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By Rob Curran
April 5, 2021
A man riding gold upward like a mechanical bull.
Kiersten Essenpreis for Money

Ounce for ounce, gold has been among the most valuable items on earth for millennia. For that reason alone, many investors think it’s worth considering allocating a small part of your overall portfolio to the commodity.

Some strategists argue that gold is a safe haven. During some macroeconomic shocks – including the initial onset of the coronavirus pandemic – gold increases in value, just at the moment when stocks are falling most sharply.

Gold, like other precious metals, is also an intuitive hedge against inflation – a phenomenon many economists say is imminent – as prices of the popular commodity typically rise alongside those of other goods.

Skeptics say other “tangible assets” like real estate and farmland, for example, have advantages over gold because, unlike gold, they produce cash flow. One of gold’s attractions as an alternative to these assets is that investors can inch into the market with small amounts. Indeed, the most popular form of gold investment – exchange-traded funds – often carry no investment minimums.

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What's the difference between physical gold and a gold ETF?

The other reason to buy gold ETFs rather than physical gold (aka gold bullion) is that you don’t have to walk around with a suitcase full of yellow metal bars or a hide a combination safe behind a family portrait in the den like some kind of 80s “Miami Vice” villain.

There are plenty of Main Street dealers who will sell you bullion, from one-ounce ingots or coins all the way up to one-pound bars. But then you have to consider the costs of verifying, insuring and storing the gold. An ETF takes care of all those headaches for you.

After its launch in 2004, the runaway success of the SPDR Gold Trust ETF became one of the milestones for the now multi-trillion dollar exchange-traded fund industry. Passively managed ETFs meet the main criteria of gold and commodities investors much more efficiently than their predecessors, actively managed mutual funds. Actively managed mutual funds carried high fees, meaning the risk of “tracking error,” where the fund’s price performance diverges from that of the commodity, was high.

Lower cost “index” mutual funds, meanwhile, did not have the ETFs’ ability to be bought and sold like stock throughout the day. That meant investors could not retreat from the market during wild intraday movements, which are much more common in commodities markets than on the stock market.

How to buy gold ETFs

You can buy ETFs that own physical gold

Shares of these funds represent fractional ownership of gold bullion stored in a vault maintained by the fund manager. The SPDR Gold Trust (GLD) is the largest of these funds with $58 billion of assets under management, according to fund parent company State Street Global Advisors. Competitor iShares Gold Trust (IAU) is another giant.

Physical gold ETFs store billions of dollars worth of gold, whose quantity and value is audited every day. These audits give the fund a transparent net asset value, based on the quantity of gold they own, fund expenses and any extra cash they may hold.

As long as the U.S. market is open, investors with a brokerage account can buy and sell shares of the ETF, which closely tracks the spot price of gold, based on London bullion market prices. This is probably the “cleanest” way for a fund investor to own gold, and, thanks to relatively low fund fees, one of the cheapest.

You can buy ETFs that own gold futures

This once popular method for investing in commodities has recently fallen out of fashion. The peculiarities of the futures markets means that investors are exposed to the risk of “rolling” out of the contracts owned by the fund. Typically, funds own the “front month,” or most actively traded contract, on the COMEX exchange operated by CME Group.

As the expiration date approaches, funds are forced to sell out of the old contracts and buy into the new most actively traded ones. During this “roll,” there’s a risk that the difference in price between two contracts will be large enough to cause a deviation between the price performance of the ETF and that of gold on the spot market. The Invesco DB Gold Fund is the big player here, with a relatively modest $90 million in market value, according to Invesco’s Web site.

You can buy ETFs that own gold miner stocks

Advocates of this approach say the fund owner can benefit from mine and corporate management in addition to appreciation of gold prices.

Critics say investors in these funds are also exposed to corporate mismanagement The Van Eck Vectors Gold Miner exchange-traded fund, with about $13 billion in assets under management, is among the largest in this niche.

There’s also Sprott Gold Miners exchange-traded fund. Both are down by roughly 14% for the year to date, an even bigger loss than the roughly 10% deficit for spot gold and the physically backed ETFs.

The gold-mining ETFs are effectively a “leveraged bet” on gold prices. If spot gold prices rise rapidly, then a mining company with fixed costs could become exponentially more profitable. But leverage also works on the way down. If a significant fall in gold pushed miners into a position where there were doubts over their viability, losses on the miners’ shares could be much steeper than those on the spot gold price.

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Steps to invest in gold ETFs

Step 1: Know how gold reacts in bear markets

Gold’s reputation as a “safe haven” is based on short-term price reactions to market shocks. When a war breaks out, or a major bank runs into difficulty, a knee-jerk reaction for many investors is to buy gold. This was borne out early in the pandemic shock, with gold hitting record highs above $2,000 an ounce even as the world locked down. This is an almost psychological phenomenon based on the instinct that, if civilization unravels, people will still value the shiny metal.

Don’t expect gold to ride out all crises unscathed, however, as it famously failed to serve as a safe haven during the worst of the 2008-2009 financial crisis. Gold first crossed the $1900-an-ounce level in 2011, but didn’t get near that level again until last year, when it topped $2,000 an ounce, before falling back to current levels around $1700, according to data Web site GoldPrice.org. Still, the fact that gold’s price cycles are generally on a different schedule to those of the stock market mean that it’s bound to serve as a shelter from some stock-market storms.

Step 2: Know how gold to fits gold into your portfolio

Gold is an “alternative” asset, meaning that there remains an experimental, speculative aspect to holding it. Bonds and stocks have been mainstream retirement investments for 100 years or more. The IRS only allowed gold to be held in tax-protected Individual Retirement Accounts in 1997.

Walter Davis, an alternative-asset strategist for money manager Invesco, said investment firms often allocate 10% to 20% of their assets to “alternatives.” Individual comfort levels are a factor, said Mr. Davis, in a post on Invesco’s Web site, but investors who decide to use alternatives should put enough into them to have a palpable impact on portfolio performance. Allocating too little to an alternative asset like gold, “defeats the purpose,” he said.

Step 3: Pay attention to gold ETF expense ratios

Some investors now skip over disclosures on funds they buy online. In the stock-investing world, the “race to zero” has made rock-bottom fund fees almost ubiquitous. That’s not the case in commodities investing. By ETF standards, the SPDR Gold Trust’s expense ratio of 0.4% — meaning you pay $40 per $10,000 invested per year — is relatively high, even if it’s cheaper than insuring or storing gold bars.

Step 4: Know how gold ETFs are taxed

If you are investing in gold ETFs in a taxable brokerage account, there’s a few tax rules you need to be aware of. Physically-backed ETFs are taxed as collectibles because the owner is a de facto owner of the physical asset. That’s different than with stocks and bonds. The top rate for trading profits on collectibles is 28%, compared to the 20% capital gains rate that applies to most other investments.

A commodity ETF that is structured like a partnership and owns futures contracts in commodities would require an investor to pay annual taxes on the ETF’s capital gains at a hybrid rate of 60% long-term and 40% short-term gains, according to Fidelity Investments.

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