Choosing The Best Junior Gold Miner ETF

May 13, 2014

In the world of small gold miner ETFs, the best call isn't necessarily the one you'd think.

Junior gold miners are one of the the riskiest equity investments one can make without a margin account. These small companies, armed with cash and a few unproven mining prospects, have the potential to quickly create or destroy fortunes for their investors in a literal search for buried treasure.

ETF investors are lucky enough to have two options when it comes to junior gold miners, both global in scope. But strangely, the more popular of the two funds doesn't provide the best exposure to the niche.

The larger fund, Market Vectors Junior Gold Miners (GDXJ | D-28), is the little brother to popular total-market gold mining fund Market Vectors Gold Miners (GDX | B-56). It chooses its holdings based on market cap, with the largest constituents currently about $1 billion in size. GDXJ has about $1.9 billion in assets.

The smaller fund, with less than $50 million under management, is the Global X Gold Explorers (GLDX | D-22). It chooses companies that are primarily involved in searching for new gold deposits, resulting in an average market cap of less than half GDXJ's.

What's the difference? The key is that GLDX only holds explorers, firms that seek out new claims and determine how much recoverable gold exists. GDXJ has those too, but it also holds producers—firms that actually extract gold ore from the ground.

It's an important distinction because the risks of each activity are different.

Both types of firms are exposed to gold prices. Gold is a notoriously speculative and volatile investment. And last year was not kind to the yellow stuff, which ended the year 37 percent below its 2011 peak.

Gold_Price_Since_Peak

Production miners have historically hedged this risk away. While hedging is now uncommon among larger miners, some small producers still partially hedge production to shore up fragile balance sheets. But explorers don't have the option. It's hard to hedge the production of gold that may not be recoverable, or even exist.

Then there's risk from operating leverage. If mining expenses are high, operating profit will be particularly sensitive to changes in gold price. This is a problem for all miners, but explorers in particular run the risk of sinking capital into developing a claim only to find it can no longer be profitably mined.

Finally, there's the obvious risk of investing in a new mining claim: Is there anything down there? Can it be recovered at a reasonable cost? These things are almost impossible for the average investor to evaluate.

All of these risk factors together make accurately valuing an explorer a nearly impossible task. Accordingly, even the faintest rumors about an exploration company can cause huge swings in its stock price.

That risk is part of the appeal of these companies—the possibility of that one big win.

 

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