Advantages and Disadvantages of Gold ETFs

Even if you follow the mainstream financial news only occasionally, you’ll realize how much is made of exchange-traded funds, known as ETFs, these days.  ETFs have been around since 1989; the original was actually a proxy for the S&P 500 that traded on the American Stock Exchange and the Philadelphia Stock Exchange. That was until the Chicago Mercantile Exchange managed to have the fund quashed in a lawsuit.

But once a similar product, Toronto Index Participation Shares, gained popularity on the Toronto Stock Exchange, the American Stock Exchange developed a similar investment vehicle that would satisfy the SEC. As a result, Standard & Poor’s Depositary Receipts (NYSE Arca: SPY) – SPDRs or “Spiders” – were introduced in 1993.

An ETF trades just like a stock, but it’s designed to track an index, a commodity—like gold, a bond, or a group of assets. But unlike a mutual fund, where net asset value is calculated at the end of the trading day, an ETF undergoes price changes during the trading day each time it’s bought and sold.

Many investors prefer them to mutual funds, because ETFs don’t entail a conventional mutual fund’s high sales and management costs. Also, as the Nasdaq website points out, they offer certain tax advantages to an investor:

“ETFs are less likely than actively managed portfolios to experience the trading of securities, which can create potentially high capital gains distributions. Fewer trades into and out of the trust mean fewer taxable distributions, and a more efficient overall return on investment.

Efficiency is one reason ETFs have become a favored vehicle for multiple investment strategies – because lower administrative costs and lower capital gains taxes put a greater share of your investment dollar to work for you in the market.”

Seems ideal, doesn’t it? Want to track a particular market or fund without incurring exorbitant losses and taxable distributions? Then forget mutual funds and individual stocks; go with ETFs.

If only investing were that simple!

In fact, since an ETF trades likes a stock, it incurs similar trading commissions. So any savings you receive in taxable and capital gains distributions can easily be offset by trading fees.

Also, don’t let anyone persuade you they offer a simpler way to track a particular market. If you let yourself get somehow hooked into trading a leveraged ETF, you’ll find it’s like the Wild West all over again.  Or, as this painful dissection of gold ETFs on the Fox Business site reminds us, in the reputed words of John Maynard Keynes, “Markets can stay irrational longer than you can stay solvent.”

Leveraged ETFs, like stocks purchased on margin, are investments devised to offer enhanced profits in a bull market. Through the use of “financial engineering” and futures contracts, a leveraged ETF may yield a valiant investor two or three times the market gain.  The downside? If the market goes south, that same investor will incur two or three times the loss. Yikes.  In fact, a recent study shows not only are the stocks indexed within a given ETF more volatile than they would otherwise be, simply by virtue of that relationship; the very existence of ETFs makes the whole stock market more volatile than it would otherwise be.

For the individual investor, Fox Business makes clear, “Leveraged ETFs are expensive. They are not buy-and-hold instruments. Over long time-horizons, they deviate wildly from their stated objectives.”  In other words, if you like everything about gold except that pesky stability and how gold maintains its value over the long haul, this is the investment for you!

Of course, focused as I am here on retirement, a (hopefully) long-haul proposition if ever there was one, I love the stability of physical gold, and the fact that, unlike stocks, it can never go to zero.  That’s what lets me sleep at night, even during the craziest markets.  But when you buy an ETF, even one with “gold” in its name, you’re trading paper, pure and simple.

Ask yourself the purpose of holding gold in the first place.  For real investors the point is to avoid paper investments and the problems associated with continually devaluing currency.  Once you invest in physical gold, in your regular portfolio or through your IRA, you can hold it for an emergency, as a legacy for your kids and grandkids, or for any purpose you please.  You’ll no longer have to concern yourself with going long or short, or trading in, out or sideways in a paper market.