Seven Factors To Consider When Evaluating Gold ETFs

Gold ETFs are a relatively new innovation, popping up over the last several years as a tool that allows all types of investors to gain access to an asset class that has appeal for a wide variety of reasons. Gold ETFs have seen a tremendous increase in popularity since their introduction in the early 2000s, as everyone from small individual investors to billion dollar hedge fund managers have embraced the exchange-traded structure as the most efficient means of accessing precious metals.

The reasons for the tremendous popularity of gold ETFs are numerous; these vehicles allow investors to maintain an ownership interest in gold without going through the hassle of acquiring bullion and devising secure storage arrangements. Buying shares of an exchange-traded security is infinitely easier than purchasing gold bars or coins and storing in a safe deposit box or secure vault.

Gold ETFs also provide a cost-efficient means of accessing the yellow metal; most exchange-traded products charge management fees that are significantly less than 1%, and far below the costs that would be incurred to store gold locally (sign up for the free Gold ETF newsletter).

Evaluating Gold ETFs

As the popularity of gold ETFs has skyrocketed, it shouldn’t be surprising that the number of products offering exposure to this asset class has increased tremendously as well. Investors around the globe now have a number of different choices for establishing exposure to gold. And while more choices is almost always a positive development for investors, navigating through all the options to find the one that is most suitable to specific objectives can be a challenging task. Below, we walk through seven criteria that should be considered when trying to find the gold ETF that is best for you or your client:

1. Best Approach To Gold Exposure: Commodity Or Equities?

Gold is one of the most widely followed commodities in the world, and many investors considering a gold ETF are likely interested in a product whose underlying assets consist either of gold bullion or physical gold. But one increasingly popular option for gold exposure involves investing in the stocks of companies engaged in the extraction and production of the precious metal [see also 50 Excellent Tools, Resources, and Blogs For Gold Bugs].

Like any company, the profitability of a gold miner is impacted by the prevailing market price for the goods sold. So when gold prices climb higher, companies whose operations focus around mining and selling gold see their profitability increase—and vice versa. As such, there tends to be a relatively strong correlation between spot gold prices and the profitability of gold miners (and therefore the value of their stock).

There are some potential advantages and potential drawbacks to this strategy. Because gold miners often maintain significant fixed costs that remain stable regardless of gold prices, these securities often trade as a leveraged play on spot gold prices. That can be either a pro or a con; investors looking to bet big on gold may appreciate the effective leverage, while those with a lower risk tolerance may not. Unlike gold bars, gold mining companies have an identifiable stream of cash flows generated from their operations. A gold coin will never make a distribution or coupon payment, making fundamental valuation of the metal challenging. But gold miners generate regular cash flow, a characteristic that some investors value.

Scenario 1: Gold = $1,000/ounce Scenario 2: Gold = $2,000/ounce
Revenue (1,000 ounces) $1,000,000 Revenue (1,000 ounces) $2,000,000
Variable Costs (25%) (250,000) Variable Costs (25%) $500,000
Fixed Costs (500,000) Fixed Costs (500,000)
EBITDA $250,000 EBITDA $1,000,000
Valuation (7x EBITDA) $1,750,000 Valuation (7x EBITDA) $7,000,000

 

On the downside, it’s important to keep in mind that gold miners are, at the end of the day, stocks. As such, they may exhibit stronger correlations to global equity markets than physical gold—diminishing one of the major attractions of the metal in the first place.

There is no universally right answer; exposure to gold through mining stocks makes sense for some investors but not for others. For those interested in this approach, there are a number of different types of equity ETFs focusing on companies in gold-related industries:

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

2. Physically-Backed vs. Futures Based

For investors who decide to achieve exposure to gold directly as opposed to the stocks of companies that discover and extract the metal, there is another important choice to make. The current suite of gold ETFs includes both physically-backed funds and futures-based products. The underlying holdings of physically-backed products are generally gold bullion—bars of gold stored in a secure vault (much more on this below). Futures-based products achieve exposure to gold prices by investing in exchange-traded futures contracts with gold as the underlying. There are both pros and cons to each approach.

