What to Invest In: Gold ETFs
This article will focus on the most popular way to invest in gold: through physical gold ETFs and gold mining ETFs. Actively managed gold mutual funds are not my focus since I do not believe I am able to select funds that will outperform their index benchmarks. (I’m skeptical about whether anyone can.) Nor am I going to suggest buying gold coins or bars, since I believe the costs of transaction, storage, and insurance make that impractical for most people. Buying shares in individual gold mining companies is certainly a valid strategy, but I prefer to diversify stock-specific risk with funds.
The table below is the list of funds that I would like to highlight. In addition to the largest and most popular funds, I include a few smaller funds either because of their low cost or because of their potential tax advantages. Physical gold funds are taxed as collectibles just like directly owning gold bars, and the IRS is not very friendly to gold investors, as we shall see below, so avoiding tax may be an important consideration for taxable accounts.
As a basis of comparison for some of the statistics, at the bottom of the table I included a few of the largest mutual funds.
Why to Invest in Gold
Physical gold funds and gold mining funds are excellent diversifiers of stock market risk. In the table above, the market R-squared statistic measures how much of the return of a fund is explained by S&P 500 return. The lower this number, the more incremental diversification of market risk a fund provided over the past 36 months (the time period I use for all of these statistics). Both physical gold funds and gold mining funds have much lower market R-squared statistics than U.S. or international equity funds.
Bond funds also do an excellent job of diversifying market risk, but the expected return on bonds (yield) is very low compared to historical norms. Also, if interest rates increase, bond funds often experience negative returns. Physical gold funds and gold mining funds can experience negative returns too, but not usually at the same time as bond funds, so gold can also diversify bond market risk.
Gold-related assets also tend to diversify U.S. dollar risk. Gold, Treasury bonds, and the U.S. dollar are all considered “safe haven assets.” Gold has a particularly strong negative relationship with the U.S. dollar, providing protection for those periods when the dollar declines in value, as it has this year. With the blowout fiscal deficits and unprecedented monetary expansion since the Covid-19 pandemic, many analysts expect further weakness in the dollar in the months and years ahead.
Over the long-term, the price of gold has not had a tight relationship to inflation. Over extremely long time periods, it has been a good store of value, but over monthly or annual intervals, the relationship is indeterminate. Perhaps some of the uncertainty in the relationship has to do with the varying causes of inflation. For example, the Arab oil embargo was an inflation shock that did not much affect the price of gold.
Arguably, the inflationary spiral of the 1970s, although sparked by the price of oil, was fed by various legal, regulatory and cultural barriers to the free flow of goods, services, and labor. Weak competition allowed prices to slowly rachet upwards.
Restrictive monetary policies at the Fed under Volker broke the inflationary spiral in the early 1980s. At the same time, global trade slowly increased, providing more effective competition in many goods and services. Also, increased use of technology made the production of goods and services more efficient.
In recent years, we have been experiencing a reversal in all of these trends that heretofore have kept inflation under control. In the wake of the Great Recession, the Fed not only lowered short-term interest rates to zero, but began a policy of “quantitative easing,” which was designed to drive down longer-term interest rates. They had not had a chance to normalize their monetary expansion when the Covid-19 pandemic hit. Their response has been essentially a doubling-down of the monetary expansion.
Global supply chains have been disrupted by the pandemic. Global trade tensions, already escalating, may further harden, disrupting the efficiencies of global competition. Recent technological progress has not been translated into enhanced labor productivity as most focus has been on personal rather than business use of technology.
Inflation in the prices of goods and services has been tame because of the government shutdown of the economy, but inflation was quick to arise in the prices of financial assets, particularly stocks and bonds. It is reasonable to assume that, given present trends, inflation will increase in the years ahead. Perhaps dramatically. Gold is likely to prove a good hedge against this risk.
Investors already seem to be attuned to the potential benefits of gold in the current economic and policy environment. The cumulative return of three representative ETFs through June 30 is shown in the graph below: 1) SPY (S&P 500), 2) GLD (physical gold), and 3) GDX (gold mining shares). Physical gold, shown in green, has powered through the Covid-19 environment, rising to a cumulative return of about 23%. Gold mining shares were caught in the downdraft, but have recovered much more strongly than the overall equity market, rising to a 12-month return of about 37%. By comparison, the S&P 500 is up only about 7.5% over the 12 months ending June 30.
