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Gold. What a decade it has had. The seemingly unstoppable precious metal goes higher and higher year after year relative to fiat currencies. Whether you own it as a store of value or because you are hoping to expand your wealth in fiat currency, gold has worked. For those investors comfortable enough with their asset allocation in gold to diversify their precious metals exposure, besides silver (NYSEARCA:SLV) and platinum (NYSEARCA:PPLT), the Market Vectors Gold Miners ETF (NYSEARCA:GDX), managed by Van Eck Global, is a popular alternative.

What is Van Eck Global seeking to accomplish with the GDX? Its stated goal for the GDX is to “replicate as closely as possible, before fees and expenses, the price and yield performance of NYSE Arca Gold Miners Index (GDM).” When I read this, two questions immediately come to mind. First, what is the GDM? And second, how well does the GDX correlate to the GDM?

Van Eck’s website defines the GDM as a “modified market capitalization-weighted index (that) provides exposure to publicly traded companies worldwide involved primarily in gold mining, representing a diversified blend of small-, mid- and large- capitalization stocks.” In terms of the correlation between the GDX and the GDM, it is very strong. By overlaying charts of the two, beginning with the GDX’s inception in May 2006, one can easily see that the correlation between the two is strong both in terms of magnitude and direction. The bottom line is that since May 2006, the GDX has tracked the GDM quite well. While the two may deviate on a day-to-day basis, for those investors holding the GDX over a prolonged period of time, surely they have been pleased with the results.

Now that we know the GDX accomplishes what it aims to do, the question is, should we invest in it? And to answer this question, I want to know how well it tracks the price of gold (NYSEARCA:GLD). Using the GLD as a proxy for gold prices, when overlaying charts of the GLD and the GDX, one easily sees that the GLD has outperformed the GDX by roughly 10,000 basis points since May 22, 2006. That is worth repeating. Since May 2006, the GDX has not provided exposure to gold commensurate to the metal’s actual price performance, but it has instead underperformed by roughly 10,000 basis points. I am aware there are multiple ways to get direct exposure to gold prices (futures, allocated account at depository, unallocated account at depository, physical gold not held in depository, GLD, etc.) and depending on the manner one chooses, it may alter the exact underperformance of the GDX. Nevertheless, I hope the point is well taken.

Given the extreme underperformance of the GDX relative to gold, one question an investor should immediately ask is whether it is worth owning the fund at all. And, if it is not worth owning, is it perhaps worth owning certain miners? To help think through these questions, let’s take a look at the fund’s holdings, as provided by Van Eck Global on its website:

