Going For Gold

April 08, 2009

GLD is not the only option in gold ETFs. At least seven golden choices are available, ranging from bullion to futures, stocks and leveraged funds.


(Editor's Note: The following is an updated excerpt of an article that originally appeared in the March issue of the Exchange-Traded Funds Report. ETFR subscribers wishing to read the complete analysis can view the full piece here.)


The combination of global uncertainty and mounting inflationary pressures has exchange-traded fund investors running for gold.

The most popular gold ETF, the SPDR Gold Trust (NYSE Arca: GLD), had $31.5 billion in assets under management through Monday, making it the second-largest ETF in the world after the S&P 500 SPDR Trust (NYSE Arca: SPY), with $61.3 billion.

In fact, in the first quarter, GLD was by far the biggest attraction in ETFs. With more than $12 billion in net inflow heading into April, the fund's total topped the combined inflow of the next seven most popular ETFs. (See related story here.)

But GLD is not the only way to buy gold. Investors have at least seven golden choices in the ETF market, running the gamut from physical bullion to futures, equities and leveraged products.

The ETF an investor uses to access the gold market can have a dramatic impact on returns: For the four funds that existed for all of 2008, the range of returns ran from 5.11% to -26.08%; in December 2008 alone, the returns of the funds ranged from 1.44% to 27.51%.

Bullion: GLD And IAU

The simplest (and most popular) way to buy gold using ETFs is through one of the two bullion-backed ETFs: the aforementioned GLD or its chief competitor, the iShares COMEX Gold Trust (NYSE Arca: IAU). The two funds are substantially identical. Both hold physical gold bullion as their sole asset, literally storing gold bars in a vault. Both charge 0.40% in annual expenses, and deliver roughly identical returns. These are about as close as you can get to holding actual Krugerands or American Eagles in an exchange-traded format.

Futures: DGL

The next best thing to owning gold—and sometimes an even better thing—is to own gold futures. The PowerShares DB Gold ETF (NYSE Arca: DGL) holds a basket of gold futures contracts. Generally speaking, futures and bullion returns will be similar. But there are important differences between them to keep in mind.

The first is taxes. Bullion-based ETFs like GLD and IAU are treated as "collectibles" by the Internal Revenue Service, meaning they never qualify for long-term capital gains treatments. No matter how long you own the funds, all gains on GLD are taxed at a 28% tax rate.

DGL, in contrast, is taxed like a futures position, meaning all gains are taxed as 60% short-term gains and 40% long-term gains, no matter how long you own the fund. That creates a combined maximum tax rate of 23% for high-income individuals; for people with lower incomes, the tax rate is lower, as the 60% short-term gains are taxed at regular income tax rates.

On the downside, gains in DGL are marked-to-market at year-end, meaning investors must realize all gains in the fund each year, regardless of whether they sell or not. This complicates the tax comparison. Clearly, DGL has better short-term tax treatment than the gold bullion ETFs. It also gets a lower maximum tax rate on long-term positions. But because GLD and IAU allow you to defer taxation until you sell, they may be more favorable than DGL in certain situations.

Beyond taxes, there are two other critical factors to consider with DGL and other futures-based products. The first is contango. Contango exists when the price of an out-month futures contract—say, June gold—is more expensive than the price of a near-term contract-say, April gold. A futures-based fund like DGL must constantly sell expiring futures contracts and replace them with contracts set further out on the calendar. If those out-dated contracts are more expensive than expiring contracts, it can hurt returns. The opposite situation—when out-month contracts are cheaper than near-month contracts—can help returns; it's called backwardation.

Gold has historically traded in a small contango, meaning there has historically been a consistent but slight negative impact on returns from the process of rolling contracts forward each month. DGL uses a trading mechanism to limit the impact of contango, but over the past two years, contango has been a small drain on returns.



The contango issue is offset in part by the fact that futures-based funds must only put up a portion of their assets to buy futures, and can invest the rest of their money in fixed-income instruments, earning interest. In the case of DGL, it invests its collateral cash in 3-month Treasuries. Unfortunately, short-term Treasuries are not earning much interest these days, so this benefit is muted for now. If that situation reverses itself, DGL could become more attractive.



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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