As Markets Shake, Are Investors Watching Gold ETFs Again?

Since 2001, there has been a gold bull market with gold prices having risen steadily to extremely high levels per ounce.  The increase occurred at the same time as U.S. debt continued to rise, thereby weakening the U.S. dollar as compared to other currencies.  In 2005, gold prices reached $500 for the first time since 1987. 

Just three short years later in 2008, gold prices reached $1,000.  The main reason why gold prices took off so rapidly was the financial crisis of 2008.  The crisis increased the demand for actual gold and exchange traded funds that dealt with gold.  In fact, the largest gold ETF, SPDR Gold Trust (NYSE: GLD) had a record of 1320 tons of gold in its possession, which is more gold than what is controlled by the Chinese National Bank.  Additionally, several central banks were planning on increasing their gold reserves, including the Chinese National Bank, the Central Bank of Russia, and the Reserve Bank of India. 

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On December 7, 2010, gold prices reached a new record high of $1,431.60 per troy ounce.  Conversely, the U.S. dollar experienced an all-time low.  These events occurred because there were uncertainties revolving around whether the economic recovery was sustainable, increasing inflation, and the possibility of corporate bankruptcies.   

Additionally, the demand of gold was increasing due to the growing national debt, the low interest rates, and the increasing size of the money supply in the U.S.  Add to this the fact that gold production had declined by 10% since 2001coupled with strong gold demand for jewelry and by institutional investors, led to further skyrocketing of the price of gold.

If gold intrigues you as a worthwhile investment, you may be debating about whether to invest in gold mining shares or in gold ETFs.  Gold mining shares are stocks in companies that are in the business gold mining.  These companies vary in size from multibillion-dollar companies that have large mines in Africa, Australia, Canada, and Nevada to small exploration mining companies that are on the lookout for new areas to find gold throughout the world. 

“Major minors” are those companies that are stable and whose profits will fluctuate based upon what the price of gold is doing.  Smaller gold companies have to find gold before they can mine it and sell it.  Smaller gold companies can be a worthwhile investment if the company is successful in finding a spot of gold and mining it.  If these companies are not successful, however, shareholders can lose all of their investments. 

Gold ETFs enable investors to buy fund shares that directly track the price of an ounce of gold.  Major gold ETFs hold gold bullion to back those shares that are being traded on the exchanges.  Gold ETFs can give investors a way to buy, sell, and trade the value of gold via their brokerage accounts.  The advantage here is that investors of gold ETFs know exactly how their investments will perform in relation to the actual price of gold. 

When the price of gold rises, those who have invested in gold ETFs will see their investments rise along with the price of the metal itself.  Those who have invested in a mining company may see higher profits than those indicated by the price of gold itself.  This varies depending on the company used, as some companies may have sold future production at a cheaper price or used futures to hedge the price of gold. 

When gold prices are flat or falling, a gold ETF provides no growth potential, such as a dividend, to investors other than the price of gold itself.  As a result, the ETF doesn’t do much when the price of gold is falling.  A mining company can provide the investor with a good return on investment even when the gold price stays the same or falls in value.  Shareholder value can be increased due to the payment of dividends or an increase in the production of gold.  It’s important to note, though, that sharp declines in the price of gold can lead to substantial dropoffs in the stock prices of mining shares, though this dropoff is usually just temporary.

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The SPDR Gold Shares ETF (NYSEARCA:GLD) is the largest physically backed gold exchange traded fund (AMEX:ETF) in the world.  It was originally listed on the New York Stock exchange in November 2004; it has traded on NYSE Arca since December 13, 2007.  Besides trading on the New York Stock Exchange, it is also traded on the Tokyo Stock Exchange, the Stock Exchange of Hong Kong, and the Singapore Stock Exchange. 

