From the May 2011 issue of Investment Advisor • Subscribe!

So, Your Client Wants to Own Gold ETFs?

For centuries, gold has been seen as a safe haven and a store of value. Why should modern times be any different? Today, investing in gold is easier than ever, thanks to exchange-traded funds (ETFs). If your clients are clamoring for some exposure in their portfolios, read up on the ins and outs of this unique asset class.

Gold has long been used as a hedge against political and economic uncertainties, and central banks around the world back their currency with gold reserves. Gold is the metal that is seen as a “safe haven” in times of world turmoil, prompting some investors to buy gold bars, which always will have some value. Gold is also used widely in industry, including computers and telecommunications.

Some investors will simply never be comfortable with owning gold they can’t see and, for them, taking physical possession makes the most sense. But if your clients simply want exposure, consider the benefits of owning gold ETFs.

What’s great about gold is that it tends to have a low correlation to other asset classes, which means that it is a great diversifier. Historically, gold is negatively correlated to stocks and other financial instruments. In utilizing the proper combination of gold with other assets, an investor may reduce the overall volatility and risk of his or her portfolio.

Why would you own a gold ETF instead of actual gold? Simply put, it’s more convenient.

Owning a gold-focused ETF is a good way to get physical exposure to gold without the hassle of taking physical possession—finding storage, paying for storage and so on. Each share of a physically-backed gold ETF is just that: backed by a piece of gold.

This gold is stored in secure vaults in London and Switzerland, and the holdings within are audited and inspected on a regular basis. Some investors aren’t comfortable with this—some will simply never be comfortable with owning gold they can’t see. If your clients are like this, gold ETFs may not be the right choice for them.

You have three options to invest in physically-backed gold ETFs:

  • SPDR Gold Shares (NYSEArca: GLD)
  • iShares COMEX Gold (NYSEArca: IAU)
  • ETFS Physical Swiss Gold Shares (NYSEArca: SGOL)

The differences between the three come down to both where the gold is held and the expense ratio of each of the funds. After recently slashing its cost, IAU is the cheapest, with a 0.25% expense ratio. GLD and SGOL have a 0.40% and 0.39% expense ratio, respectively. SGOL stores its gold in Swiss vaults; GLD and IAU have their gold stored in London.

The Future of Gold
Record market volatility and uncertainty have pushed gold demand to new heights, and prices to new records. Asian countries are particularly large consumers of gold; the commodity is not just a store of wealth or a safe haven, but it’s also heavily used in jewelry.

In addition, ETFs have also become one of the world’s largest holders of gold bullion, and demand for ETFs will only drive the fund providers to allocate more gold into their vaults. In fact, the World Gold Council recently said that quarterly demand for gold soared 414% in the second quarter of 2010, driven primarily by ETFs.

While gold isn’t necessarily a volatile instrument, it has periods where it comes in and out of favor. To effectively invest in gold ETFs, you need to watch them for any signs of a drop-off and act accordingly.

From a tax viewpoint, physical gold and physically-backed gold ETFs are treated as collectibles. If held for less than one year, they’re taxed at the normal 15% rate. If held for more than a year, they’re taxed at a 28% rate.

If physically-backed gold ETFs aren’t your style, there are other types of gold funds:

  • Market Vectors Gold Miners (NYSEArca: GDX) and Market Vectors Junior Gold Miners (NYSEArca: GDXJ) both hold the stocks of mining companies. These ETFs only track the performance of these companies—they do not track the spot price of gold. The companies held in these funds tend to perform better when the price of gold is elevated, as it is now.
  • PowerShares DB Gold (NYSEArca: DGL) owns gold futures contracts, rolling them forward instead of taking physical delivery each month. Like all futures-backed ETFs, this fund is a partnership and generates a K-1 at tax time.
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