Investing In Gold Over The Long-Run: Which ETF Is Best?

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Includes: DGL, GLD, IAU, SGOL
by: Hedgewise

Summary

Gold is an excellent addition to any portfolio as a hedge against inflation and recessions.

However, investors are often confused about the best way to invest in gold over the long-run.

We discuss the pros and cons of the various ETF options, as well as the differences between a physically-backed and a futures-based strategy.

We also give you access to a daily monitor that helps identify which strategy currently makes the most sense.

Introduction

As written in a few of our other articles, gold is generally an excellent part of any well-diversified portfolio. It tends to spike when markets are crashing or when inflation is taking off, which are typically the environments when such a hedge is most desperately needed. However, there are a variety of ETF options for getting gold exposure, and many investors default to the SPDR Gold Trust ETF (NYSEARCA:GLD) even though it may not be the best choice.

Though GLD is far and away the most popular gold ETF, with over $28b in assets, there are a few other options worth understanding. Gold investments generally fall into two camps - physically-backed and futures-based. Physically-backed ETFs basically store gold at a secure facility, making it a fairly close proxy to simply buying a gold bar and putting it in your safe. While this is quite straightforward, there are still differences between the ETFs that merit further understanding, such as fees and location.

Futures-based ETFs do not own any physical gold, but rather invest in derivative contracts that provide direct exposure to the price of gold. Due to how the futures market functions, this type of investment can be either an advantage or a disadvantage to investors, depending on market conditions. While these ETFs are probably not suited for a pure 'buy-and-hold' strategy, savvy investors may want to monitor and use them occasionally to potentially provide a 'boost' to their gold returns.

We'll break down which investments make the most sense and why.

Physically-Backed Gold ETFs: Comparing GLD, IAU, and SGOL

The three biggest ETFs in this category are the SPDR Gold Trust, the iShares Gold Trust ETF (NYSEARCA:IAU), and the ETFS Physical Swiss Gold Trust ETF (NYSEARCA:SGOL). There are three primary considerations when evaluating these options: fees, volume, and location.

To get a quick sense of how these ETFs compare, here's a general breakdown:

GLD

  • Assets: $28b
  • Annual Fee: 0.39%
  • Avg Volume: 6m Shares
  • Vault Location: London

IAU

  • Assets: $6b
  • Annual Fee: 0.25%
  • Avg Volume: 3.5m shares
  • Vault Locations: London, Toronto, New York

SGOL

  • Assets: $1b
  • Annual Fee: 0.39%
  • Avg Volume: 32,000 shares
  • Vault Location: Zurich, Switzerland

Fees will be the most critical component for most investors, and IAU has a clear advantage on that front. While a fee of 0.25% vs. 0.39% may not seem like a substantial difference, it can still make a dent in the long-run. Both IAU and GLD have been around since 2005, and a comparison of their performance provides some insight.

Performance of Gold Benchmark, GLD, and IAU - January 2005 to April 2015

Source: WSJ, Yahoo Finance

Both investments slightly underperformed the Gold benchmark price over this ten year period, due to fees and small amounts of tracking error, but IAU performed about 4% better than GLD. This can be entirely attributed to the difference in fees, making it a more sensible investment for most individuals. While it does have fewer assets, IAU is still highly liquid with tight trading spreads.

So why would anyone stay in GLD? For more advanced, larger traders, GLD has a much more liquid options market than IAU, which can be a substantial benefit. There's also the natural tendency for investors to stick with what they've heard of. However, if you aren't an options trader, the lower fees on IAU make it a more compelling choice.

Our final choice is SGOL, a relatively new player that was released in late 2009. It has the same fee as GLD, but it is much smaller and trades on lighter volume. Its only advantage is that its vault is located in Zurich, Switzerland. Should you care about this? First, let's see if that makes any difference in overall performance.

Performance of Gold Benchmark, GLD, and IAU - January 2005 to April 2015

Source: WSJ, Yahoo Finance

As expected, it performs right in line with GLD, and slightly worse than IAU. While the vault location has no impact on performance, it may provide peace of mind if you are particularly concerned about literal vault security. There have been various instances in history when governments have forcibly seized gold bullion due to some kind of crisis. Presumably, a vault in Zurich would be free of any such threat.

