The Swiss Gold ETF: A Fundamentally Decent Product Once You Get Beyond The Gimmickry

Sep.21.12 | About: ETFS Physical (SGOL)

By Samuel Lee

Gold is the "Armageddon currency." Its holders are naturally concerned about the rules of the game being changed on them--fraud, government expropriation, and, for the extremist fringe, the collapse of social order, are not inconceivable scenarios. While some gold bugs like to be able to fondle their bullion, the cost-conscious must make do with paper ownership, via exchange-traded funds. However, the logic of gold fights against the attenuated ownership rights ETFs provide, so ETF firms plaster attestations of the safety of their gold all over their websites: inspectorate certificates, gold bar lists, pictures of the gold in the vaults, and so forth. ETFS Physical Swiss Gold Shares (NYSEARCA:SGOL) goes even further. Its gold is held in subcustodian UBS' (NYSE:UBS) Zurich vaults.

Switzerland's centuries-long history as a haven for capital appeals to investors worried about the safety of claims on gold held in New York or London vaults by the other big gold ETFs. That added safety is, for the most part, illusory. The ETF's shares are issued in the United States, its primary custodian is JPMorgan Chase (NYSE:JPM) (the same custodian as iShares Gold Trust (NYSEARCA:IAU)), and the independent audits are conducted by Inspectorate International Ltd., the same firm that inspects bullion held for SPDR Gold Shares (NYSEARCA:GLD) and IAU. They all rely on American rule of law to enforce ownership claims. The real reason to diversify geographically is concerns about the physical safety of gold held in New York or London. Let's not go into when that might be a good idea.

Gimmickry aside, SGOL stands on its own as a reasonable way to get gold exposure. It has done a good job of tracking the spot price of gold, is fairly liquid, and charges a competitive fee.

But before hopping on the bandwagon, investors should strongly consider gold's proper role as an investment. Gold, like all commodities, earns nothing itself, and its theoretical long-run expected return is zero. Its record-busting performance has attracted a lot of speculators and performance-chasers. However, speculation is a zero-sum game that usually profits a small slice of investors--the lucky and the clever--leaving the less lucky and less clever holding the bag. Investors should look beyond its speculative uses: Gold is a decent inflation/currency debasement hedge and uncorrelated with stocks and bonds, so it can be a good diversifier.

Fundamental View
It's worth critically examining gold's purported diversification benefits. From 1973 to 2010, gold's yearly performance had a 0.49 correlation with yearly inflation. Its yearly performance had a 0.43 correlation with three-year forward inflation. At that level, gold's movements predict about 18.5% of the variation in future inflation--not quite a slam-dunk as a pure inflation hedge. Over the same period, gold had a negative 0.33 correlation with the dollar's value versus a basket of major currencies. There are far more efficient ways to hedge against such risks, such as holding Treasury Inflation-Protected Securities or foreign currency. However, it doesn't correlate much with stocks or bonds, so it's potentially a good diversifier. Gold is more like all-purpose disaster insurance, useful for reasons other than narrow bets on currency debasement or inflation.

It's hard to value gold in the current environment. Gold doesn't produce an income stream or come with a set of financial statements. One logical way to value gold is to divide the world money supply by the total gold stock. By such measures, gold is quickly approaching its historical mean. Another factor to consider is momentum. Gold's price exhibits a lot of trendiness, perhaps owing to its hard-to-value nature and the fact that some of its biggest buyers, central banks, are not motivated by economic profit. Its yearly performance is moderately correlated with its past year's performance.

There are substantial risks to the shiny metal as it approaches its historical mean. Until a short time ago, most of it was made into jewelry, with a small slice for industrial uses. Over the past decade, the demand mix has changed toward investment, starting at 4% of demand in 2000 and growing to 38% by 2009, according to the GFMS Gold Survey 2010. Investors' growing appetite for it coincided with 17.7% annualized returns from 2001 to 2010. What could happen when no one wants gold anymore? We need only look back to the 1990s for some perspective, when gold lost 4% annualized from 1988 to 2000--far worse than the disastrous "lost decade" for U.S. stocks. The money supply's growth could slow down or even shrink when central banks begin mopping up excess liquidity. Though a ways off, such a readjustment will probably brutalize gold prices. Investors who buy gold as insurance should understand that insurance policies aren't supposed to make you rich.

Portfolio Construction
Each share represents about 0.1 ounce of gold bullion, less accumulated fees. The gold is held by UBS AG in Switzerland. ETF Securities publishes a daily list of bar numbers and posts audit results on its website. Like the other big gold ETFs, this fund is structured as a grantor trust, which acts as a pass-through vehicle for the underlying gold.

The fund charges 0.39% annually. It will sell off gold to pay its expenses, so each share will hold a tiny bit less gold over time. The fund isn't as liquid as the bigger gold ETFs, so trading in and out will take an additional bite of perhaps a few basis points.

The two biggest gold ETFs are SPDR Gold Shares (GLD) and iShares Gold Trust (IAU), also grantor trusts. GLD is the biggest, most-liquid gold ETF and charges only 0.40% a year. IAU is slightly less liquid, but it's the cost champion at 0.25% and therefore our favorite.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.