Choosing The Best Junior Gold Miner ETF

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.

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.

And in that respect, GLDX delivers better than GDXJ.

As a pure exploration fund, it excludes small-production miners with relatively predictable future cash flows. Production miners make up about two-thirds of GDXJ.

And despite GDXJ's market-cap focus, GLDX holds smaller companies overall.

In the end, an ETF wrapper may not really be the best way to gain exposure to this area of the market, because the smallest—and most speculative—miners are just too small and illiquid to be practical in an ETF basket. Many trade on the pink sheets, or not at all.

But GLDX manages to hold companies further down the market-cap spectrum, for an average market cap that's half of GDXJ's.

Lastly, GLDX is less diversified. If you're hoping for a lotterylike payoff, your best bet is to hold—at most—a handful of miners, and hope that at least one of them makes a big find. GDXJ holds 70 names, while GLDX holds just 20.

As shown in the table below, GLDX is more volatile than both GDXJ and total-market mining fund GDX— and far more so than physical gold or the broad equity market.

That's the real value proposition of a junior gold mining fund. It's a highly volatile instrument, only loosely correlated to other equities, which can be used to add diversification to a portfolio of stocks and bonds.

Unfortunately, neither of the two junior mining funds does its job extremely well. Both are fairly expensive—0.55 percent annually for GDXJ, and 0.65 percent for GLDX¸ or $55 and $65, respectively, per $10,000 invested. They also track their indexes loosely.

That said, it's surprising to see GDXJ has attracted so much more investor attention than GLDX. GDXJ mostly resembles its larger sibling, while GLDX provides a unique exposure and a wilder ride overall. And in this small corner of the equity universe, that could be a good thing.

Call it an undiscovered treasure.

As the time this article was written, the author held no positions in the securities mentioned. Contact Scott Burley at [email protected].