The 3 Types Of Gold Investing

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Includes: GDX, GDXJ, GLD, PHYS, RING
by: Ted Waller

Summary

The desire to have some type of gold in the portfolio is growing among investors.

Three types of gold investments and three types of gold investors.

Correctly matching investment objective and investment type is important.

I have a feeling this article will be of interest to you, dear reader, regardless of whether or not you have invested in gold. Why? Because in 43 years of observing and interacting with the yellow metal I have learned that almost everyone considers gold from time to time. The idea may wax and wane or disappear for years, but often returns.

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In recent years discussion about gold investing has increased as economic variables like inflation, the money supply, and stock markets have reached extremes never seen before. The reason for this is a unique combination of qualities that magnify its impact beyond a relatively small size in the world economy.

Some of what gives gold its unique character:

  • It has been used as money for 3,000 years and as a store of value for over 5,000 years (4,770 more than the US dollar, 4,978 more than the credit default swap).
  • It is a very efficient store of value. Physically it takes up very little space. $50,000 of Krugerrand coins is a stack 4.5 inches high.
  • Virtually all of the gold ever mined is still in existence, creating unusual supply dynamics.
  • The price of gold does not seem to be closely tied to many factors that affect other investments.
  • Sentiment plays an unusually large role in price.

In this article I will construct a framework for gold investing and suggest types of gold-related holdings most suitable for different types of investors.

The Three Main Types Of Gold Investments

Physical ownership: Some individuals prefer to have physical possession of their gold (most often bars or bullion coins like the South African Krugerrand or Canadian Maple Leaf). This has an interesting set of advantages. There is no cost of ownership, it has a minimal tax profile, and there are no threats from counterparty risk, fraud, or other bad actors. It is surprisingly easy to do. Any quantity can be bought and sold online from reliable dealers like California Numismatics, which has a buy/sell spread of as little as 2.8%.

Bullion ETFs: Often referred to as "paper gold," the sole asset of these funds are gold bars and closely track the price of gold. Investors buy shares that are fractional ownership of the assets; it is a proxy for physical possession. The largest fund is SPDR Gold Shares (NYSEARCA:GLD), with assets of about $32 billion. These funds offer the benefits of ownership without the hassles of buying, storing, selling, and insuring physically owned metal. There is a vocal minority of gold enthusiasts who question whether GLD really owns the amount it claims. They believe that GLD is not a substitute for physical possession. Most stock market investors have confidence in the integrity of financial institutions and do not see this as a valid concern. The Sprott Physical Gold Trust (NYSEARCA:PHYS) addresses this issue by investing only in "unencumbered and fully-allocated London Good Delivery gold bars." In addition, PHYS is the only bullion ETF that enables investors to pay capital gains taxes at the long term rate.

Gold mining stocks and ETFs: Of the three types of investments, gold mining companies and non-bullion ETFs have the loosest connection to the price of gold. On the downside, they are affected by the same risks as other corporations, such as the price of energy, economic conditions and political instability. On the upside, their profits theoretically leverage the price of gold. Since some of their costs are fixed, a large part of any increase in the gold price goes right to the bottom line. My experience is that this relationship is not as direct or immediate as one might expect, though. The largest ETF is Market Vectors Gold Miners (NYSEARCA:GDX). As the chart below shows, its price does not closely track either the price of gold or the bullion ETF GLD.

Interestingly, many mining ETFs have significant holdings of non-gold miners, particularly silver. This includes GLD, Market Vectors Junior Gold Miners (NYSEARCA:GDXJ), and iShares MSCI Global Gold Miners (NYSEARCA:RING)

The Three Main Types Of Gold Investors

Catastrophe investors: Some individuals believe that our economic system is headed for total collapse, far more crippling than 2008 or 1933. Everything based on fiat money, such as stocks, bonds, bank deposits and paper money will become worthless. Gold will retain its value as it has for thousands of years. Although this may seem far-fetched, thousands of people follow Harry Dent, Peter Schiff, Bill Bonner and others who have become rich and famous promoting variations of this theme for decades.

Traders: These individuals try to profit from shorter term changes in the gold price in a time frame of one day to 12 months, much as any other type of investment. They will trade based on anticipated supply and demand, inflation, the supply of money and so on.

Long-Termers: These investors hold gold vehicles for a number of years, believing that the price of gold will increase over the long term. There are a variety of rationales behind this idea, such as the historical fall in the value of the dollar or the increasing ratio of world population to gold supply. There is historical support for this as shown in the chart of the inflation adjusted price below:

Investments Suitable For Each Type Of Gold Investor

In the matrix below;

+ indicates maximum suitability,

0 indicates partial, and

- indicates low/no suitability.

Catastrophe investors The only acceptable gold for these investors is physical possession of bullion. In an economic collapse the functioning and viability of many institutions, even a bullion ETF, could be compromised. Retrieving bars from somewhere else when communications and transportation are disrupted could be difficult.

Long term investors: Physical bullion and gold-backed ETFs like GLD and PHYS are both suitable. Both have the direct one-to-one correspondence with the price of gold. Over years the higher initial cost of physical ownership will be amortized and insignificant considering gold's volatility. Gold company stock and ETFs, on the other hand, do not offer the close connection to the gold price that is the main objective for many investors.

Traders: Gold company stock or ETFs and bullion ETFs are useful to traders in the same ways as any other commodity-based investment vehicle. Physical ownership is not suitable for this group because of high transaction cost and slow transaction speed. In addition, the leverage that some traders like is not available.

Summing Up

The question of whether to invest in gold is a common one partly because of gold's unique economic characteristics but also - very legitimately -- because of its place in our history and culture. As something that has been used as money for millennia, it has special importance in times of economic extremes or insecurity.

There is a gold investment suitable for almost everyone, and it's important to match investment objective with investment type. Many advisors recommend an allocation to precious metals, usually a small one. People with an interest in gold see this as a smart and responsible move towards a diversified portfolio.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.