Massacre In Gold Miner ETFs Reaches New Climax

Gold plunged on Monday, sending prices below $1,100 for the first time in five years. While the yellow metal's decline has certainly been sharp and swift, it's nothing compared to the breathtaking sell-off in the gold mining sector. Each of the major gold miner exchange-traded funds fell by double-digit percentages on Monday alone.

It's not unusual to see miners underperform gold when prices are falling. But this latest sell-off has been historic and calls into question the entire investment thesis for the sector.

Perennial Underperformers

Betting on gold miners has seldom paid off for investors. Since its inception in 2006, the Market Vectors Gold Miners ETF (GDX)―the largest ETF in the space with nearly $5 billion in assets―has consistently lagged the performance of physical gold.

It's almost always been a better idea to buy an ETF tied to physical gold, such as the SPDR Gold Trust (GLD), than to buy GDX or any of the other miner ETFs.

For example, in the five years leading up to gold's peak in August 2011, GLD returned 183 percent, while GDX only rose by 76 percent. As gold prices tumbled during the next four years, GLD lost 43 percent, while GDX shed a whopping 77 percent.

Perhaps illustrating the point most starkly is the fact that GDX is down 60 percent since its inception in May 2006, while GLD is up 61 percent in that period.

GDX vs GLD

Industry Problems

Of course, the poor performance of ETFs like GDX stems from the host of troubles that have plagued the mining industry. Newmont, Barrick - whose stock hit a 24-year low this week - and the many other gold miners that make up these funds have struggled for years.

Costly and ill-timed acquisitions, poor management and enormous debt loads are all to blame for the industry's woes.

"Mining equities have traditionally been leveraged vehicles," explained Rick Rule, CEO of Sprott US Holdings. However, "these traits were exacerbated by the mining industry's aggressive expansion and acquisition strategies, and occasional imprudent borrowings."

The industry was able to scrape by with poor decisions, but only when gold prices were high and rising, said Chris Thompson, mining analyst with Raymond James.

"High costs were the common culprit a number of years ago born by limited resources and excess demand," he said. "This wasn’t too much of a problem as prices were rising and costs could be accommodated. Unfortunately, mining companies got lazy, didn’t explore, forgot about how to run companies like real businesses , and relied on ever-increasing metal prices to substitute for growth and discovery."

Once gold prices began to fall out of bed a couple of years ago, miners found themselves in dire straits.

"Margins were squeezed and the volatility in precious metal prices made it almost impossible to recalibrate operations around being economic at lower metal prices," said Thompson.

Looking Ahead

While it's clear that the gold mining sector has been through the wringer, what's less certain is where it will head from here. Is now the time to get into GDX and other miner ETFs?

One inescapable fact is that miners will continue to take their cues from the price of gold itself. Regardless of the state of the industry, if the yellow metal continues to slide, there's no reason to expect anything but more pain for the miner ETFs.

On the flip side, if gold manages to stabilize or eventually turn higher, shares are likely to bounce. Sprott's Rick Rule, whose firm manages the third-largest ETF in the space, the Sprott Gold Miners ETF (SGDM | B-71), sees the ingredients in place for a turnaround.

Indeed, at some point, the sector may even become attractive to value investors. The NYSE Arca Gold BUGS Index, perhaps the most popular gold miner index, is trading at levels not seen since the financial crisis. Moreover, the price/book ratio for the index is less than 0.6, the lowest level on record.

The Bottom Line

Gold miners, in general, are not for the faint of heart, and the only certainty is that there will be more big price swings ahead.

In the short-term, the sector is likely to be tied at the hip with gold prices. Longer-term, any recovery and outperformance versus gold will depend on whether the industry as a whole has made the necessary management adjustments and improved its operations significantly.

Otherwise, an investment in miner ETFs doesn't make sense and investors are better off simply buying a physically-backed gold ETF for their precious metals exposure. Investors have every reason to be skeptical of an industry that has consistently destroyed shareholder value throughout the years.