All Fund Holdings as of 12/06/2011

Number

Holding

Ticker

Shares

Market Value

% of net assets

1

Barrick Gold Corp

ABX

32,059,031

$1,646,204,558.20

16.96%

2

Goldcorp Inc

GG

26,085,064

$1,359,292,685.04

14.01%

3

Newmont Mining Corp

NEM

15,851,555

$1,069,979,962.50

11.03%

4

Anglogold Ashanti Ltd

AU

12,353,341

$579,810,996.57

5.98%

5

Kinross Gold Corp

KGC

36,454,425

$504,529,242.00

5.20%

6

Yamana Gold Inc

AUY

29,046,699

$475,494,462.63

4.90%

7

Gold Fields Ltd

GFI

27,855,128

$472,701,522.16

4.87%

8

Randgold Resources Ltd

GOLD

3,986,676

$424,102,592.88

4.37%

9

Silver Wheaton Corp

SLW

12,169,435

$407,919,461.20

4.20%

10

Cia De Minas Buenaventura Sa

BVN

10,386,239

$396,797,017.34

4.09%

11

Eldorado Gold Corp

EGO

22,854,793

$388,302,933.07

4.00%

12

Iamgold Corp

IAG

16,339,059

$309,951,949.23

3.19%

13

Agnico-Eagle Mines Ltd

AEM

6,761,773

$295,143,748.57

3.04%

14

Harmony Gold Mining Co Ltd

HMY

18,725,219

$266,085,361.99

2.74%

15

New Gold Inc

NGD

19,587,612

$208,608,067.80

2.15%

16

Royal Gold Inc

RGLD

2,374,711

$191,282,971.05

1.97%

17

Pan American Silver Corp

PAAS

4,698,183

$116,092,101.93

1.20%

18

Aurico Gold Inc

AUQ

12,179,899

$112,664,065.75

1.16%

19

Coeur D'Alene Mines Corp

CDE

3,903,363

$112,690,089.81

1.16%

20

Hecla Mining Co

HL

12,191,360

$79,609,580.80

0.82%

21

Nevsun Resources Ltd

NSU

8,618,146

$51,795,057.46

0.53%

22

Silver Standard Resources Inc

SSRI

3,498,475

$50,168,131.50

0.52%

23

Minefinders Corp

MFN

3,535,839

$42,147,200.88

0.43%

24

Aurizon Mines Ltd

AZK

7,082,335

$41,077,543.00

0.42%

25

Seabridge Gold Inc

SA

1,845,995

$40,427,290.50

0.42%

26

Golden Star Resources Ltd

GSS

11,259,458

$23,870,050.96

0.25%

27

Great Basin Gold Ltd

GBG

20,650,324

$20,856,827.24

0.21%

28

Tanzanian Royalty Exploration Corp

TRX

4,343,342

$12,725,992.06

0.13%

29

Vista Gold Corp

VGZ

3,099,238

$11,374,203.46

0.12%

There are two things I would immediately like to explore:

First, let’s review the definition Van Eck’s website provided for the GDM. It used the word “primarily” in a way that stood out to me. The GDM “provides exposure to publicly traded companies worldwide involved primarily in gold mining.” What I would like to know is just how much exposure to metals other than gold the Market Vectors Gold Miners ETF has. Without going through each company one-by-one and examining the breakdown of their mining operations, when briefly scanning the list of 29 companies, three immediately stand out to me. This is because they have the word “silver” in their names: Silver Wheaton (NYSE:SLW), Pan American Silver (NASDAQ:PAAS), and Silver Standard Resources (NASDAQ:SSRI).

By virtue of the fact that the GDX has included three companies largely exposed to silver prices (SLV), I want to spend some time checking the correlations between each of the 29 companies and the GLD. Sure enough, the correlations between some of these stocks and the GLD have broken down in a big way over the past year. For the three silver stocks I just mentioned, we can point to silver prices peaking in April of this year as the reason for the breakdown in correlation. Silver headed lower, whereas gold headed higher. To explain the other breakdowns in correlations I found, further investigation is needed. Of course, given the huge underperformance of the GDX relative to gold over time, it would be expected that the magnitude of the moves in many of these stocks would largely underperform gold prices. But, if the directional correlation itself is not even there, then I start to wonder why I would want to have exposure to that particular equity.

Second, let’s take a look at the relative lack of diversity in terms of the concentration of assets between the 29 companies. A whopping 75.61% of net assets are invested in the top 10 holdings. This means that approximately one-third of the stocks in the fund amount to roughly three-quarters of the net assets. In fact, just over half, or the top 15 holdings in the GDX, account for 90.73% of net assets. Investors not opposed to owning 15 stocks rather than the convenience of owning one ETF could replicate a significant portion of the fund’s exposure while avoiding the smaller capitalization stocks the GDX holds.

Furthermore, by owning individual stocks rather than the fund, an investor would avoid the expense ratio, currently at 53 basis points. This means that all things remaining equal, the 9.27% of the fund’s exposure left by the wayside would need to rise 5.72% each year just to make up for the expense ratio being avoided by only owning the top 15 holdings.

There are many other ideas that could be explored in an attempt to create a better correlation in terms of price between a portfolio of gold miners and gold prices. Such ideas could center on the dividend paying miners or between combining stocks from the GDX with a couple from the Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ). An investor could also look to drop the stocks with heavier exposure to metals other than gold. Furthermore, investors could even focus on buying just a handful of the top holdings in the GDX under the assumption that the effects of indexing will make the portfolio more or less no worse off in the event one of the companies runs into trouble.

Of course, exploring and eventually executing any of these ideas would require a decent amount of work. I understand that it is much more convenient to simply buy the GDX and be done with worrying about how to improve the correlation to gold prices. If convenience plays a dominant role in your equity allocation decision making, then the GDX might be a better route than buying several individual stocks.

Source: How Well Do You Know Your Gold Miners ETF?

Additional disclosure: I am long gold, silver and platinum.