Using a Gold ETF

Gold is one of today’s most exciting investments. A $10,000 investment in gold in 2000 would be worth $63,407 today (a huge gain of 534%!), while a $10,000 investment in stocks mirroring the Dow Jones Industrial Average in 2000 would only be worth $12,323 today (a gain of only 2.3%). Recent speculation of more monetary easing by central banks could result in strong additional gains for gold.

The easiest way to invest in gold is to buy gold exchange traded funds (ETFs). However, gold ETFs aren’t always perfect substitutes for owning physical gold.

An exchange traded fund (ETF) is a security that tracks an index, a basket of assets or a commodity, but trades like a stock on an exchange. They can be bought, sold, bought on margin or sold short at prices that change throughout the trading day. They provide diversification through a single security, and offer expense ratios lower than those of comparable mutual funds. On the downside, ETF traders must usually pay trading commissions to their brokers as they would for normal stock trades.

Gold ETFs are exchange traded funds designed to track the price of gold. People buy gold ETFs for the same reasons they buy gold bullion or coins. The most common reasons to buy gold ETFs--or any other form of gold--are (1) for investment diversification, (2) as a hedge against inflation, (3) a hedge against a declining currency, (4) a stable store of value, (5) a commodity subject to the laws of supply and demand, and (6) a safe haven in times of severe political or economic instability.

Investing in gold ETFs provides advantages over investing in gold bullion or coins, while also suffering disadvantages. The advantages of investing in gold ETFs vs. physical gold include:

• Convenience: Gold ETFs are more convenient than physical gold since gold ETFs are bought and sold like stocks, while physical gold must be shipped, stored securely and insured.

• Speed: Gold ETF trades are as fast as stock trades since gold ETFs can be traded electronically in brokerage accounts. Trading physical gold takes longer since the gold must be transported.

• Flexibility: Gold ETFs are traded like stocks, so it is possible to buy or sell options on gold ETFs. Thus, investors in gold ETFs can use trading strategies unavailable to owners of physical gold.

The disadvantages of investing in gold ETFs compared to investing in gold bullion or coins include:

• Accuracy: The price of gold bullion and coins tracks the market price of gold with a high degree of accuracy, while there are tracking errors between the market price of gold and gold ETFs.

• Complexity: Gold ETFs are derivative securities defined by complex legal documents. In contrast, physical gold is a simple investment that is basically just a hunk of metal. Thus, gold ETFs have the disadvantage of being subject to potential unexpected events that will not affect physical gold.

• Doomsday: It is unclear what would happen to gold ETFs after a severe political or economic calamity, such as nuclear war or major natural disaster. In contrast, physical gold will remain as is.

Many investors seeking to diversify their investments by adding exposure to gold will be better off buying a gold ETF rather than physical gold. Buying gold ETFs is more convenient than buying physical gold, since these investors will be able to buy and sell gold ETFs just like any stock.

The most popular gold ETF is the SPDR Gold Trust ETF (“GLD”). The price of GLD closed today at $167.29 per share, representing 1/10 of the price of gold, minus expenses. Investors trade shares of GLD in their brokerage accounts by entering buy or sell orders the same way they trade shares of GE, IBM or other stocks. Along with trading commissions, investors pay an annual expense ratio of 0.40%, or $40 per $10,000 invested. GLD is the most liquid gold ETF due to its average trading volume of 8.6 million shares per day. GLD was recently backed by 38 million ounces of gold.

Another popular gold ETF is the iShares COMEX Gold Trust ETF (“IAU”). IAU closed today at $16.80 per share, representing 1/100 of the price of gold, minus expenses. As with GLD, investors can trade shares of IAU in their brokerage accounts by entering buy or sell orders. Along with commissions, investors pay an annual expense ratio of 0.25%, or $25 per $10,000 invested. IAU is not as liquid as GLD, with an average trading volume of 4.7 million shares per day (each worth only 1/10 as much as a share of GLD). IAU was recently backed by 2.6 million ounces of gold.

The Sprott Physical Gold Trust ETV (“PHYS”) is not technically an ETF since it does not create nor redeem units each day. It is a closed-end fund which can trade at a premium to its net asset value. Thus, the price of PHYS may deviate from the market price of gold. PHYS closed today at $14.83.

The PowerShares DB Precious Metals Fund ETF (“DBP”) tracks an index formed by a basket of futures contracts for both gold and silver. Thus, DBP will not accurately track the market price of gold since it will also be influenced by the price of silver. The price of DBP closed today at $59.90.

Most investors contemplating purchasing a gold ETF will select GLD. GLD is the most popular gold ETF, with the highest liquidity, and backed by more physical gold than other gold ETFs.

Investors contemplating an investment in a gold ETF should consider the tax implications.

Under IRS rules, ETFs holding physical gold and silver are treated as “collectibles” for tax purposes. (The fact that investors of gold ETFs never see or touch the precious metals is apparently irrelevant). Thus, profits from gold ETFs do not qualify for the 15% maximum long-term capital gains tax rate that applies to investments in stocks and mutual funds. Rather, these profits are taxed at a maximum tax rate of 28% if held for more than one year, or at ordinary income tax rates if held for less than one year. Further, if the gold ETF itself buys or sells gold, any gains or losses are passed along to its shareholders, who are subject to the maximum tax rate of 28% even if they did not realize the gain.

Thus, potential investors of gold ETFs should study the tax implications before they invest in them. One solution to this problem is to buy gold ETFs within tax-deferred or tax-free retirement accounts.