Whenever I think of gold, I can't help but think of Die Hard: With a Vengence. In the movie, thieves break into a New York bank and use dump trucks to haul out the gold.
Gold is heavy to carry, expensive to transport and a pain to insure. It also must be continuously monitored by authorized custodians to ensure its authenticity. The weight alone, 350 to 430 ounces each, discourages most people from buying physical gold bars. And where would you hide your gold bars once they're delivered to your home?
Luckily, there's an easier way. Some gold ETFs buy and physically own gold bullion. Others trade in gold futures, giving you exposure to significant leverage. Knowing how each works will help you decide which ETF is right for you.
ETFs that Hold Gold Bullion
The SPDR Gold Trust ETF (NYSE: GLD) is the largest traded gold ETF. GLD is actually a trust (hence the name) that owns gold bullion and then issues debt instruments, i.e. shares, that represent a claim on the gold assets. 100,000 share blocks are issued at net asset value (NAV) to Authorized Participants who make a market in the GLD shares and distribute them to end buyers.
Other gold bullion trusts operate similarly to GLD. It's important to note that while a share of a bullion-backed ETF represents a claim on physical gold, the shareholder doesn't actually have gold allocated in his or her name.
The Good
Each share represents an actual amount of real gold. As of September 27, 2010, GLD held 1,300.5 tonnes, or 41,813,063 ounces, of gold worth $54.2 million. Each share of GLD represents one-tenth of an ounce of gold, enabling anyone to invest even with a small capital investment. GLD should always track the price of gold -- it should trade just a hair below 1/10 the price of an ounce of gold.
Gold bullion trusts are super liquid. As the most liquid gold ETF, it is easy to buy and sell your GLD shares on the market. As of September 27, 2010, the three-month average trading volume was 11,906,000 shares per day on 418,130,630 total outstanding shares.
John Paulson likes it. According to its latest 13-F filings, John Paulson’s hedge fund, Paulson & Co., holds about $4 billion of GLD, making his fund the largest holder of the SPDR Gold Trust. Paulson famously bet big against subprime mortgages and earned a rumored $15 billion for his fund in 2007 alone, one of the largest hedge fund pay days in history. If you're looking to invest alongside a guru, he's a good choice.
The Bad
The amount of gold you own declines overtime. To pay the annual fee of 0.40% the trust sells some gold, reducing the amount held by each share. As stated in the prospectus, "gold represented by each share has gradually declined over time." For long-term shareholders, this could represent a notable loss.
Shareholders aren't protected by commodity regulation. Many GLD investors believe they receive the protection of various commodity laws and regulations. This is not true. As stated in the prospectus, "The Trust is not a commodity pool for purposes of the Commodity Exchange Act of 1936, . . .its sponsor is not subject to regulation by the Commodity Futures Trading Commission . . ."
You can't redeem your shares for gold…unless you hold 100,000 shares. Since you own shares in a gold bullion trust, you do not have property rights to the gold. But if you are a large investor, meaning you hold more than 100,000 of a gold ETF, you have the option to redeem your shares for physical gold bullion. You then must assume responsibility for its integrity, storage, insurance, etc. There are funds, like BullionVault, that can allocate gold to individual investors, though must buy at least one 340 to 430 ounce bar.
You have to pay higher taxes. Finally, the gold trust ETFs do not receive a favorable long-term capital gains tax rate. Again, according to the prospectus, the United States Internal Revenue Service (IRS) treats gold as a collectible for long-term capital gains tax purposes. This means you must pay capital gains at the current rate of 28% even if you hold your GLD for more than one year.
ETFs that Trade in Gold Futures
Several ETFs use gold futures to give investors exposure to gold prices. Normally, these ETFs track the price of gold, though they can deviate due to the nature of the futures market, depending on whether it's in backwardation or contango.
The Good
Investors harness the power of leverage. The biggest advantage of futures-based gold ETFs is their ability to use leverage. Leverage allows the fund to control large amounts of gold while putting up only a little bit of money.
Uncle Sam helps pay your fund expenses. The PowerShares DB Gold Fund (NYSE: DGL) seeks to track the Deutsche Bank Liquid Commodity Index – Optimum Yield Gold Excess Return (DGLDIX). By collateralizing futures positions with 3-month U.S. Treasury securities, DGL receives income from Treasury securities that helps offset expenses incurred by the fund. This is typical of futures ETFs.
The taxes are lower than bullion trusts. At the end of the year, your returns from a futures ETF are lumped together and reported on a single Form 1099. Any profits in commodity-based futures (regardless of the holding period) are taxed at the "60/40" rate; 60% is taxed at the favorable long-term rate and 40% is taxed at the short-term rate, giving you a more favorable tax treatment than the gold backed trusts.
The Bad
Higher fees than bullion trusts. Like all funds, the gold futures ETFs charge a fee. DGL charges 0.79% annually, almost twice as much as GLD. Helping to offset the fee is the income derived from holding treasury securities. Unfortunately, Treasuries are now returning less than 0.10%, so not much of that expense is offset.
The fund can also incur higher costs as it rolls contracts. Since futures contracts have expiration dates, the fund managers must roll the front-month to maintain the desired exposure to gold. Rolling the contracts exposes the fund to the risk the prices will vary along the term structure of the futures prices.
Regulators could limit the fund's holdings. The Dodd-Frank Financial Reform bill requires the Commodity Futures Trading Commission (CFTC) to regulate commodities in "finite" supply. The CFTC might restrict the number of futures contracts an entity can hold. This could cause problems for the gold funds and their shareholders.
The Investing Answer: If it's more important to you to buy actual gold, you should look closer at bullion funds. But if you're in the mood for something more speculative with the chance for higher returns, look closer at futures funds.
Before you venture into buying any gold ETF, take the time to read the details in the prospectus of the fund you are considering. Investing in gold is an exciting but volatile market. Be sure you understand the fine print before you commit your hard-earned capital.
P.S. Gold may be hitting new highs, but that doesn't mean it's the most valuable thing in the world. Click here to check out Nine of the Most Surprising Things Worth More Than Their Weight In Gold.
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Cached on May 24, 2012, 1:40 pm