The ultimate gold investing primer

By Markets Covestor

When it comes to investing in gold, there’s more than one way to skin a cat.

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The form in which you hold this yellow metal will largely depend on why you own it in the first place. The way that is most sensible for you will depend on a variety of factors, including liquidity needs, tax status and privacy concerns, among others.

With the Federal Reserve itching to raise rates and with inflation still very muted, I’m not particularly bullish on the yellow metal. In fact, I’m actually short gold as a short-term tactical trade.

But if you’re more bullish, here are some options:

 

 

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Physical Stuff

Gold can be easily purchased in the form of one-ounce coins in virtually any city in America.

Assuming the coins are not collector’s items, they will generally sell for a very modest premium to the current spot price of gold (a little over $1,300 per ounce, as of September 16.)

So, for a little over $13,000, you could walk out of the coin store with ten, 1-ounce American Eagles, Krugerrands, etc. in your jacket pocket.

For the higher rollers out there, you can also buy gold bars in various sizes. The most common is the 1-kilogram brick, which will set you back a little over $43,000 a piece at today’s prices.

The pros of owning physical bullion are pretty obvious. Owning it in physical form keeps it out of the financial system, so you have no counterparty risk. It can be owned anonymously.

Of course, by keeping it out of the financial system, you expose yourself to the risk of theft, unless you pay to store it or insure it (which sort of eliminates the point of keeping it out of the financial system).

It’s also bulky and illiquid in this form, and it’s expensive to sell. So if your holding period is relatively short-term, owning physical bullion makes no sense at all.

 

Gold Futures

A futures contract is exactly that — a contract. It’s an agreement between a buyer and a seller to exchange a set amount of a commodity — in this case gold — at a set time and price.

Futures are a standardized, exchange-traded versions of forward contracts, which are as old as finance itself.

Of course, most futures trading today has nothing to do with reducing risk and everything to do with speculation.

Gold futures are highly liquid and cheap to trade, which makes them great to use as short-term trading instruments, in my opinion. And because you’re trading a paper derivative tied to gold, you don’t have to worry about theft or about insurance or storage costs.

You can also easily short gold futures, making them a convenient way to bet against gold if you feel the urge.

But, in my opinion, the biggest selling point of gold futures — or detraction, depending on your point of view — is the leverage.

One standard gold futures contract controls 100 ounces of the yellow metal … or a little over $130,000 at today’s prices. But you might need only $7,000 in collateral.

So if you’re really feeling bullish (or bearish), you can effectively leverage the trade by a factor of nearly 20 to 1.

The biggest drawback to gold futures is simply that it’s easy to really get yourself into a mess if you don’t know what you’re doing.

 

Gold ETFs

The oldest and most popular gold ETF is the SPDR Gold Trust (ETF) (GLD). While not quite the same as owning physical bullion, GLD gets you a lot closer than gold futures.

Unlike most commodity futures, gold futures generally can’t be settled by physical delivery. But GLD is indeed backed by real bullion.

Gold ETFs have most of the same benefits as gold futures — liquid, cheap to trade, etc. — and have the added benefit of being available in standard brokerage accounts and even IRAs and Roth IRAs.

The only thing missing is the leverage. Depending on your broker, you might be able to leverage a gold ETF two to three times with portfolio margin.

And you can buy leveraged ETFs, such as the VelocityShares 3x Long Gold ETN ((UGLD)), if you’re really wanting a more aggressive bet. But for the most part, the available gold ETFs are a less aggressive, less leveraged way to play gold.

 

Closed-End Funds

A close cousin to gold ETFs would be gold closed-end funds (CEFs). Although many investors are unfamiliar with them, CEFs are actually the oldest form of mutual fund in existence, predating both traditional open-ended mutual funds and ETFs.

CEFs are an interesting animal and can be best understood by comparing them to a traditional mutual fund.

When you invest in a mutual fund, you send money to the manager (or your broker does), and the manager takes your money and invests it. When you want your money back, they sell off part of the portfolio and send the proceeds your way.

That’s distinctly not how CEFs work. CEFs trade on the stock market like stocks … making them seem similar to ETFs at first. But there is a big difference.

ETF shares track their underlying indexes very closely because, should they deviate, institutional investors can create or destroy shares and generate an arbitrage profit. This forces the ETF’s market price very close to its index.

Well, CEFs don’t have that mechanism. So their prices can deviate wildly from their net asset values. In plain English, rather than pay a dollar for a dollar’s worth of assets, you can often pay 90 cents … or $1.10.

There are few reasons to ever pay a premium for a CEF. Why pay $1.10 for a dollar’s worth of assets, after all? But when the discounts get deep, I get interested.

Right now, there are two closed-end funds with decent liquidity that own gold. The Central Fund of Canada Limited (USA) (CEF) holds about 60% of its assets in gold bullion and most of the remaining 40% in silver. (It keeps about 1% in cash to cover expenses and pay fees.)

CEF currently trades at a 6% discount to its NAV, which is about in line with its average for the year. The Sprott Physical Gold Trust (PHYS) is 100% invested in gold and generally trades fairly close to its NAV because, unlike most CEFs, it does allow for redemptions.

 

Mining Stocks

Gold is a commodity; it’s an inert metal that doesn’t actually do anything. Gold miners, on the other hand, are real operating businesses with everything that means, so profits and losses, labor disputes, operational risks, etc are all added into the mix.

None of this is bad, in my opinion. It’s just different. But the important takeaway is that gold miners are not a substitute for the yellow metal, and their stock prices can actually move in the opposite direction of gold prices for significant stretches of time.

In my view, if you want long-term exposure to the shiny stuff, then buying physical bullion or a gold ETF is your best bet. But if you want a more aggressive short-term trade, then I would say that gold miners (and gold futures) are your better bet.

Gold miners — which you can buy via funds like the Market Vectors Gold Miners ETF (GDX) — can be thought of as leveraged plays on the yellow metal because their profit tends to spike when the price of gold is high.

Larger gold miners tend to hedge at least part of their annual production in the futures market, so their revenue streams tend to be at least marginally more stable. But in my opinion smaller miners are often unhedged, making them riskier.

So, if you’re looking to own this shiny metal as a long-term portfolio allocation or as a crisis hedge, gold miners really don’t make a lot of sense, in my view. But I believe that if you’re looking to speculate fairly aggressively, gold miners can be a useful tool.

 

Charles Sizemore is the principal of Sizemore Capital Management, based in Dallas, Texas.

 
 
Photo Credit: Moyan Brenn via Flickr Creative Commons