As more investors begin to consider gold as a stability hedge for their portfolios, many stop short due to some issues associated with owning and holding physical gold. Some are less enthused about having to securely store it, and other are concerned with liquidity, having the ability to quickly convert it to cash again. If you are not set on buying and owning the actual physical metal, gold ETFs may be the next best way to participate in the gold market.

Gold ETFs are exchange traded funds, similar to mutual funds except that the holdings of the fund consist of a basked to stocks or commodities that are not actively managed. The objective of gold ETF is to closely mimic the returns produced by the underlying gold holding. For instance, some gold ETFs hold gold bars, so the value of the ETF will closely follow the value of the underlying gold bars.

ETFs then are traded on the major exchanges much like stocks. They are offered at an “ask” price and purchased at a “bid” price the same as stocks. Because there is an open market for ETFs they can be traded at any time during exchange hours. When ETFs are traded, the investor pays a broker commission, and, generally, the costs associated with storage and insurance are deducted from the value of the underlying investment.

Advantages of Gold ETFs

• Increases access and availability of gold for smaller investors
• Enables investors to “time” their purchases (buy low, sell high)
• The stamp duty associated with gold investments is paid by ETF
• No need to hold, store and insure physical gold
• ETFs can be traded easily through online trading accounts

Disadvantages

• Actual investment decisions are made by the ETF manager
• Internal fees can eat into the value of share holdings
• Gold ETFs are taxed as collectibles at 28% as opposed to the capital gains tax rate
• ETF shares are only redeemable in cash, not gold
• Investor only owns a gold “certificate”, not the asset itself

 

Know Which Type of ETF You’re Buying

Investors need to do their own due diligence to ensure that they fully understand how the ETF operates. Typically, the ETF buys and holds a certain amount of gold buillion bars and stores them in a bank vault. In most countries, an audit is conducted of the holdings to ensure that they reflect the reported value of the shares minus expenses. When an investor buys ETF shares, he or she owns a proportionate share of the holdings.

Another type of gold ETF invests in gold futures contracts which has nothing to do with buying and holding physical gold, rather the contracts are bought and sold based on the future spot price of bullion. In essence, a futures contract for thousands of dollars of gold bullion can be purchased for a fraction of its actual value. The contract holder is betting that the spot price of gold will go up at some point in the future, at which point the contract is then sold for a profit. There is no actual transfer of gold bullion.

While this can be a very profitable way of participating in the gold market, its success is based largely on correctly forecasting the direction of gold prices. Most of the time these futures contracts are hedged to protect the investor against an adverse movement in the price. Generally, these types of ETFs still manage to track the relative value of gold, but their prices tend to fluctuate more.