The price drivers of physically-backed ETFs are relatively simple; these funds move in unison with spot gold prices. Futures-based ETFs are a bit more complex, as three factors impact performance: 1) spot price of gold, 2) roll yield related to the slope of the futures curve, and 3) interest earned on non-invested cash.

Since these futures-based ETFs don’t take delivery of the physical gold, they must sell contracts as they approach expiration and buy futures that reach maturity further off in the future. This “roll” process can contribute to overall ETF 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.

The market level of interest rates can also determine the relative merits of these two strategies; when rates are near zero, the additional money earned on uninvested cash will be negligible. But if rates climb higher, this source of return may become more material.

Since gold markets are consistently contangoed, physically-backed products will generally deliver a more attractive return, and they will always track spot gold prices more closely. Many of the largest and most popular gold ETFs are physically backed, including GLD and IAU. But there are a number of futures-based products that can be attractive in certain environments or for certain investors. These include:

3. Is It Really An ETF?

This question may sound a bit absurd, but understanding the impact of product structure on overall return can be a challenging task—especially in the commodity space. Exchange-traded products are open-ended in nature, meaning that there exists the flexibility to create new shares when needed. Closed-end mutual funds, on the other hand, don’t have the ability to issue new shares. That’s a potentially important distinction, because it limits the ability of closed-end products to efficiently track the price of gold.

Exchange-traded funds are backed by an arbitrage mechanism that allows certain authorized participants to create or redeem shares if the market price of the fund deviates from its net asset value. When the price of the fund rises above its NAV, the AP would exchange bars of gold for additional shares of the ETF. Selling those shares on the open market would result in an arbitrage profit, and the additional supply serves to reduce the spread to NAV. But when new shares can’t be easily created, demand for an investment product can result in the creation of a premium as investors clamor to gain gold exposure.

A great example of a gold closed-end fund is the Sprott Physical Gold Trust (PHYS). Like ETFs, PHYS is traded on an exchange—the NYSE and TSX to be specific. And like GLD or IAU, the underlying assets consist of gold bars stored in secure vaults. Yet PHYS doesn’t always move in unison with spot gold prices, as this product is a closed-end mutual fund that can’t create new shares to keep prices in line with NAV. As a result, there is another risk factor introduced to the equation: the premium/discount value. PHYS has historically traded at a premium to its NAV, reflecting significant demand for the exposure offered (we’re not exactly sure why).

Suppose that you invest in a closed-end gold fund trading at a premium of 5%. Gold prices then rise by 7%, but the premium on the fund flips to a discount of 5% as a result of shifts in investor sentiment. Instead of a nice gain, you’d experience a loss as a result of the flip from premium to discount. This is obviously an extreme example, and fluctuations in the premium/discount can work in favor of investors as well. But it’s important to understand where exactly your risk exposure is [see the full Gold ETF list here].

Understanding the nuances of various product structures is far from exciting, but it’s an important step of evaluating potential gold ETF investments. Make sure any product you’re considering is an open-end fund; just because it looks like an ETF and trades like an ETF doesn’t mean it’s an ETF.

4. Vault Location

For investors who choose to achieve pure play exposure to gold through an ETF whose assets are bullion stored in secure vaults, there are still more decisions to make. Though the owner of shares in a gold ETF will likely never come in physical contact with the metal in which they maintain an ownership interest, he or she still has a say in where that gold is stored.

Some investors aren’t concerned with the location of the gold that underlies their gold ETF. 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. But there are other options as well.

Gold bugs are known to skew towards the paranoid, so it is perhaps no surprise that gold ETFs offering alternative vaulting arrangements. Some point to the 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 are 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.

For these concerned investors, there are gold ETFs that offer exposure to assets stored securely in other locations around the globe. 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, a country known for its neutrality and strong investor protections.

There’s also the Physical Asian Gold Shares (AGOL), a fund that vaults gold in Singapore. This Asian Gold ETF might be appealing to investors looking to store bullion in an out-of-the way location.