Of course, such dire circumstances seem incredibly unlikely. It may be smarter to go with IAU for now, and you can always make the switch if a London or U.S. government collapse starts to appear more pressingly imminent.

Futures-Backed ETFs: Understanding the Futures Market

For most, using IAU is the simple choice. However, for more advanced traders, the futures market may present additional opportunities to slightly improve gold returns and even reduce taxes. Before discussing the relevant ETFs, here is a quick overview of how the futures market works.

A gold futures contract is an agreement to buy or sell gold at a specific price at some point in the future. This 'future price' is almost always different than the current spot price, meaning that the market has an expectation for which direction the price is going to go. If the future price is less than the spot price, this is called "backwardation", and it means the market is expecting that the price will go down. Conversely, if the future price is more than the spot price, this is called "contango".

When the market is in backwardation, you can basically buy gold at a discount. For example, say you can buy a futures contract next month for $1,100 but the spot price of gold is $1,150. Even if the price of gold stays exactly flat, you would still make $50 on that contract.

This type of trade was recently possible at the beginning of March, when the April 2015 futures contract was available at a slight discount.

Performance of Gold Benchmark and April 2015 Gold Futures Contract - March to April 2015

Source: CME Group, WSJ

As you can see, the futures contract consistently outperformed the Gold benchmark during this timeframe. However, capturing such an opportunity requires constant monitoring of the futures market and the ability to directly trade futures contracts. For most individuals, this will not be possible.

Luckily, there is an ETF that does all the work for you: the PowerShares DB Gold ETF (NYSE:DGL). This fund achieved similar performance over this timeframe without the need to directly trade futures contracts.

Performance of Gold Benchmark and DGL - March to April 2015

Source: PowerShares, WSJ

Seems great, right? Well, not so fast. While the futures market does indeed provide short-term opportunities for additional gain, the reverse can also occur. Taking advantage of these opportunities requires very adept timing and constant monitoring of the underlying holdings of DGL.

If you look at the performance of DGL over a longer timeframe, it is easy to see the drawbacks.

Performance of Gold Spot Price, GLD, IAU, and DGL - January 2007 to April 2015

Source: WSJ, Yahoo Finance

Clearly, investing using futures contracts is not a good buy-and-hold strategy. However, it may present the opportunity for short-term benefits if you are willing to be nimble.

If this strategy sounds appealing to you, you can see our daily tracking of gold futures prices and DGL holdings here. This can give you a general sense of which investment is currently optimal, though be wary that the data is not real-time and is meant only as broad guidance.

Note that while there are a few other ETFs with a similar underlying structure, the choices besides DGL are much too small to merit consideration.

Considering Taxes: Physically-backed vs. Futures

Futures contracts, as well as ETFs which hold futures contracts, are typically taxed at a different rate than physically-backed ETFs. Gold is considered a 'collectible', and if you physically own it, any gains are usually taxed as regular income, regardless of how long you hold it.

Futures contracts, however, are generally taxed at a rate of 60% long-term capital gains, 40% short-term capital gains. This may provide some additional savings as well, assuming that you are comfortable with the earlier caveats of futures trading.

Note that each individual's tax situation is unique and that we are not a tax advisor. The final taxation of any investment gain or loss depends on many individual factors.

Conclusion

For the majority of investors, IAU is the best long-term bet for investing in gold. If you need to use options contracts, then GLD still makes the most sense. For government skeptics, SGOL gives you a vault in the confines of Zurich. For more advanced traders, there may also be opportunities to boost your return and reduce your taxes by using futures contracts.

Disclosure: Hedgewise is an investment advisor that specializes in helping to protect clients from market crashes without sacrificing their long-term returns. Hedgewise may utilize the strategies discussed in this article for its clients.

Disclosure: The author is long GLD, DGL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. To the extent that any of the content published may be deemed to be investment advice or recommendations in connection with a particular security, such information is impersonal and not tailored to the investment needs of any specific person. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios.