ETFs trump shares and physical metal

Renewed appetite for precious metals has coincided with perhaps the most democratising revolution in asset management since mutual funds were introduced: exchange-traded funds (ETFs).

ETFs have been incredibly successful in most asset classes, but arguably the most success has been in commodities, notably physical gold ETFs.

Equity ETFs in mining stocks have been very popular as well. Assets under management in gold ETFs peaked at more than $150bn in 2012.

The first precious metal ETF was launched in 2002 when ETFS Physical Gold was listed on the Australian Stock Exchange. The largest is the SSGA Gold Trust (GLD), listed on the NYSE.

At its peak in 2012, GLD had more than $80bn of gold in its vaults – more than most central banks. The sophistication of precious metal ETFs has developed over the years and even includes short and leverage products.

ETFs have been at their most powerful as a ‘market access’ tool. This essentially means that they give access to difficult-to-trade assets. To illustrate further, if an investor wants to buy and hold actual physical gold it will probably cost them more than 2 per cent a year to hold it and up to 7 per cent to get in and out each time. To hold a physical gold ETF, an investor will pay 0.4 per cent annualised, while spreads on exchange are less than 0.1 per cent.

Traditionally, investors have looked to gain exposure to precious metals through investments in mining stocks or mutual funds that invest in such stocks. But these stocks are a poor proxy for the underlying metal prices.

The main disadvantages are the management risks. Each company has executives and a board of directors, who will make good and bad commercial decisions that will impact its value, growth and development.

There are also operating risks that can affect returns. Some are operating in politically unstable parts of the world – for example, South African platinum producers have suffered significantly from strikes.

Leverage is another disadvantage. Mining stocks tend to be highly geared to rising and falling precious metal prices, so it is likely their value will rise and fall faster than the rises and falls in the underlying metal.

There are correlation risks as well. The link between gold and miners tends to be relatively low (often around 0.2 per cent) when computed over longer time frames and when market conditions are stable. But in periods of high uncertainty and volatility, the correlations tend to be relatively high.

As most of the readily available precious metals were sourced many years ago, most producers are having to live with rising costs and increasing complexity. Production is therefore often not profitable if metal prices fall sharply. As most new mines take many years to produce precious metal, rises and falls in the metal price can be devastating to profitability.

By holding the metal directly, investors get a purer play on the metal price and avoid the majority of these risks. They can also use a mutual fund to gain access to mining stocks and precious metals, but these are often expensive and have historically underperformed the ETFs after fees.

The main benefits of ETFs are that they trade and settle on exchange the same as equities, making them efficient to buy and hold in a portfolio. They are usually very cost-efficient too.

They are safe and secure and usually hold only physical bars that are on the London Bullion Market Association and London Platinum & Palladium Market official lists. Most ETF providers will print and audit actual bar lists on their websites.

ETFs trade through the trading day in line with the underlying metal being tracked. Any discounts or premiums are minimal and momentary due to arbitrage. Mining stocks tend to be more volatile and can move wildly from the precious metal price as a result.

Investors should also note that ETFs are open-ended and can be created and redeemed on demand. Creations can only be achieved once the metal is received by the custodian and ‘allocated’.

The availability of precious metal ETFs has resulted in hundreds of billions of investor dollars flooding into them in less than 15 years. This growth and choice appears to be here to stay.

Hector McNeil is co-chief executive of Boost ETP