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By Stoyan Bojinov

In recent years, exchange-traded funds have become popular as vehicles for financial advisors and individual investors looking to establish exposure to gold, a precious metal that has tremendous appeal both as a means of enhancing returns and smoothing overall portfolio volatility. The most popular gold ETFs, such as GLD and IAU, offer investors direct access to the yellow metal through a physically-backed structure that includes gold bullion as the underlying holdings. But other approaches to betting on gold have also become popular in recent years; more and more investors are now electing to establish “indirect” access through stocks of companies engaged in the extraction and production of precious metals.

Some investors are hesitant to hold gold because of uneasiness over concentrating wealth in an asset that will never make a dividend or coupon payment. Exposure to the metal through the stocks of companies engaged in the discovery, extraction, and production may be an intriguing alternative. Just like any other company, the profitability of gold miners–and therefore the value of their stock–depends on the market price for their goods and services. In other words, a general relationship should hold: when gold prices go up, so too do the prospects for the companies that get the metal out of the ground. As such, gold miners often trade as leveraged plays on spot gold prices, allowing investors to achieve indirect access to an asset class that has delivered some huge returns in recent years.

The Global X Pure Gold Miners ETF (GGGG) is a relatively new product that offers an interesting alternative to one of the most popular ETFs in the world. The investment thesis behind GGGG is relatively straightforward; positions in gold mining stocks may allow investors to achieve indirect exposure to the precious metal while avoiding some of the potential pitfalls that make some nervous about physically-backed or futures-based gold strategies.

Under The Hood

We view GGGG as an alternative to the Market Vectors Gold Miners ETF (GDX), one of the largest ETFs in the world with assets of about $7 billion. But while GGGG is perhaps an alternative to the ultra-popular GDX, it should be noted that these funds are far from identical–even if there are similarities in the names of the products. While there is some overlap between the two portfolios, the differences are both significant and numerous. Perhaps the most important element of GGGG is the strict membership requirements for inclusion in the underlying index; companies must generate the vast majority of their earnings from gold mining in order to be included. Perhaps somewhat surprisingly, that distinguishes this product from GDX, which includes several stocks whose operations revolve around silver mining.

For example, Silver Wheaton (SLW) is one of the largest individual components of GDX. And a number of other firms that make up that portfolio also have limited gold-centric operations: Pan American Silver Corp. (PAAS) and Silver Standard Resources (SSRI) are also included in the portfolio. And while the majority of companies that make up the GDX portfolio generate the majority of their revenues from gold, most of them also maintain material operations that revolve around other metals–both precious and industrial.

Pure Miner Difference

Gold and silver often exhibit strong correlations, but certainly are not interchangeable. Some of the price drivers behind these two precious metals are definitely unique, and the mix of exposure to these assets through mining stocks will definitely have an impact on the bottom line risk/return profile realized. GDX relied on gold for the majority of its indirect precious metals exposure through the mining stocks held, but silver makes up a meaningful portion of the portfolio as well. GGGG, on the other hand, consists almost exclusively of gold exposure. For different investors, of course, different strategies may make sense. Those who prefer some diversification among the underlying metals may gravitate to GDX, or even PSAU. But for those looking to isolate gold exposure with their mining stock portfolio, GGGG is the clear winner.

The focus on only pure play gold miners also has some other interesting ramifications on the GGGG portfolio. Compared to GDX, the allocations to small and mid cap companies is considerably greater. That impacts the risk/return profile as well; GGGG doesn’t have much in the way of exposure to diversified mining giants, focusing instead on smaller firms with gold-centric operations.

As far as the portfolio itself, GGGG is similar to many other targeted sub sector-specific ETFs; there is a relatively shallow basket of underlying securities and significant concentration. About 30 stocks in total make up GGGG, with ten of those accounting for about half of total assets. Though no one name makes up more than about 6% of assets, the portfolio is clearly top heavy and subject to outsized impact by movements in a small handful of stocks.

Pros

The biggest advantages of GGGG come in the unique methodology used to construct the underlying index. The strict membership requirements are clearly an advantage for any investor looking to isolate gold exposure through mining stocks. Though GGGG may appear to be generally similar to GDX on the surface, a closer look shows that these two ETFs are actually quite different in terms of the exposure offered and the risk factors that must be considered.

Another advantage for certain traders is the availability of GGGG for commission free trading on the Interactive Brokers platform; for investors with reasonably high turnover, the ability to trade without forking over traditional brokerage fees might be a big advantage.

Cons

The potential disadvantages of GGGG are not too serious. The concentration mentioned above should of course be considered, and it’s also worth noting that this ETF has average daily volumes considerably lower than GDX. That doesn’t mean that investors should steer clear, but it certainly makes sense to be cautious when executing trades and embrace the powers of limit orders. Finally, GGGG is a bit more expensive than the Van Eck competitor. The gap in annual fees is relatively small–just six basis points–so this issue shouldn’t really be of much concern.

Final Verdict

GGGG is a very unique way of achieving exposure to gold prices, giving investors an option that targets the yellow precious metal exclusively. For some, that may be ideal; the silver exposure included in funds like GDX and GDXJ may be less than optimal for investors with a very specific outlook. Others may not mind having a little diversification; funds like GDX or PSAU may be better choices for anyone in that camp.

Regardless of which gold miner ETF is used, investors should note that the assumption of strong correlations with spot gold prices doesn’t always hold. While it can generally be expected that gold mining stocks will move along with market prices for gold, it’s important to remember that that won’t always be the case. Mining stocks are, after all, stocks, and as such will sometimes exhibit risk/return profiles that differ from commodities such as gold. The first half of 2011 serves as a powerful reminder of this phenomenon; gold prices skyrocketed during that stretch, but mining stocks struggled. Funds like GGGG and GDX lagged behind physical gold ETFs by as much as 20%, no doubt frustrating those investors who utilized these funds to achieve exposure to the precious metal.

Disclosure: No positions at time of writing.

Source: Gold ETF Analysis: Global X Pure Gold Miners ETF (GGGG)