesn’t have a meaningful impact on the returns realized, some may be more comfortable with knowing that their bullion is outside of the U.S. or London (AGOL’s gold is vaulted in Singapore). While that may sound cooky, this exposure is available at a reasonable price; both of these funds are actually cheaper than GLD, and only slightly more expensive than IAU.

Disclosure: No positions at time of writing.

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