The steep decline in stocks over the last two months, as of February 2016, has awakened the safe-haven seekers who have poured billions of dollars into gold exchange-traded funds (ETFs) since early January. Although the large ETFs such as the SPDR Gold Shares (NYSE: GLD) and iShares Gold Trust (NYSE: IAU) have been the biggest recipients of inflows, gold-focused mutual funds have also seen a spike, which raises questions for investors as to which investment option serves them best. The quick answer is “it depends,” because the two options differ in several respects, and they are aimed at different types of investors. The following is a breakdown of the two options and why investors might choose one over the other.
On the surface, ETFs and mutual funds are very similar. Both are pooled investments designed around specific investment objectives. Both offer shares that can be purchased by individual investors and offer investors the opportunity to invest in certain markets or market segments with instant diversification. This is where the similarities end.
Mutual funds collect assets from investors, which are then pooled together to be invested based on the investment objectives of the fund. Most mutual funds are actively managed, meaning professional money managers direct the assets into securities based on their analyses. They buy and sell securities for the purpose of achieving the best possible returns for investors. Index funds are passively managed, meaning managers tend to buy baskets of securities that closely reflect particular market indexes. They may still buy and sell securities as the weightings of securities in the indexes change, but this is done infrequently. Mutual fund shares are not listed on the stock exchanges. They are typically bought and sold through brokerage firms or directly through the mutual fund companies.
Conversely, ETFs are created as companies or trusts, into which blocks of shares are placed to track certain market indexes or segments. For example, an investment company can create an ETF to track the S&P 500 Index by allocating a block of shares that matches the makeup of the S&P 500 and selling it to the ETF. ETF shares are listed on the stock exchange and bought and sold like any other shares of stock. Their prices fluctuate throughout the day, just like other stocks, and they may trade at premiums or discounts to the underlying portfolios that comprise the ETFs. Mutual fund shares are only priced at their net asset values (NAVs) at the end of the trading day.
ETFs and mutual funds also differ in their investment costs. Mutual funds may charge annual management fees, administrative fees and sales charges. The average expense ratio of actively managed equity mutual funds is 0.86%, which does not include sales loads. However, equity index funds average just 11%. The average expense ratio of an equity ETF is 0.4%, but it can go as low as 0.09%. Because ETFs are traded like stocks, you also pay small trading fees.
There are two types of gold ETFs. One holds the actual physical metal in its portfolio, while the other holds a basket of stocks of companies engaged in gold-related activities, such as mining and processing. For investors who want the security of owning the physical metal, there are two gold ETFs that trade in the United States that hold gold bullion as their only asset, the SPDR Gold Shares and the iShares Gold Trust. These ETFs closely track the spot price of gold. Although you never take possession of the bullion, you do own a certificate indicating your share.
Gold-related ETFs hold a basket of stocks of companies engaged in the mining, fabrication, processing and distribution of gold. These ETFs tend to act more volatile than the metal due to the fundamentals of the underlying companies. Although the share prices of gold mining companies tend to move in the same direction as gold prices, many companies are leveraged, which can cause their share prices to fluctuate more widely. When the price of gold goes up, the shares of a gold-related ETF can go up. They can also go down when the price of gold declines.
Gold-focused mutual funds generally invest in the stocks of companies engaged in gold-related activities. Many gold mutual funds also include silver, platinum and other metals in their portfolios, so they are not purely gold-focused. Unlike gold-related ETFs, these mutual funds are actively managed, using fundamental analysis to buy and sell stocks to try to maximize returns. Like gold-related ETFs, gold mutual funds are typically more volatile than the metal itself. They tend to outperform and underperform the price of gold.
If you are looking for gold as a long-term investment or as a safe haven, your best course is probably to own the gold ETFs, either the SDPR or the iShares. If you are willing to take on a bit more risk for the potential of higher returns, consider adding a gold-related ETF or mutual fund to the mix. The advantage of a mutual fund over an ETF in this case is the active management, which can utilize its expertise to hone the portfolio to those stocks it believes will perform the best and sell stocks that underperform. A gold-related ETF generally holds a complete basket of stocks that could include both major losers and major winners. The ETF will typically have a more diversified portfolio, which could stabilize returns over time.