The second-largest gold ETF, the iShares Gold Trust ETF (NYSEARCA: IAU), is not your standard ETF.  This is because the Trust is not an investment company that was registered under the Investment Company Act of 1940 or a commodity pool under the Commodity Exchange Act.  Additionally, the shares of this ETF are not subject to the same regulatory requirements that mutual funds are.  The iShares Gold Trust ETF (NYSEARCA:IAU) was designed to generally correspond to the day-to-day movement of the gold bullion price.  It is backed by gold and is held by the custodian in vaults throughout the world, including London, Paris, Toronto, New York, and elsewhere.  Investors may also choose to purchase and sell shares through their traditional brokerage accounts.  Shares can be bought or sold at any time during the trading day.  These shares are listed and traded on NYSEArca.

ETFs like the iShares Gold Trust ETF (NYSEARCA:IAU) can represent an effective way for investors who couldn’t or wouldn’t participate in the market for physical gold.  IShares Gold Trust’s volume on April 27, 2012 was 2.594 million, with a 10-day average trading volume of 4.140 million.  It contained 180.17 tons of gold that were located in New York, Toronto, and London.  It was first traded on the New York Stock Exchange on January 21, 2005.

The ETFS Gold Trust (NYSEARCA: SGOL), another popular Gold ETF, reflects the performance of the price of gold bullion minus the expenses of the Trust’s operations.  It issues ETFS Physical Swiss Gold Shares in exchange for deposits of gold and distributes gold when Baskets are redeemed.  ETF Securities USA LLC is the sponsor of this ETF, the trustee is The Bank of New York Mellon, and the custodian is JP Morgan Chase Bank N.A.  It first began trading on the New York Stock Exchange on September 10, 2009.  While some questioned whether another gold ETF was needed with GLD and IAU available, the index creators believe they hold an advantage in that the gold in this ETF is stored in Switzerland, which is generally known as one of the most stable and safest countries in the world due to their history of remaining neutral throughout most conflicts.  The annual expense ratio for this ETF is 0.39% and its average volume on April 27, 2012 was 114,186.

The DB Gold Short ETN (NYSEARCA:DGZ) is an Exchange Traded Note (not Exchange Traded Fund, ETF) that tracks the Deutsche Bank Liquid Commodity Index-Optimum Yield Gold.  It is designed to reflect the performance of specific gold futures contracts along with the returns from investments in 3-month U.S. Treasury Bills.  It was first traded on February 27, 2008.

Lastly, the most popular Gold Miners ETF is the Market Vectors Gold Miners ETF Trust (NYSEARCA:GDX).  This ETF attempts to closely resemble the movements of the price and yield performance of NYSE Arca Gold Miners Index (GDM).  The GDM is a modified market capitalization-weighted index that allows the investor exposure to publicly traded companies that are involved in gold mining from around the world.  The GDX was first traded on May 16, 2006.  The volume for Friday, April 27, 2012 was 8.766 million, with its gross and net expense ratios being at 0.53%.

Executive Summary: There are many investment choices you have when it comes to putting your money into gold.  However, there are two main categories of investments: gold mining shares and gold ETFs.  The advantage with gold mining shares is that investments can really take off if the price goes up, as these shares very closely track the indexes they are associated with, but the disadvantage is that you can lose your entire investment quickly if the price suddenly falls, especially if you invest in gold mining shares of a smaller company.

Conversely, gold ETFs will not jump up as quickly as the indexes they track, since there is a little more divergence with ETFs as compared to gold mining shares, but ETF investors are a little more protected from price fluctuations due to the built-in diversifications of ETFs.

Additionally, gold ETFs don’t offer much value when gold prices are falling, whereas you can still gain on your investment when gold prices are falling thanks to dividends. 

Bottom Line: Many investors are looking to invest in gold as the U.S. dollar continues to remain weak, the EuroZone debt crisis continues with the credit reduction in Spain, and China’s economy is starting to slow in terms of growth.  All in all, if an investor chooses to invest in gold, gold ETFs and gold miner ETFs are a good place to start.

John Nyaradi is the author of The ETF Investing Premium Newsletter.