Primarily due to profit-taking and consolidation, the gold price slumped back to $1,230/oz after trading above $1,250/oz earlier in week. This pullback clearly impacted the various gold-backed ETFs as well as ETFs tracking gold mining companies (such as NUGT and GDX). We'll take a look at the difference between these two distinct types of funds. Yet, as always, the reader should bear in mind that there's no replacement for physical gold bullion!
All ETFs Are Not the Same
For most investors who are involved in the gold market, there is some degree of familiarity with exchange-traded funds. These funds are quite popular in the financial news due to the convenience they offer.
Detractors of holding gold bullion (and there is never any shortage of pundits of this sort) point out that you have to store the physical gold somewhere; gold is not a yield-bearing asset; and gold requires physical transport when you sell it. By contrast, both gold ETFs and gold mining ETFs avoid these restrictions. Like gold futures contracts (which are what most people refer to when they say "paper gold"), ETFs backed by bullion or mining firms are equivalent to shares in an asset—rather than holding the tangible asset yourself.
Both of these kinds of ETFs benefit when the price of the precious metals rise. However, this is generally where the similarities between the two end.
First and foremost, the standard gold-backed ETFs like the SPDR Gold Trust (GLD) and the iShares Gold Trust (IAU) track almost perfectly in lockstep with gold prices. This means that the only factor that really influences their performance is demand for gold. While it's true that there are a variety of reasons why investors might demand gold (safe haven, portfolio diversification, inflation hedge, long-term wealth preservation), these all boil down to rising demand for bullion.
By contrast, the ETFs that are tied to the gold mining industry are influenced by the health of these mining companies in addition to metal prices. Gold mining stocks (and, by extension, gold mining ETFs) are usually more volatile and risk-oriented than their physical-backed counterparts. As a result, when the precious metals market is rallying, the mining ETFs often provide investors with outsized returns by comparison.
Many investors choose gold mining stocks and mining ETFs for this reason when they're looking for a speculative tool to maximize how they capitalize on a rising precious metals market. The Market Vectors Gold Miners ETF (GDX) is the most popular choice in this regard, boasting a market cap of over $6 billion. Beyond this dynamic, many ETFs are "leveraged," meaning they offer multiples of whatever their underlying price driver returns. This is how the Direxion Shares ETF Trust (NUGT) works: it is leveraged 3x over the normal return of the basket of mining companies that it tracks.
Although leveraged ETFs like NUGT offer investors significantly stronger gains during a market upswing, the same is true on the opposite end. Anytime that the miners or broader gold market experience a downward correction or modest sell-off, a leveraged ETF like NUGT loses three times as much.
This is what makes NUGT (and other forms of paper gold, for that matter) such a risky play. Something to always remember is that physical gold has no counterparty risk—there's no chance that the other party in a contract defaults and doesn't pay you. The same cannot be said of any kind of share of a future or ETF.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.