The Best Gold ETF Isn't An ETF

Includes: DGL, GLD, UBG
by: Michael Johnston

As interest in gold as an investable asset has increased in recent years, more and more investors looking to gain exposure to the precious metal are turning to exchange-traded products. U.S.-listed gold ETPs now have assets in excess of $80 billion, representing a material portion of the total industry. Gold ETPs have generally performed very well over the past five years; prices of the metal have climbed steadily higher, and the stellar performance has no doubt been one of the substantial drivers of interest in this asset class.

For investors looking to purchase a gold ETP, there is no shortage of options; several different products allow cheap, easy access. While these products are generally similar, there are nuances to each that can impact the returns realized. And this is one case where bigger isn’t always better; some of the smaller, lesser-known gold ETPs have features that may make them the most useful products out there.

Gold ETPs And Taxes

Consider a hypothetical $10,000 investment in gold made at the beginning of 2009. Through the end of the first quarter of 2012, gold prices had jumped by about 90% over that 39-month period. But not all exchange-traded products that offer exposure to gold delivered equal returns; that initial investment in GLD would have grown to about $18,738 while futures-based gold ETPs would have grown to a smaller sum.

Initial $10,000 Investment
$18,738 $17,978 $18,058

At first glance, GLD, which holds physical gold bullion, appears to be the best bet. That fund outperformed DGL and UBG, which achieve exposure to gold prices through futures contracts, by a relatively wide margin. But that value on your account statement doesn’t necessarily reflect the amount that investors get to keep or that can be converted to cash at any given time. The biggest consideration, of course, is as unavoidable as death; taxes.

GLD is taxed as if investors held the underlying gold themselves, meaning the collectibles rate of 28%. DGL, a commodities pool that holds futures contracts, is taxed at a blended rate between short-term and long-term capital gains that generally works out to about 23%. UBG, an exchange-traded note (ETN) doesn’t actually hold anything; it’s a debt security whose underlying value fluctuates based on the performance of a specified index. The ETN structure introduces credit risk to the equation–UBG is a debt of UBS–but it also brings some potentially advantageous tax treatments to the table. Specifically, positions in UBG held for longer than a year will be taxed at the long-term capital gains rate of 15%.

So when we consider the amount of the gains in these gold ETPs that investors get to keep, the picture begins to look dramatically different:

Gold ETPs
Value $18,738 $17,978 $18,058
LTCG Rate 28% 23% 15%
Taxes ($5,247) ($4,135) ($2,709)
Net Value $$13,491 $13,843 $15,349

In this example, the favorable long term capital gains treatment more than offsets the performance lag for UBG; after considering Uncle Sam’s take in these hypothetical investments in gold ETPs, the ETN leaves investors with the most take home money at the end of the day.

There are, of course, a number of caveats here. Tax circumstances vary by investor and account type; when taxes are irrelevant, it doesn’t make much sense to consider the relative rates associated with different products. And it is entirely possible that the numbers won’t always favor the product with the lowest tax rate; had the gap in performance been a bit wider, one of the other products might come out ahead in this calculation (moreover, the tax treatment of DGL is simplified for this example; in reality, that commodity pool would pay taxes annually regardless of whether a position was sold).

Gold ETN > Gold ETF?

UBG is one of the best kept secrets in the ETP industry; it is, in many scenarios, the most effective tool for gaining exposure to gold. Yet it holds only a tiny fraction of the assets held by GLD and other physically-backed ETFs, and considerably less than commodity pools such as DGL (UBG has only about $10 million in total assets, or about 0.1% of all gold ETP assets).

Because gold futures markets are generally in a state of contango, futures-based strategies will tend to underperform relative to physically-backed funds. But because that contango tends to be moderate (i.e., the curve has only a slight upward slope), there is often an opportunity to make up the difference on the tax liabilities side.

Disclosure: No positions at time of writing.

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