Since the Fed’s aggressive expansionary policy only took place in the last few months, it is recent returns that have been most affected by it. It appears that a rise in the price of gold has been fueled by it, and that gold mining shares have been supercharged by it.
To put the recent performance of gold mining stocks into perspective, the graph below shows the 12-month exponentially-weighted average monthly return of my universe of 72 sector- and industry-specific ETFs as of June 30. Two gold mining funds are among the highest:
- 5.94% VanEck Vectors Gold Miners ETF (GDX)
- 6.55% VanEck Vectors Junior Gold Miners ETF (GDXJ)
This very strong performance is supported by upward revisions in analyst’s earnings expectations for gold miners:
In addition to this underlying fundamental driver, analysts are also very positive in their overall assessment of these companies, as reflected in their very high buy-sell average ratings:
Historically, there has been a strong tendency for industries with these characteristics—1) strong trailing 12-month returns, 2) positive revisions of analyst EPS forecasts, and 3) high average analyst buy-sell ratings—to continue to perform well.
In addition, two other factors may help gold to continue its upward trajectory. The first is extremely low interest rates. Traditionally, the lack of “carry” (dividends or interest) has detracted from the appeal of gold as a long-term investment. However, in the current environment, that concern has been neutralized.
Also, when uncertainty is high and investors are nervous, gold has historically done well. One way of measuring investor risk aversion is with the CBOE volatility index (VIX), which reflects the average volatility expectation for the S&P 500 over the next 30 days. The VIX has been relatively high since the pandemic, which is positive for the price of gold.
How to Invest in Gold
The two most common ways to invest in gold are 1) physical gold funds and 2) gold mining stock funds. Physical gold funds (and their close cousin, gold futures funds) are a direct play on the price of gold. Referring to the first table above, note that the gold R-squared and gold beta for physical gold funds is very close to 100%. Gold mining stocks, on the other hand, have a gold beta of around 300%, so they are essentially leveraged plays on the future price of gold. Also, changes in the price of gold explain only about 50% of the return of gold mining funds. Some of the rest of their return is related to the stock market. Whereas almost none of the return of physical gold is explained by market return (with market R-squared statistics close to zero), the stock market explains about 20% of the return of gold mining stocks.
Consequently, the mix of return and risk is somewhat different for physical gold funds vs gold mining funds. If risk control and diversification are more important, then physical gold may be a better fit for you. On the other hand, if you are more interested in return capture, then gold mining stock funds may be your choice. Especially if you expect higher gold prices, the relatively high gold beta of gold mining funds will maximize your return if you are right.
Physical Gold Funds
The first table above lists four physical gold ETFs. From a risk and return standpoint, there is almost no difference among them. The differences are related to the structural terms of the funds. GLD is the largest in terms of AUM ($70 Bil). It has significantly higher trading volume than the others, which results in an extremely tight bid-ask spread of only .01%. If you are a frequent trader, GLD is likely to be an attractive choice. However, its expense ratio is the highest of the four at .40%, making it the most expensive to hold for the long-term. IAU is also quite large ($27 Bil), has a lower expense ratio of .25%, but has a higher bid-ask spread of .06%. A pair of relatively newer funds are coming up fast and likely to continue to take market share away from the two giants: GLDM and SGOL. Both have a bid-ask spread of .06%. Their expense ratios are markedly lower than those of their two giant competitors. GLDM’s expense ratio is only marginally higher than that of SGOL: .18% vs 1749%. (In tables, it gets rounded down to .17%.) GLDM has the same sponsor (State Street Global Advisors) as the behemoth GLD. This may help it to grow a bit more over time and lead to a thinner bid-ask spread compared to SGOL. Time will tell.
Gold Mining Funds
The two gold mining stock funds are GDX and GDXJ. The difference is mostly in the size of the companies in which they invest: GDX invests in “major” gold mining companies like Newmont, Barrick, and Franco-Nevada, whereas GDXJ invests in “junior” gold miners below the market cap cutoff of GDX. GDXJ has slightly higher gold and market betas, so it is the riskier of the two. Expense ratios and bid-ask spreads are virtually the same between the two. Gold prices explain slightly more, and market returns slightly less of the returns of GDX compared to GDXJ.
