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Gold's Dull Future?

Reviewing the biggest, oldest gold exchange-traded fund.

Samuel Lee, 03/29/2013

There are many ways to own gold. Because the metal is a bet on disaster, some gold owners prefer physical possession, preferably beyond the knowledge of the tax man. They fret the government could criminalize the private ownership of gold, which last happened when President Franklin D. Roosevelt signed Executive Order 6102 on April 5, 1933. If you're truly worried about such a scenario, no exchange-traded fund is worth consideration. In fact, no mode of ownership that relies on the rule of law--gold accounts, structured notes, certificates, futures, warrants, and so on--will shield you from the government should the unthinkable occur.

For investors who aren't worried about confiscation or a Mad Max scenario, exchange-traded funds are likely the most efficient way to own gold. SPDR Gold Shares GLD is synonymous with gold investing, owing to its massive size and liquidity. GLD has at times held more assets than any other ETF. You pay up for liquidity, though. GLD charges a 0.40% expense ratio, whereas its closest competitor, iShares Gold Trust IAU, charges 0.25%. Traders are more than willing to bear that extra 0.15% annual charge because GLD's share price is about 10 times greater than IAU's. Penny-wide bid-ask spreads (the difference between the prices of buying and selling shares) translate into much smaller transaction costs as a percentage of total assets traded (0.01% in round-trip trading costs for GLD versus 0.06% for IAU).

The best way to think of gold is as a nonyielding currency with a special trait: The only way to "print" it is to pull it out of the earth at great cost. As a currency with no yield and limited practical use, it's unreasonable to expect gold to appreciate by more than gross domestic product growth over the long run. Warren Buffett is right: A century from now gold will almost certainly be less valuable than an investment in stocks compounded over the same period. Gold's investment case largely rests on its ability to insure against currency depreciation. Few people expect to make money by taking out insurance policies. I don't recommend allocating any more than 10% of a portfolio to gold.

Fundamental View
Even though gold's long-run return is almost certainly abysmal, I'm reminded that a great economist once said, "In the long run we are all dead." Gold, as a currency, can do well for all the reasons currencies do well: It can yield more than alternatives, be perceived as safer, or have a favorable real exchange rate. We'll treat each factor in turn.

The biggest determinant of gold's price is its relative yield, not inflation, as many believe. The gold run got its legs when short-term interest rates hit zero in 2008 and the Federal Reserve began its first round of "quantitative easing," reducing fears of deflation. When short-term interest rates went negative, the opportunity cost of holding gold as opposed to cash became positive. Should real rates rise, gold investors will be slaughtered. Therefore, gold is a bet that real interest rates will remain low for a long time.

Another big determinant of gold's price is market's perception of the dollar's safety. Since 2008, emerging-markets central banks have bought gold to diversify their foreign exchange reserves away from the currencies of the big debtor nations. Prominent investors, such as Bridgewater Associates, have advocated for gold as a strategic holding. John Paulson, who famously made a fortune betting against subprime mortgages, is GLD's biggest shareholder. There's a lot of fear baked into gold's elevated price, so investors will have to get a lot more fearful than they are today for this factor to come into play.

Finally, gold has a real exchange rate, just like any other currency. Exchange rates tend to converge on the point where purchasing power is equalized. Gold's purchasing power of real goods is at an all-time high: Since 1975, the gold price/CPI ratio averaged 3.5, but now is higher than 7, suggesting gold is overvalued by 100% in real purchasing power against its history. However, unlike with normal currency pairs, there's no mechanism for arbitragers to buy goods in the cheap currency and sell them in the expensive one, so gold can remain expensive for a long time.


  - source: Morningstar Analysts

Aside from the currency factors, there is also a wild card in Chinese and Indian investment demand. As emerging markets become richer, gold demand may continue to rise. In this regard, gold is an implicit bet on emerging-markets growth.

Portfolio Construction
Each GLD share is worth about a tenth of an ounce of gold. The fund--technically, trust--is sponsored by World Gold Trust Services LLC and is marketed by State Street Global Markets LLC, but the day-to-day management is conducted by the trustee, BNY Mellon Asset Servicing. The gold itself is held in the London vaults of HSBC Bank USA, N.A., though at times some of the gold will be held by other banks, or "subcustodians."

The gold is insured by the custodian, but the prospectus makes clear the custodian doesn't have to maintain insurance to cover the full amount of gold held, and subcustodians aren't required to be insured. If you're hoping for total insurance, you're out of luck--the custodian is only "liable for losses that are the direct result of its own negligence, fraud, or willful default in the performance of its duties."

Taxes
As far as U.S. federal taxes go, the trust is treated as a "grantor trust," meaning your ownership is taxed as if you owned the gold bullion directly. If you sell within a year of buying, your gains are taxed at ordinary income rates. Beyond a year, bullion, alas, is taxed at a special collectibles rate, which as of writing is 28%.

Intriguingly, U.S. investors in Canadian gold closed-end funds may be able to sidestep the 28% collectibles tax rate. The two biggest such funds are Sprott Physical Gold Trust Common PHYS and Central GoldTrust Common GTU. Both funds are "Passive Foreign Investment Companies" for U.S. tax purposes, allowing unitholders to make a "Qualified Electing Fund" election each year. Under this tax treatment, the CEFs are taxed as if they were U.S.-based mutual funds, according to Moskowitz LLP, meaning capital gains on shares held for longer than a year are taxed as long-term capital gains. Of course, you should consult your tax advisor before you pursue this path.

PHYS' total expense ratio for fiscal-year 2011 was 0.47%; GTU's expense ratio was 0.35%. Historically, both funds have traded at modest premiums to net asset value.

 

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index

Samuel Lee is an ETF Analyst with Morningstar.
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