Test of Metal: Gold Futures vs. ETFs

05/30/2012 8:30 am EST

Focus: COMMODITIES

Noble DraKoln

Author, Trade Like a Pro and Winning the Trading Game

Potentially detrimental cost and risk factors make gold ETFs problematic for some traders and investors, explains Noble DraKoln, and under the right circumstances, gold futures may be the better alternative.

In 2004, the first exchange traded fund (ETF) specifically developed to track the price of gold was introduced in the United States. It was touted as an inexpensive alternative to owning physical gold or buying gold futures, and since its introduction, ETFs have become a widely accepted alternative.

Many investors look to certain gold-specific ETFs as a convenient and exciting way to participate in gold without having to be exposed to the risks of physically purchasing bullion or becoming savvy on how gold futures operate.

However, what many investors fail to realize is that the price of trading ETFs that track gold may exceed their convenience, and that trading gold futures contracts may be a better alternative under the right circumstances.

In this article, we’ll explore whether it’s better to invest in gold ETFs or go with the more traditional gold futures.

Problems with Gold ETFs

For more sophisticated investors, or those with investing capital that exceeds a few hundred dollars, there are significant drawbacks to investing in gold-specific ETFs that go beyond the day-to-day fluctuation of gold prices. These problems include tax implications, non-gold-related market risk, and additional fees.

Taxed as a Collectible

An investment in an ETF that tracks gold prices does not consist of actual gold ownership on the part of the shareholders. An investor cannot make a claim on any of the gold shares, and under IRS law, their ownership in the ETF represents an ownership in a "collectible."

Despite the fact that the managers of gold ETFs do not make investments in gold for their numismatic value, nor do they seek out collectible coins, the shareholder’s investment is treated as a collectible. This makes long-term investing in gold ETFs (for one year or longer) subject to a relatively large capital gains tax (maximum rate of 28%, rather than the 15% rate that is applicable to most other long-term capital gains).

In order to avoid this tax implication, investors often exit their positions before a year, which diminishes their ability to profit from any multi-year gains that may occur in gold.

Market Risk

ETFs that track gold are also exposed to a host of company risks that have nothing to do with the actual fluctuation in gold’s value. In the SPDR Gold Trust (GLD) prospectus, for example, the trust can liquidate when the dollars in the trust fall below a certain level, if the net asset value (NAV) drops below a certain level, or by agreement of shareholders owning at least 66.6% of all outstanding shares. These actions can be taken regardless of whether the gold prices are strong or weak.

Fees, Fees, and More Fees

Finally, gold ETFs are inherently diminishing investments. Because the gold itself produces no income and there are still expenses that must be covered, the ETF’s management is allowed to sell the gold to cover these expenses. Each sale of gold by the trust is a taxable event to shareholders. That means that a fund’s management fee along with any sponsor or marketing fees must be paid by liquidating assets. This diminishes the overall underlying assets per share, which, in turn, can leave investors with a representative share value of less than one-tenth of an ounce of gold over time. This can lead to discrepancies in the actual value of the underlying gold asset and the listed value of the ETF.

Given these drawbacks, many ETF investors turn their attention to trading gold futures.

NEXT: Benefits of Gold Futures Over ETFs

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Think About Gold Futures

The risks that gold-focused ETFs have are not seen in gold futures. Gold futures, in comparison to the ETFs, are fairly straightforward. Investors are able to buy or sell gold at their discretion. There are no management fees, taxes are split between short-term and long-term capital gains, there are no third parties making decisions on the investor’s behalf, and at any time, investors can own the underlying gold. Finally, because of margin, every $1 that’s put up in gold futures can represent $20 or more worth of gold.

For example, while a $500 investment in an ETF such as GLD would represent half an ounce of gold (assuming gold was trading at $1,000), using that same $500, an investor can have a mini-futures gold contract that represents 33 ounces of gold. The drawback to this kind of leverage is that investors can both profit and lose money based on 33 ounces of gold. Couple the leverage of futures contracts with their periodic expiration and it becomes clear why many investors turn to an investment in an ETF without really understanding the fine print.

The Bottom Line

ETFs and gold futures both represent a diversification into the metals asset class. There are pros and cons to both instruments, but that doesn’t automatically make gold-specific ETFs superior to gold futures.

Investors must be aware that while on the surface an ETF can instantly create portfolio reallocation in one place, the fund may end up costing them more than they expected in both taxes and management fees on the back end.

By Noble Drakoln, founder and president, Liverpool Trading Company and Speculator Academy

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