Our Pick in the Gold ETF Sector

ETF Research written by the Barchart.com ETF Research Team

Last updated: November 15, 2010

Table of Contents

Our Pick in the Gold ETF Sector

Investors who want to invest in gold have several options:  (1) buy gold jewelry, coins, or bars and hold them at home or in a safety deposit box, (2) buy gold certificates from a bank or dealer, (3) buy gold futures contracts, or (4) buy gold exchange-traded funds.

Holding gold at home or in a safety deposit box might seem like a good idea, but the main problem is liquidity since selling the gold back to a dealer to get cash might involve a large discount.  Gold certificates can be attractive in some cases although there is a degree of concern about liquidity, safety, and the degree to which the institution issuing the certificate can be trusted.  Futures contracts provide a large amount of leverage and are very attractive for active traders.  However, holding futures contracts for a long-term gold investment doesn’t make much sense because of the large size of the contracts and because of the uncertain effects of the futures curve and the roll yield on the investor’s bottom line return.  Another choice is buying gold mining stocks, which we will discuss in a separate report.

Gold ETFs have a variety of advantages and have been extraordinarily popular.  As Figure 1 illustrates, the amount of gold held by ETFs has soared from zero in 2004 to the current level of 67 million troy ounces, which makes the ETF industry as a whole one of the world’s largest holders of gold.

Figure 1:  Gold Held in ETFs

The largest gold ETFs hold gold bullion in secure vaults.  These ETF funds are open-ended, which means the number of outstanding shares in the fund can fluctuate up and down.  As with other ETFs, authorized participants can deliver or take delivery on baskets of the underlying asset, in this case gold, in return for shares in the fund.  So in the case of gold, an authorized participant, which is usually a large bank trading desk, can deliver a big quantity of physical gold to the ETF fund’s vaults and receive in return shares in the fund (i.e. creation shares), which the trading desk can then use to sell into the marketplace or use to offset a prior arbitrage trade.  By the same token, an authorized participant can buy ETF shares in the open market and then deliver a block of those shares to the ETF fund and take delivery of physical gold, thus redeeming those shares and causing in a decline in the outstanding total number of shares in the fund.  This in-kind share creation-redemption process, which usually involves arbitrage trading by authorized participants, is what keeps the value of the ETF fund close to the spot price of physical gold and provides liquidity for retail investors who simply want to trade the listed ETF in small-lot shares with good liquidity and depth.

Let’s look at the major gold ETF products in more depth.

GLD – SPDR Gold Shares (web site link ) — SPDR Gold Shares from State Street is the largest gold ETF by far with $57 billion in assets under management.  GLD also happens to be the second largest ETF in existence behind the SPDR S&P 500 (SPY).  GLD was the first gold ETF with its launch in November 2004.  GLD also trades on the Singapore Stock Exchange, the Tokyo Stock Exchange, and the Stock Exchange of Hong Kong. The fund has an expense ratio of 0.40%.  GLD holds gold bullion, which means that the price of the fund correlates very closely with spot gold prices except for the fact that GLD will of course underperform spot gold by the 0.40% annual fee.  All of GLD’s gold is held by the fund’s custodian, HSBC Bank (USA), in a secure vault in London.

IAU — iShares Comex Gold Trust (web site link ) – IAU is the second largest gold ETF with $4.7 billion in assets under management.  IAU holds a total of 3.3 million troy ounces of gold bullion, split among three vault locations with 47% held in Toronto, 31% in London, and 22% in New York.  The fund has a low expense ratio of 0.25%.  The sponsor of IAU is Blackrock Asset Management International Inc. the trustee is The Bank of New York Mellon, and the custodian is JPMorgan Chase Bank, N.A. London Branch.

Unlike the other bullion ETFs, IAU allocates 100% of its gold daily, which means that all of the gold in the fund is fully owned by shareholders and there is no gold in an unallocated account that is subject to counterparty risk.  Other ETF funds have small unallocated quantities of gold due to rounding effects and the need to hold some gold to sell to obtain the expense fee.  The effect of unallocated gold is trivial from a financial standpoint, but it is nevertheless significant that iShares has made effort to eliminate the uncertainties associated with unallocated gold.  As seen in Figure 2, IAU tracks spot gold very closely, except that it underperforms to a small degree due to the annual expense fee of 0.25%.

Figure 2:  IAU iShares COMEX Gold Trust vs Spot Gold (live chart link )

PHYS — Sprott Physical Gold Trust (web site link ) – PHYS has $1.2 billion of assets under management.  This fund trades at NYSE Arca under the ticker symbol of PHYS and also trades at the Toronto Exchange under the ticker symbol of PHY.U.  The Canadian listing gives Canadian investors a convenient way to own a gold ETF.  All of the fund’s gold bullion is held at the Royal Canadian Mint in Ottawa, Ontario, Canada.  The trust is administered by Sprott Asset Management LP, which is a wholly-owned subsidiary of Sprott Inc. a publicly-traded company listed on the Toronto Stock Exchange under the symbol SII.

