The Shiniest of Golden Opportunities

11/08/2011 9:48 am EST

Focus: ETFS

As uncertainty clouds global macroeconomic and currency outlooks, investor demand for the yellow metal persists, says Abraham Bailin of Morningstar ETFInvestor.

The price of gold has increased 460% in the past ten years, and has doubled since the 2008 market downturn alone.

For many investors, the question is no longer whether they should gain exposure to gold, but rather how to gain exposure, and at what percentage of their overall portfolio. Physically backed offerings have provided razor-sharp tracking, while equities can introduce non-commodity-specific pressures.

Coming out of the market bottom of 2008, miners substantially outperformed spot. That trend seems to have changed.

Rather than owning bullion directly, as some funds do, Market Vectors Gold Miners ETF (GDX) invests in the shares of firms that mine the precious metal. The fortunes of these miners are inextricably tied to the trajectory of gold prices, and so the fund provides investors an indirect play on gold.

This thematic sector ETF should be treated as a satellite holding. The position may be maintained for several years, so long as your own investment thesis remains intact.

Prospective investors should note that broad index funds already have some exposure to this fund’s largest holdings, so adding this offering to an already diversified portfolio will only magnify your exposure to the gold-mining complex. In our opinion, investors holding greater than 5% exposure to gold miners are placing a substantial speculative bet that would require a strong fundamental thesis.

Fundamental View
This fund will not perfectly track the price performance of gold. In fact, some of GDX’s largest holdings, like Barrick Gold (ABX), hedge a portion of their precious-metals reserves, meaning gold will not overwhelmingly drive performance.

These firms have enormous fixed-operating costs. Their cash flows—which are what you ultimately invest in when buying this fund—can swing much more dramatically than metal prices.

That leverage, along with currency gyrations, has made this fund’s index more than twice as volatile as the spot price of gold in the past three years. Shares of these miners can certainly get cheap from time to time as they trail gold prices, but as of this writing we find the fund to be fairly valued.

For their ability to better manage geopolitical, currency, and operation-specific risks, we continue to favor gold-related exchange traded funds and mutual funds over individual stocks.

Gold’s primary demand drivers are jewelry consumption and identifiable investment, and can exert opposing price pressures. Growing concerns of a global recessionary period might curb discretionary spending on jewelry, but gold’s use as a store of value could offset the trend to an extent.

This fund’s 0.53% expense ratio is low in absolute terms, and when compared with many precious-metals mutual funds. It’s not the cheapest game in town when pitted against other precious-metals ETFs, but investors should bear in mind that this ETF differs in an important respect from its gold peers: It invests in the stocks of gold miners, not the bullion itself.

Few equity-based ETFs compete directly with this fund. The closest competitor would be PowerShares Global Gold & Precious Metals (PSAU), but that fund lacks sufficient assets under management to make it competitive. Furthermore, the PowerShares offering charges a considerably higher fee of 0.75%.

Market Vectors offers a sibling product similar to GDX: Market Vectors Junior Gold Miners ETF (GDXJ). The main difference between the two is that the Junior fund holds equity-security positions in small- and mid-cap gold miners.

These “junior” miners tend to be involved in exploration and initial prospecting of gold veins. Thus, investment tends to be speculative in nature. GDXJ maintains a 0.54% expense ratio.

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