Going For Gold

April 08, 2009


Futures Through ETNs: UBG And GOE

In addition to DGL, investors can access futures-based gold exposure through two exchange-traded notes: the E-TRACS UBS CMCI Gold (NYSE Arca: UBG) and the ELEMENTS MLCX Gold TR ETN (NYSE Arca: GOE). GOE tracks a standard futures index, holding the near-month contract and rolling it forward each month, while UBG tracks a "continuous commodity index," meaning it spreads its bets over more than a dozen contracts with expiration dates stretching out as far as three years. The UBG methodology aims to mitigate the impact of contango and provide more-diversified exposure to the gold futures market.

ETNs come with two distinctions. First, and most importantly, they are debt notes. That means that the value of an ETN is entirely dependent on the underwriting bank. If the underwriting bank were to go bankrupt, the ETNs would lose substantially all of their value. In this case, Credit Suisse underwrites the ELEMENTS ETN and UBS underwrites the E-TRACS ETN, so those are the banks that must be considered.

The second issue involving ETNs pertains to taxes. Currently, the IRS treats commodity-based ETNs as "prepaid forward contracts," which means that, effectively, commodity ETNs receive the same treatment as regular stocks, including a 15% capital gains tax treatment if notes are held for more than a year. That gives the ETNs a decided tax advantage against competing products for long-term holdings. The IRS is believed to be reviewing the tax treatment of commodity ETNs, however, and it could place more-onerous conditions on the notes in the future. Chances are that this more favorable tax treatment will remain.

Equities: GDX

An alternative approach to the gold market is to invest in gold mining equities, the companies that create deep pits in the ground and do the dirty work of actually digging up the gold. The Market Vectors - Gold Miners ETF (NYSE Arca: GDX) is the leading tool for this, holding a diversified portfolio of 32 gold mining companies. The largest components are Barrick Gold (13.75%), Goldcorp (10.08%) and Newmont Mining (8.56%). The ETF is diversified globally, with a large allocation to Canada (60.6%) and substantial allocations to both South Africa (14.5%) and the U.S. (12.4%).

The choice between straight gold exposure and gold equities comes down to what kind of returns you want to achieve. Gold mining companies are more exposed to the vagaries of the stock market than gold bullion itself, and will have higher correlations to the equity market as a result. Companies will also be more influenced by broader global economic conditions: The credit crunch made it harder for these companies to access capital, for instance, while falling oil prices are driving down their cost of production and boosting profits.

Generally speaking, gold miners should deliver leveraged returns compared to bullion, as the companies take on debt that they use to invest in operations. The returns should be more volatile, with larger upside and downside moves.

Leverage: UGL

For investors who are truly gung ho about gold, the ProShares Ultra Gold ETF (NYSE Arca: UGL) offers a unique angle. The fund is designed to deliver 200% of the daily return of the London fixed gold price, minus expenses.

There are caveats with this fund, of course. Chief among them is that 200% of the daily return is not the same as 200% of the long-term return. Investors can expect the long-term returns of the fund to differ substantially from a simple 200% multiple. For shorter holding periods, however, UGL offers a lot of bang for its 0.95% expense ratio.

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