SGOL — ETFS Physical Swiss Gold Shares (web site link ) – SGOL has $1.0 billion in assets under management.  The fund’s gold bullion is all held in Zurich, Switzerland.  The sponsor is ETF Securities USA LLC.  The fund has an expense ratio of 0.39%.  Even though this fund’s expense ratio of 0.39% is higher than IAU, some investors may prefer this fund since its gold is all held in Switzerland.  Investors who are particularly suspicious of government intervention and regulatory abuse might be more comfortable with their gold being held in Switzerland, rather than in New York, London or Canada.  Knowledgeable gold investors are well aware that the U.S. government in 1933 effectively confiscated gold from the public.

DGL-PowerShares DB Gold Fund (web site link ) – DGL is the fifth largest gold ETF with about $300 million of assets under management.  This ETF holds futures contracts rather than gold bullion. Specifically, DGL tracks the Deutsche Bank Liquid Commodity Index — Optimum Yield Gold Excess Return.  The fact that DGL holds futures contracts means that the value of DGL can deviate substantially from the spot price of gold due to the fact that futures contracts may trade substantially above or below spot prices (for further information on the contango effect on ETFs, please see our report Commodity ETP Performance and the Importance of the Futures Curve and Contango .

DGL uses what Deusche Bank calls its Optimum Yield methodology for seeking to minimize the effects of negative roll yield that may be experienced by conventional commodities indexes.  The index is rolled each period into the futures contract that produces the best roll yield, which the firm says has the effect of minimizing the negative effects of contango and maximizing the beneficial effects of backwardation.  Nevertheless, we see no reason for investors to choose DGL over one of the gold bullion ETFs because the average investor does not want to take on the uncertainty generated by the roll yield on the futures contracts.  In addition, DGL has management fee of 0.75%, the highest of the group.  To top it off, Figure 3 illustrates that DGL has substantially underperformed spot gold over the past several years and by much more than IAU, for example (see Figure 2).

Figure 3:  DGL-PowerShares DB Gold Fund vs Spot Gold (live chart link )

UBG – UBS E-TRACS CMCI Gold Total Return – UBG has only $6 million in assets under management, which in our opinion means this product is too small for an investor to consider.

Investment Conclusions

Our pick for the gold ETF sector is the iShares COMEX Gold Trust (IAU).  Our reasons for picking IAU are as follows:  (1) IAU has a low expense fee of 0.25% relative to GLD’s 0.40% or SGOL’s 0.39%, (2) IAU holds its bullion in three different locations (New York, London, and Canada) versus GLD’s concentration in London, with that diversification reducing regulatory and physical risks, and (3) IAU has made its structure more transparent and attractive to investors by making its gold 100% allocated to the shareholders’ account.  As mentioned earlier, we would recommend against DGL because we have a preference for gold bullion ETFs over gold-futures based ETFs and because DGL has a substantially higher expense ratio of 0.75%.

Leveraged and Short Gold Exchange-Traded Products

There are several leveraged and short gold exchange-traded products.  Most of the PowerShares and ProShares gold products are double leveraged products (long or short), which means the return on the ETF should be twice as much as underlying spot gold, for better or worse.  If spot gold rallies by 5%, for example, then a double-long gold ETF should rally by about 10% (less fund expenses, trading slippage, brokerage commissions, etc.) and a double-short ETF should lose about 10%, and vice versa.

It is important to note that an investor can also get short and get leverage with the regular 1X gold ETFs mentioned earlier with the shorting and margin features offered by most brokerage firms in an investor’s brokerage account.  For example, an investor can essentially create a double-long (2X) ETF by simply buying a regular 1X ETF with 50% margin in his/her brokerage account.  By borrowing 50% of the funds needed to buy the ETF, an investor is gaining 2X leverage.  An investor can get a short ETF gold effect in his/her account by simply shorting a regular 1X gold ETF.

The following is a list of leveraged and short exchange-traded products:

• DGP — PowerShares DB Gold Double Long ETN - $500 million in assets under management (AUM).
• DGZ – PowerShares Gold Short ETN — $30 million AUM.
• DZZ – PowerShares DB Gold Double Short ETN –$100 million AUM.
• UGL – ProShares Ultra Gold ETF – $240 million AUM.
• GLL — ProShares UltraShort Gold ETF – 80 million AUM.

The three PowerShares ETN products (web site link ) are all based on the Deutsche Bank Liquid Commodity Index-Optimum Yield Gold index.  As we have explained in other reports, we are not fans of exchange-traded notes (ETNs) because of the counterparty risk and the possibility that an investor could lose his/her entire investment if the fund’s backer should go bankrupt.  In addition, these ETN products track an index that is based on futures, which means these ETNs are subject to the vagaries of the futures curve and contango, making them less attractive than the gold bullion ETFs in our view.

The two ProShares ETFs (web site link ) hold gold futures and gold over-the-counter forward contracts, which again brings up the risks of the roll yield and contango.  In addition, the forward contracts have higher counterparty risks than futures contracts, which are guaranteed by a well-backed AAA-rated clearing corporation.

The PowerShares and ProShares short and leveraged exchange-traded products can be appropriate for investors or traders who are just looking to take a short-term position in the market.  However, for longer-term positions, we think it is more attractive for an investor to stick with the IAU-iShares Gold Trust ETF and use the privileges available in most brokerage accounts to gain the desired short or leverage effects.

By the Barchart.com/ETF Research Team

Last updated:  11/15/2010