Among Gold ETFs, Bigger Isn't Always Better

by: Michael Johnston

As the roster of exchange-traded products has grown to nearly 1,300, many investors find themselves with the luxury of multiple options for establishing a position in a desired asset class. There are, for example, four different pharmaceutical ETFs, three homebuilder funds and even two choices for playing the automotive industry.

Once the ETF universe has been whittled down to funds that fit a given investment objective, there are a number of strategies for determining which of the candidates represents the most efficient way to play. It makes sense, for example, to compare ETFs on the basis of expenses, depth of holdings, liquidity and tracking error. But many investors are much more basic in their assessments. There is a tendency among ETF investors to gravitate toward the biggest products in favor of smaller or lesser-known funds. If bigger is indeed better, this approach should work well. The size of a product would reflect its general efficiency and usefulness to investors. But in reality, a big AUM total is just as likely to result from a lengthy operating history and strong brand recognition. For ETF investors, following the crowd isn’t always the best path. Often, there are better options available for those willing to dig a bit deeper.

Gold ETFs In Focus

Gold is another asset class that is accessible through a number of different exchange-traded products. There are currently seven different gold ETFs, in addition to several more focusing on precious metals or mining and exploration stocks. And it’s also a corner of the market where some of the better options may be those that are smaller alternatives to the 800 pound gorillas.

For investors seeking to achieve exposure to gold through ETFs, there are three general strategies: holding physically-backed funds that invest in gold bullion, using futures-based products, or achieving “indirect” exposure through stocks of companies engaged in the discovery and extraction of the precious metal. In each of these three categories, there is a clearly dominant product that has attracted the lion’s share of assets. But there are also intriguing alternatives to each that may represent a better way to invest in gold.

Physical Gold ETFs: GLD vs. IAU

GLD is not only the largest physically-backed gold ETF, it’s the biggest ETF in any asset class thanks to a flight to precious metals in recent weeks. GLD has more than $75 billion in assets, dwarfing the combined total of the other three physically-backed gold ETFs available to U.S. investors (IAU, SGOL, AGOL). But GLD’s massive size doesn’t necessarily indicate that it’s the best way to access this precious metal.

Because gold is a commodity, so too are the exchange-traded funds that hold bullion. There are few opportunities for these products to distinguish themselves from the competition. One such opportunity is expenses. Because the assets held by gold ETFs are uniform in nature, differentials in expense ratios should translate pretty clearly into differentials in bottom line returns. And in this arena, IAU holds a significant edge. The expense ratio charged by the iShares product undercuts GLD by 0.15% per annum. That obviously isn’t a huge amount, but it is significant enough to virtually guarantee that IAU will outperform GLD on a regular basis. Gold is gold, regardless of which ticker it’s stored under. But expense differentials lead directly to gaps in performance, making it a bit strange that the world’s largest ETF is destined to underperform its much smaller competitor (though IAU’s $9 billion in assets is still an impressive total).

Futures-Based Gold ETFs: DGL vs. UBG

Futures-based gold ETFs are understandably much less popular than their physically-backed counterparts. While funds such as GLD and IAU track the spot price of gold with precision, nuances related to futures-based strategies can create gaps between movements in spot bullion prices and products such as the PowerShares DB Gold Fund (NYSEARCA:DGL) and UBS Gold Total Return ETN (NYSEARCA:UBG). When interest rates are depressed - as in the current environment - the interest earned on uninvested cash often isn’t significant enough to offset the adverse impact of contango.

Among the futures-based gold ETPs, DGL is dominant. This ETF has nearly $400 million in AUM, compared to less than $10 million for UBG. But again, there are elements of the much smaller product that may give it the edge over the much larger competitor.

Futures-based gold ETPs are less homogeneous than physically-backed funds, in part because the “roll” process that is a critical component of any futures-based product can be completed in any number of ways. DGL is part of the suite of ETFs linked to “optimum yield” benchmarks that determine the roll process based on the slope of the futures curve. UBG, on the other hand, is linked to an index that is diversified across five constant maturities from three months up to three years. But that’s not where UBG might have an edge. It would be foolish to declare one of those strategies to be universally superior.

Similar to GLD vs. IAU, the UBS gold product has a major advantage in terms of cost efficiency: UBG charges just 0.30% annually, while DGL charges 0.75%. That’s a major difference in expenses that will flow through to bottom line returns.

Another key difference relates to the structure of the products in question. DGL is a commodity pool, while UBG is an exchange-traded note (ETN). Though ETNs have taken a bum rap from many analysts due to the inherent credit risk, there are some potentially significant advantages to this structure. First, the potential for tracking error, which can be significant in any futures-based strategy, is eliminated since there is no underlying portfolio. Second, the tax treatment may be advantageous compared to commodity pools such as DGL. IRS regulations require that the PowerShares fund be marked to market at the end of each year, with gains or losses, then assigned to investors based on their ownership interest. So even if you don’t liquidate a position in DGL during the year, you could owe taxes on any gains incurred. There’s nothing like an unexpected visit from the tax man to take a bit of the shine off of a stellar performance.

ETNs, on the other hand, will generally only incur taxes upon liquidation - potentially creating a nice loophole for investors looking to establish exposure to commodities. It’s interesting to note that UBG has generally outperformed DGL, yet maintains a considerably smaller base of assets.

Gold Miners: GDX vs. GGGG

Many investors have elected to establish “indirect” exposure to gold prices through stocks of companies that are responsible for digging the metal out of the ground. Because the profitability of gold miners depends on the price they are able to charge for their products, the values of these companies tend to move in unison with spot prices (though the relative performances in 2011 are evidence that this relationship is far from perfect).

The Market Vectors Gold Miners ETF (NYSEARCA:GDX) is one of the largest ETFs in the world with nearly $9 billion in assets. With a portfolio that consists of many of the largest gold miners, this ETF has become a popular tool for those bullish on this corner of the materials market. But there are some potential drawbacks to this product. First, GDX is extremely top-heavy and somewhat lacking in terms of balance: 10 stocks account for nearly three quarters of total assets. Second, some of the component companies generate substantial revenues from other industrial and precious metals, potentially resulting in a weaker correlation with spot gold prices. One of GDX’s largest holdings, Silver Wheaton Corporation (NYSE:SLW), focuses primarily on a metal, silver, that has historically exhibited very different returns.

The Global X Pure Gold Miners ETF (NYSEARCA:GGGG) is one alternative that addresses these concerns quite nicely. In order to be included in the underlying index, a company must generate all or substantially all of its revenues form gold mining. That requirement strips out diversified mining companies and gives a more targeted focus on gold. It also has the impact of lessening the concentration, since more small-cap stocks are included. GGGG’s top 10 assets account for about half of the portfolio.

The comparison between these two gold miner ETFs isn’t the same as those head-to-head analyses made above. Either one of these products may be appealing to investors depending on their specific objectives and risk tolerance. And GGGG certainly isn’t a lock to outperform GDX, whereas the other two “underdog” ETFs had clear performance-related advantages.

Going beyond the industry’s big dogs can be a rewarding activity. In many cases, excellent ETFs come in small packages.

Disclosure: No positions at time of writing.

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