PowerShares DB Gold Offers a Sophisticated Strategy to Small Investors

Out of the 26 funds we added to our PowerShares Momentum Tracker universe to begin 2008, commodity based funds showed some of the most promise. While gold has inspired both issuers and investors alike in recent months, results have been mixed on our Commodities Momentum Table for PowerShares DB Gold Fund (DGL). At the end of January, DGL gained the No. 2 spot, a position that it held for almost a month, before sliding as low as No. 21 last week.

Gold prices, however, may get a renewed boost in the weeks to come. Gold is commonly used as a hedge for inflation, and inaction by the Fed last week has led many to believe that the U.S. dollar may inevitably fall lower. While the Fed does seem to be increasingly concerned about inflation, most analysts agree that central banks will not hike rates for some time. With currency concerns looming in both the U.S. and abroad, many investors, from individuals to banks, will seek shelter in gold.

June ended with some good news for gold investors. Gold ETFs welcomed another member on June 30, as Japan premiered a SPDR Gold Trust ETF that is structured much like its U.S. counterpart. The U.S.-based SPDR Gold Trust (GLD), the biggest exchange-traded fund for gold, climbed to 644.16 tonnes on June 27, from 628.21 the day before, according to their website.

There are three main types of gold ETFs in the market today: physical gold, gold mining and gold futures contracts. DGL falls into the last of these three categories, tracking the Deutsche Bank Liquid Commodity Index–Optimum Yield Gold Excess Return[TM] (Index), and is managed by DB Commodity Services LLC. Performance in the ETF is designed to mirror the performance of the index, which is composed of COMEX gold futures and three-year treasuries.

Gold futures promise delivery of gold at a specific price on a future date. If you were to buy DGL now, you are betting that gold prices will continue to rise in the future. If the dollar begins to slide again and investors rush to gold as a hedge for inflation, DGL could experience significant returns for investors who understand and embrace its complexities.

While derivatives, such as futures, are not appropriate for every portfolio, trading them will certainly give you the most leverage when dealing with the gold market. While you will not own physical gold with DGL, your returns will still correlate with the price of gold bullion, rather than the press releases of gold companies.

Despite the heightened interest in futures markets in the last year, futures remain a risky investment. Perhaps the most talked of snag in commodities funds is contango: as the futures contracts that you own expire, the new ones that you are “rolled into” can cost marginally more. This process can slowly eat away at your underlying capital and create an undertow on your returns.

DGL has sought to combat contango with its “optimum yield strategy.” The fund uses margin deposits in treasuries against the futures contracts to generate income. The idea is that the interest generated by the treasuries will be enough to offset contango losses. This is a benefit that investors do not receive with other popular gold ETFs.

While this strategy is unique in the ETF universe, most big banks and hedge funds that invest in futures utilize these kinds of hedges. DGL, therefore, is aimed more at the smaller investor, who does not have the time or technology to manually hedge futures bets in a sophisticated way.

The enthusiasm for the Deutsche Bank Liquid Commodity Index–Optimum Yield Gold Excess Return[TM] (Index) has accelerated the launch of other new ETFs in 2008. On February 28, Deutsche Bank listed three ETNs on NYSE Arca, based off of the same index as DGL but offering new strategies. DGP is Gold Double Long, DZZ is Gold Double Short and DGZ is a single Gold Short. While the differences between ETNs and ETFs are not negligible, these three new products may calm the minds of potential DGL investors. With multiple strategies based on the same index, investors can hedge their exposure against a volatile futures investment with multiple funds.

While we have tracked DGL since the beginning of the year, we do not hold the ETF in our portfolio. This is not to say that we will not own DGL once its momentum improves. We do, however, gain exposure to gold through our commodities holding: DB Commodity Index Tracking Fund (DBC). DBC has a 10% base index portfolio target in gold futures, and since it was acquired by the portfolio on November 1, 2007, its NAV has appreciated more than 50%. By providing us with a larger piece of the commodity market, this fund helps to minimize the risk that is associated with picking a single metal, such as gold. As the ETF universe expands, products like DGL will continue to make market niches accessible to investors. On June 25, Barclays debuted 10 different commodities ETNs on NYSE Arca, including the first ETN with carbon exposure. While some of these products will undoubtedly fare better than others, the range of tools that these commodity funds supply will buoy many portfolios in a difficult U.S. economy.

Comments

[SWRichmond]

"Paper Gold" is a conflict of terms, like "political leadership" or "Federal Reserve". There already exists paper gold many times in excess of the total value of real gold that exists on the planet. When market failures begin in the paper markets, will you be able to say "I've got mine!", or will you be left holding a worthless piece of paper, an unfulfilled promise to deliver?

Real physical gold is the only investment that carries no counterparty risk. It fulfills its own promise. No lawyers or regulators required.

In an environment where no one knows who is really bankrupt, and where regulators aren't forcing banks, IB's and brokers to reveal their true financial condition, counterparty risk is the phrase that ALL investors need to be concerned about nowadays.

Always there is the siren song: "It's easy to invest in gold. Just buy this paper! It's just like gold!"

No, it's not.

[mkreisel]

GLD is kept by HSBC, a bank still in great shape.

You can always sell GLD once you see HBC drops by 90%.

Meanwhile, I'm very content in holding GLD. It offers so much more advantage over physical gold.

[GMiki]

Physical is good--to a point. It's also awkward to store and later to sell. Definitely have bullion, but mining shares give you leverage, and GLD and SLV give trading ease.

[sharesnewbie]

I tend to agree with SWRichmond that there is nothing like the real thing i.e. holding physical metal, if you are looking for the security that Gold can provide you. Yes, holding physical gold has its disadvantages as mkreisel and GMiki mentioned. However, to some people benefits may outweigh the costs. These depositories and trusts will be easy targets for the government, if tomorrow they make holding physical gold illegal. It will take them longer, if at all, to check your safety deposit box.

[mojobeta]

Don - give me a call - bruce watts - 646-637-6391
lots to talk about - I own DGP gold double long
All Best.

[TERN]

The best thing about physical gold is the completely irrational, atavistic feeling of wellbeing when your hand gets weighed down by a kilo of gold, no bigger than a chocolate bar.
Mmm, I remember this feeling from 1979..

[growthvalue]

Not inflation - deflation - gold down