Gold Equity Funds versus Gold ETFs

The demand for investment products has significantly increased over the past decade with the number of funds available to a retail investor interested in exposure to gold and precious metals providing numerous international opportunities. One primary consideration for any investor is whether they would prefer to own an actively managed fund or if they prefer to minimize investing fees and to limit the security or market timing risks of failing to correctly anticipate the future. An obvious follow up option is whether they would prefer a fund that owns gold equities or whether they would prefer exposure to the price volatility of physical gold. There are gold ETFs that track the physical price of gold and there are also gold ETFs that have exposure to a variety of gold mining and exploration stocks. With the tremendous abundance and variety of products available, a fundamental answer could involve the initial reason for adding the asset class to a portfolio.

Growing market and investment risk

As the market in gold ETFs has grown in size, so has the level of complexity and diversity of ETF products.

Many ETFs work by replicating the index they are linked to by simply reconstituting the basket of physical securities underlying the index. A number of gold ETFs track an index such as the Dow Jones North America Select Junior Gold Index or the FTSE Gold Mines Index can be an attractive investment due to low costs, tax efficiency and share-like characteristics. These ETFs can provide a relatively inexpensive and effective way to track an asset class; they have proved to be increasingly popular, and have established a successful track record with ample liquidity and traded volume.

Synthetic gold ETFs, work through entering into asset swap, such as an OTC derivative, with a counterparty, rather than physically replicating the index. Synthetic ETFs of this variety allow the underlying investment to enter into a greater number of transactions and present the opportunity of investing in assets where physical holding of the asset is not possible.

The rapid development of synthetic ETFs in Europe has seen them capture a considerable market share of the demand and the numbers are growing. Fueling this growth, according to the Financial Stability Board (FSB), are the cost synergies demonstrated between banking interests. In some instances, the ETFs can employ financial correlations using derivatives and leveraging which has generated some concern and opposition that they may be creating a new form of systemic risk. With derivative trading desks acting as swap counterparty to the bank’s proprietary asset management arm, it can become relatively cost effective and easy for investment banks to produce synthetic ETFs. Further, while U.S. regulators consider restrictions on the use of derivatives in ETFs, European ETF regulation has been minimal.

Short term outcome: year to date analysis

Upon initial screening, this year’s performance attribution seems to indicate the strongest appreciation for ETFs tracking the price of gold with SPDR Gold Shares, the biggest ETF up 7.1 percent; while according to Morningstar Inc. the average equity fund in the category has declined 7.7 percent.

This may represent a lag time, where the market is discounting the value of gold mining companies while insatiable demand for the yellow metal as a hedge against market risks and currency depreciation is a premium; however, in general a disparity in returns is often because gold mining equities are a leveraged play on gold.

Hypothetical case study

In an overly simplified example, if it costs a mining company $800 to produce a troy ounce of gold, and gold is $1,500 per troy ounce, the profit for the company is $700. If gold rises to $2,000, the profit becomes $1200. The marginal difference is equivalent to a 42 percent increase in profits generated from a 25 percent rise in the price of physical gold. As a result, gold stocks have, over time, demonstrated greater volatility compared with the price of gold.

Investors will realize that there are numerous other complicating issues and variables when it comes to gold mining companies and the funds that invest in them. Individual companies can face production and operational problems, geopolitical considerations and multifaceted financial, interest rate, and currency exchange complications.