How Does a Gold ETF Work?

Learn about the different types of gold ETFs, including their benefits, risks, and taxation.

Gold ETFs are a popular way for investors to gain exposure to gold without physically owning the precious metal. 

Learn about the different types of gold exchange-traded funds, including physically backed ETFs that hold actual gold, equity ETFs that hold a basket of gold mining stocks, and leveraged ETFs that use derivatives to amplify gold price movements.

In this article, we'll explain how these precious metals funds work, including the various types, the benefits and risks, and how they're taxed. 

How Does a Gold ETF Work? 

A gold ETF is an exchange-traded fund that tracks the price of gold, providing investors with exposure to the gold market without the need to physically own the metal. There are several types of gold ETFs, each offering different levels of exposure and serving various investment strategies.

For example, if the price of gold increases by 1%, the value of the ETF should also increase by approximately 1%. Similarly, if the price of gold decreases, the value of the ETF should decrease as well. 

When an investor buys shares of a gold ETF, they are essentially buying a portion of the gold held by the fund. This means that investors do not own physical gold, but instead own a share of the ETF that represents a certain amount of gold. For example, if an investor buys one share of a gold ETF that holds 10 ounces of gold, that investor effectively owns 1/10 of an ounce of gold. 

Types of Gold ETFs, Examples, and How They Work

• Physical Gold ETFs: These ETFs invest directly in physical gold bullion held in a vault. Each share of the ETF represents a certain amount of physical gold, typically held in vaults. The value of these ETFs moves in tandem with the spot price of gold. They offer a straightforward way to gain exposure to gold's price movements. Examples include the SPDR Gold Shares (GLD) and iShares Gold Trust (IAU).
• Gold Mining ETFs: These ETFs invest in companies involved in the extraction and production of gold. Instead of tracking the price of gold directly, they track the performance of a basket of gold mining stocks, which can be influenced by factors like the companies' operational efficiency, and management decisions, in addition to the price of gold. Examples include the VanEck Vectors Gold Miners ETF (GDX) and the iShares MSCI Global Gold Miners ETF (RING).
• Leveraged Gold ETFs: These ETFs use financial derivatives and debt to amplify the returns of gold. They are generally used for short-term trading rather than long-term investing due to their volatility and potential for significant losses. Examples include the ProShares Ultra Gold (UGL) and the Direxion Daily Gold Miners Bull 3X Shares (NUGT).
• Inverse Gold ETFs: These ETFs are designed to move inversely to the price of gold or gold-related indexes, allowing investors to profit from a decline in gold prices. By using derivatives, these ETFs provide the opposite of the daily return of gold or gold miners' indexes. Like leveraged ETFs, they are intended for short-term trading and can be very volatile. Examples include the ProShares UltraShort Gold (GLL) and the Direxion Daily Gold Miners Bear 3X Shares (DUST).

Physical Gold vs. Gold ETFs: Benefits and Risks 

Physical gold is a direct investment, and it's actual gold that you can hold in your hand, such as coins, bars or jewelry. However, gold ETFs are an indirect investment because investors do not take ownership of gold itself. Instead, they buy shares of the ETF, which may hold gold, or it may use futures contracts to track the price of gold. 

Benefits of Physical Gold 

• Tangible asset: Physical gold is a tangible asset that you can see and touch, which some investors find more attractive than an intangible asset. 
• No counterparty risk: With physical gold, you don't have to worry about counterparty risk, which is the risk that the person or company you are dealing with will default on their obligations. 
• Potential for appreciation: Physical gold has the potential to appreciate in value over time, making it a good investment for those looking for long-term gains. 

Risks of Physical Gold 

• High transaction costs: When you buy physical gold, you'll likely have to pay a premium over the spot price, and when you sell, you may receive less than the spot price. 
• Storage and security concerns: If you own physical gold, you'll need to find a safe place to store it, which can be costly and inconvenient. 
• Low liquidity: If you need to sell your physical gold quickly, you may have difficulty finding a buyer, especially if the market is in a downturn. 

Benefits of Gold ETFs 

• Low transaction costs: When you buy and sell gold ETFs, you pay a commission to your broker, which is typically much lower than the transaction costs associated with physical gold. 
• Liquidity: Gold ETFs are highly liquid, meaning you can buy and sell shares quickly and easily. 
• Diversification: With gold ETFs, you can invest in an asset that tends to perform with low correlation to other assets, which can help spread risk in a portfolio. 

Risks of Gold ETFs 

• No tangible asset: Unlike physical gold, gold ETFs are not a tangible asset, which may make some investors uncomfortable during volatile market conditions. 
• Counterparty risk: When you invest in a gold ETF, you are exposed to counterparty risk, meaning that if the ETF's issuer defaults, you could lose some or all of your investment. 
• Tracking error: Gold ETFs may not track the price of gold perfectly, meaning investors may not get the full benefit of a rise in the price of gold. 

How Are Gold ETFs Taxed? 

How gold ETFs are taxed will depend on their legal structure and how they track the price of gold, which is either through the purchase of futures contracts or through holding physical gold. Taxation on gold ETFs will also depend on the type of account that an investor is using to hold the fund.

• Grantor trusts: Like physical gold, gold ETFs that hold physical gold are generally structured as grantor trusts and taxed as collectibles. For example, capital gains coming from a gold ETF structured as a trust are subject to the top 28% capital gains tax rate for collectibles, such as art. Gold ETFs that aren’t structured as a trust or don’t directly invest in the precious metal aren’t subject to this top rate. Capital gains taxes would only be due if the investor sells shares of the gold ETF and realizes a gain.
• Partnerships: A commodity ETF structured as a partnership, and that owns gold futures contracts, has a special “60/40” tax rule, which requires that investors report the ETF’s capital gains at a hybrid rate of 60% long-term and 40% short-term gains. This can apply even if the investor didn’t sell shares. Gold ETFs investing in futures contracts provide investors with a Schedule K-1 rather than a Form 1099 to report capital gains.
• Gold ETFs held in retirement accounts: If an investor holds a gold ETF in a tax-advantaged account such as an IRA, 401(k) or Roth IRA, the investor will not owe taxes on any gains until they withdraw money from the account. In a traditional IRA or 401(k), taxes are owed on money withdrawn at the investor’s ordinary income tax rate. In a Roth IRA, investors do not owe any taxes on money withdrawn that are qualified distributions. 

Bottom Line on Gold ETFs

A gold ETF offers investors exposure to the price of gold without the hassle of owning physical gold. Additionally, gold ETFs are generally less expensive, more liquid and more diversified than owning physical gold or a single stock in a gold mining company. Before buying shares of a gold ETF, investors should understand their unique structures, risks and taxation.