They say all that glitters is gold, so it's no wonder why gold is the go-to investment when market volatility shakes investor confidence. The price of gold has typically risen during some of the biggest market crashes, making it a safe haven of sorts. That's because the precious metal is inversely related to the stock market.
Another reason why gold is so popular is the physical supply of the metal compared to the demand, which outweighs the world's reserves. According to the World Gold Council, it takes a long time for gold explorers to bring new mines into production and to find new gold deposits.
But what if you don't want to—or can't afford to—invest in the physical commodity itself? Investors have a variety of alternatives in terms of convenience and expense. These include gold exchange-traded funds (ETFs) and gold futures.
Keep reading to learn more about the differences between gold ETFs and gold futures.
- Gold ETFs provide investors with a low-cost, diversified alternative that invests in gold-backed assets rather than the physical commodity.
- Gold futures are contracts between buyers and sellers that trade on exchanges, where the buyer agrees to purchase a quantity of the metal at a predetermined price at a set future date.
- Gold ETFs may have management fees and significant tax implications for long-term investors.
- Gold futures have no management fees and taxes are split between short-term and long-term capital gains.
Gold ETFs vs. Gold Futures: An Overview
Gold ETFs are commodity funds that trade like stocks and have become a very popular form of investment. Although they are made up of assets that are backed by gold, investors don't actually own the physical commodity. Instead, they own small quantities of gold-related assets, providing more diversity in their portfolio. Generally, these instruments allow investors to gain exposure to gold via smaller investment positions than what's achievable through physical investment and futures contracts. However, what many investors fail to realize is that the price to trade ETFs that track gold may outweigh their convenience.
Gold futures, on the other hand, are contracts that are traded on exchanges. Both parties agree that the buyer will buy the commodity at a predetermined price at a set date in the future. Investors can put their money into the commodity without having to pay in full upfront, so there is some flexibility in when and how the deal is executed.
The first exchange-traded fund (ETF) specifically developed to track the price of gold was introduced in the United States in 2004. The SPDR Gold Trust ETF was touted as an inexpensive alternative to owning physical gold or buying gold futures. The very first gold ETF, though, was launched in Australia in 2003. Since their introduction, ETFs have become a widely accepted alternative.
ETF shares can be purchased just like any other stock—through a brokerage firm or a fund manager.
By investing in gold ETFs, investors can put their money into the gold market without having to invest in the physical commodity. For investors who don't have a lot of money, gold ETFs provide a flexible means to gain exposure to the asset class and efficiently enhance the degree of diversification in their portfolios. That said, ETFs can expose investors to liquidity-related risks. For instance, the SPDR Gold Trust prospectus states that the trust can liquidate when the balance in the trust falls below a certain level, when the net asset value (NAV) drops below a certain level, or by agreement of shareholders owning at least 66.6% of all outstanding shares. These actions can be taken regardless of whether gold prices are strong or weak.
Since investors cannot make a claim on any of the gold shares, ownership in the ETF represents ownership in a collectible under IRS regulations. That's because gold ETF managers do not make investments in gold for their numismatic value, nor do they seek out collectible coins.
This makes long-term investment—one year or more—in gold ETFs subject to a relatively high capital gains tax. The maximum rate for long-term investments in commodities is 28%, rather than the 20% rate that is applicable to most other long-term capital gains. Exiting the position before a year to avoid the tax would not only diminish the investor's ability to profit from any multiyear gains in gold but would also subject them to a much higher short-term capital gains tax.
One final thing to consider is the fees associated with ETFs. Because the gold itself produces no income and there are still expenses that must be covered, the ETF's management is allowed to sell gold to cover these expenses. Each sale of gold by the trust is a taxable event to shareholders. That means that a fund's management fee, along with any sponsor or marketing fees, must be paid by liquidating assets. This diminishes the overall underlying assets per share, which, in turn, can leave investors with a representative share value of less than one-tenth of an ounce of gold over time. This can lead to discrepancies in the actual value of the underlying gold asset and the listed value of the ETF.
Despite their differences, both gold ETFs and gold futures offer investors an option to diversify their positions in the metals asset class.
Gold futures, as mentioned above, are contracts that are traded on exchanges in which a buyer agrees to purchase a specific quantity of the commodity at a predetermined price at a date in the future.
Many hedgers use futures contracts as a way to manage and minimize the price risk associated with commodities. Speculators can also use futures contracts to take part in the market without any physical backing.
Investors can take long or short positions on futures contracts. In a long position, the investor buys gold with the expectation that the price will rise. The investor is obligated to take delivery of the metal. In a short position, the investor sells the commodity but intends to cover it later at a lower price.
Since they trade on exchanges, futures contracts provide investors with more financial leverage, flexibility, and financial integrity than trading the actual physical commodities.
Gold futures, in comparison to the corresponding ETFs, are straightforward. Investors are able to buy or sell gold at their discretion. There are no management fees; taxes are split between short-term and long-term capital gains; there are no third parties making decisions on the investor's behalf; and at any time investors can own the underlying gold. Finally, because of margin, every $1 that's put up in gold futures can represent $20 or more in physical gold.
Gold ETFs vs. Gold Futures Example
For example, a $1,000 investment in an ETF such as the SPDR Gold Shares (GLD) would represent one ounce of gold (assuming gold was trading at $1,000). Using that same $1,000, an investor could purchase an E-micro Gold Futures gold contract that represents 10 ounces of gold.
The drawback to this kind of leverage is that investors can both profit and lose money based on 10 ounces of gold. Couple the leverage of futures contracts with their periodic expiration, and it becomes clear why many investors turn to an investment in an ETF without really understanding the fine print.