It’s worth noting that there is no significant premium for storing gold in Singapore or Switzerland. AGOL and SGOL both charge expense ratios of 0.39%, a single basis point less than the ultra-popular gold SPDR. So there is little extra cost to this paranoia, and for many the peace of mind and diversification provided is well forth any additional fees (IAU charges just 0.25%).

5. Gold ETF…With A Side Of Silver?

Gold is by far the most popular of the precious metals—at least for use as an investable asset. But investor interest in other precious metals has picked up quite a bit in recent years, as evidenced by the plethora of funds offering exposure to silver, platinum, and palladium.

Though all of these commodities fall under the precious metals umbrella, the price drivers (and therefore the returns) can be drastically different. Gold’s primary use is in investment vehicles, while platinum and palladium are used widely in actual vehicles—they’re critical inputs in the auto manufacturing process. Silver falls somewhere in between, as it is used as both an investment and inflation hedge and in a number of industrial applications [see also Eight Legendary Gold Investors].

There are dozens of gold ETF options out there, differentiated by type of exposure, vault location, and a number of other factors. But there are also exchange-traded products that offer exposure to multiple precious metals, tilting holdings towards gold but also including allocations to silver, and in some cases platinum and palladium. For investors looking to spread the precious metals exposure around a bit, any of the following options might be worth a closer look:

  • PowerShares DB Precious Metals Fund (DBP): This futures-based fund splits exposure between gold and silver, but is heavily tilted towards the former; the yellow metal’s base weight in the underlying index is 80%.
  • ETFS Physical Precious Metals Basket (GLTR): There are two major differences between this product and DBP: 1) GLTR is physically-backed, meaning that the underlying holdings consist of vaulted bullion, and 2) this ETF includes platinum and palladium in its holdings.
  • iPath Dow Jones-UBS Precious Metals ETN (JJP): This exchange-traded note (ETN) also focuses on just gold and silver, giving the larger weighting to the more valuable commodity.

Silver has been on a tear over the last year, so many of these funds have outperformed the pure play gold ETFs out there. There is, of course, no guarantee that these trends will continue, but recent history highlights the potential value of complementing gold with other precious metals.

6. Expenses

Hundreds of billions of dollars have flowed into ETFs in recent years, highlighting the appeal of this vehicle to all types of investors. There have been a number of reasons for this surge in interest; the exchange-traded structure offers unparalleled transparency, enhanced tax efficiency, and intraday liquidity. But perhaps the biggest driver of the ETF boom is related to expenses—or more accurately, the lack thereof.

By now, even novice investors are aware that ETFs often maintain a significant cost advantage over mutual funds. But some make the mistake of assuming that all ETFs are created equal—when in fact the gap between many expense ratios is wide enough to drive a truck through.

This is certainly the case in the gold ETF space, where deltas between management fees can be significant and are obviously capable of impacting bottom line returns. The RBS Gold TrendPilot ETN (TBAR) accrues expenses at a rate as high as 1.0% per annum when invested in gold (this ETN is a bit unique, as is oscillates exposure between gold and cash depending on momentum factors). On the other end of the expense spectrum is the iShares COMEX Gold Trust (IAU), which charges investors just 0.25% annually. Somewhere in between are the futures-based DGL (0.50%) and the ultra-popular GLD (0.40%), along with several other options.

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.

7. Taxes

Many investors cringe at the idea of a discussion over taxes, but this area is important to cover for any exchange-traded product and especially for gold funds. Gold ETFs may trade just like equities, but investors who make the assumption that gains will be taxed like gains in stocks are in for a bit of bad news. 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 GLD will be given a 28% haircut by the tax man.

This point circles back to an earlier note on the impact that the product structure can have on bottom line returns. ETFs that invest in futures contracts are subject to unique taxation rules, 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.

Many gold ETF investors become aware of the tax consequences of their investment only upon sale. A hefty and unexpected bill can take some of the luster off of a successful investment; make sure you understand the tax implications before you establish a position in any of the gold ETFs out there.

Disclosure: No positions at time of writing.

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