Tax-Sensitive Gold Investing
Investors in physical gold funds may be surprised to learn that such funds are taxed as “collectibles” just like actual gold bars. This means that they are not able to take advantage of the preferential tax treatment of long-term capital gains, which are taxed at 0%, 15%, or 20%, depending on income. (As a practical matter, most taxpayers pay the 15% rate.) Gains on collectibles held for one year or less are taxed as ordinary income, the same as most other investments. However, gains on collectibles held more than one year are also taxed as ordinary income, except that the maximum collectibles tax rate of 28% applies. So, the long-term rate would be the lesser of the rate on ordinary income or 28%. This makes physical gold funds less attractive for taxable accounts than gold mining company funds, with dividends and long-term capital gains both taxed at the lower rates, 15% being the most prevalent. Therefore, physical gold funds may be best owned within a tax-deferred account such as an IRA.
There are ways to invest in physical gold without paying the 28% rate on long-term gains. However, the various “cures” may be worse than the disease for many investors. The table below provides a quick summary:
There is a very liquid closed-end fund that invests in physical gold: Sprott Physical Gold Trust Units (PHYS). This is a Canadian trust that trades on the NYSE, making it very convenient for U.S. residents to buy. It is a “Passive Foreign Investment Company (PFIC),” and as such, has different tax regulations. In short, it is possible for PHYS to be taxed like a U.S. stock, with the same preferential rate on long-term gain/losses. However, in order to take advantage of this the taxpayer must fill out IRS Form 8621 each year. This is unfamiliar to nearly all taxpayers, as well as most of their accountants. The form reports to the IRS purchase dates and number of shares held at year-end. It must be filed annually to retain the qualification. Since most clients are put off by even a form as common as the K-1, they are likely to revolt at having to file (or pay their accounts to learn about and file) Form 8621 each year. The difference in long-term tax rate is the difference between 28% and 15% in most cases. Saving 13% in taxes may be worth some trouble.
Credit Suisse X-Links Gold Shares Covered Call ETN (GLDI) is an exchange-traded note, not technically an ETF. As a note, there is credit exposure to the issuer, Credit Suisse. No special form is required, taxes are not due until the shares are sold, and favorable long-term capital gains treatment applies. The fund sells calls, which provide some income and dampen the fund's volatility. The major difficulty with this instrument lies in how thinly traded it is. With only $46 million in AUM, the bid-ask spread is .25%. In addition, the expense ratio is .65%, making it more expensive to hold for the long-term compared to less expensive ETFs such as GLDM. However, saving 13% at the end of the road will go a long way to recoup the additional .47% per year—the breakeven holding period is over 27 years!
By comparison, Invesco DB Gold Fund (DGL) is an actual ETF that owns futures. There is no credit exposure to the issuer, as with an ETN. This security is legally organized as a commodity pool, and it is taxed as such. At the end of each year, all of the futures in the portfolio are “marked to market,” and tax is owed on any net gains. Taxes for this fund are the same as they would be for directly owning futures: 60/40 long-term/short-term capital gains, no matter how long the futures contracts have been owned. Short-term capital gains are taxed at ordinary rates. There are 7 federal income tax brackets for 2020. The middle bracket rate is 24% and applies to income between $168,401 and $321,450 for married filing jointly taxpayers. Taxpayers in this bracket would pay a 15% rate on long-term capital gains. The blended tax rate for such taxpayers investing in DGL would be 18.6% (.6*15% + .4*24%). The tax form used by this fund is the K-1, which many clients loathe, but to avoid paying the 28% rate applicable to collectibles may be worth some hassle at tax time.
- Physical gold funds and gold mining funds diversify stock, bond, and U.S. dollar risk
- They are also likely to be good long-term inflation hedges
- Gold has excellent return momentum which seems likely to continue
- Gold mining stocks have three positive momentum characteristics:
- strong trailing 12-month returns
- positive revisions of analyst EPS forecasts
- high average analyst buy-sell ratings
- Gold mining funds also have favorable tax rates (usually 15%) applied to both dividends and long-term capital gains
- Physical gold funds are taxed as “collectibles” with long-term capital gains taxed at the lesser of ordinary rates or 28%
- Some physical gold funds use structures that avoid this high tax rate, but some combination of high bid-ask spread, high expense ratio, and burdensome paperwork applies to them
- The simplest way to control taxes for gold investments may be to own physical gold funds in IRAs and gold mining funds in taxable accounts