Understanding the differences and opportunities
Gold has historically served as both an efficient hedge against inflation and an integral part of a diversified investment portfolio. But how can individual investors participate in the performance of gold and use the yellow metal as a vehicle for investing, preserving and increasing one’s wealth?
Today, more than any other time in history, active investors have many ways to invest in the performance of gold. From gold bars to shares in mining stocks to derivatives, individuals have flocked into gold-related investments in an attempt to benefit from the renewed interest in gold. Two of the more popular gold investments chosen by professional money managers are Gold (GC) futures (COMEX) and exchange traded funds (ETFs) based on gold. There are significant differences in the liquidity, leverage and costs of each that need to be understood before any investment decision is made.
Differences in market liquidity
It’s estimated that world gold reserves stand at around 200,000 metric tons,1 with jewellery representing almost half of the total (45%), followed by bars and coins (21%) and central bank holdings (17%). The world’s largest gold ETF, SPDR Gold Shares ETF (GLD), was launched in 2004 and currently,as of November 2024, has assets under management in the order of $75 billion dollars, in the form of 880 metric tons of gold held at its custodians’ depositories. The SPDR ETF was developed to track the price of gold and to become an inexpensive alternative to owning physical gold. Investors can purchase a share in the ETF, which represents one tenth of an ounce of gold. Considering world gold reserves of 200,000 metric tons, the amount of bullion under management held by the ETF is fairly insignificant and the volume of gold traded by the SPDR ETF is small compared to the daily volume transacted via Gold futures.
Currently, the SPDR Gold ETF trades an average of 7 million shares (GLD)2 on a daily basis (YTD 2024) representing 0.7 million troy ounces of gold. In comparison, the average daily volume (ADV) for Gold futures is over 250,000 contracts (full year 2024), which equates to approximately 25 million troy ounces changing hands on a daily basis. In addition, the contract shows the equivalent of 48 million troy ounces,or almost 1,500 metric tons, in open interest, meaning futures positions held open by market participants as of the time of writing.
Over 90% of these futures contracts are traded electronically. This, combined with the large number of market participants and the significant daily volume, has the effect of making the futures markets very efficient. All transactions, as well as the best bids and best offers, are publicly available in real-time, which further enhances liquidity and provides what is known as transparent price discovery. Transparent pricing and small bid/ask spreads are key to a market’s success and a great benefit to the investors who use them.
Market size:
Gold futures = 25 million tr ounces/day
SPDR Gold ETF = 0.7 million tr ounces/day
Opportunities for leverage
To put it plainly, gold ETFs don’t provide leverage. Some securities brokers may loan you 50% of the money to purchase stocks or ETFs, but similar to any loan there are costs associated with this. A unique feature of futures contracts is the ability to use leverage, which is built into each contract via the margining and the daily mark-to-market mechanism. Brokerage firms extend the Exchange enforced minimum margin requirements along to their customers and manage the daily margining of their customer accounts. Margin can sometimes represent as little as 3%t of the notional value of the contract. This is a tremendous advantage for investors who wish to use leverage to take advantage of a specific opportunity in the market. However, unlike stocks, futures margin is not partial payment or a down payment for the purchase of the underlying asset, it is simply “good-faith money.” This money is placed on deposit to guarantee that each participant has the ability to perform to the terms of the contract and withstand the average daily price fluctuation of the underlying asset and is returned upon exiting a position. Brokerage firms constantly monitor margin balances and update account balances to reflect changes in market prices at the end of each day. When market conditions change, the Exchange may amend the required margin to trade that market, but there is never a need to borrow money from a broker nor are there fees associated with using this margin.
At current prices, a $5,000 investment in a gold ETF would buy you shares that equate to approximately two ounces of gold. While an investment of $5,000 represents a substantial amount of money, gold would need to make a fairly significant move before an investor would see any meaningful profits. On the other hand, that same $5,000 placed in a margin account allows the futures trader to benefit from the movement of up to 40 ounces of gold through the purchase or sale of Gold futures and its related Micro Gold, E-mini Gold and 1-Ounce Gold futures contracts, which are smaller in notional unit size. Micro Gold has a unit size of 10 troy ounces, E-Mini Gold of 50 and the 1-Ounce Gold contract, predictably, of 1 troy ounce.
Participants should know that there is no need to utilize all of the leverage available. Each investor can tailor the leverage they use to meet their individual investment goals. This is done by simply adjusting the amount of margin on deposit in relation to the value of the contract. The benefit of leverage is tempered by the fact that leverage magnifies both profits and losses. This means that investors that choose to use leverage should additionally protect themselves by using prudent risk management techniques. Using stop loss orders “stops” to limit the investors’ financial exposure to fast moving markets is one common technique used by futures traders.
SPDR Gold ETF | Micro Gold futures | 1OZ futures | |
---|---|---|---|
Initial investment | $5,000 | $5,000 | $2,500 |
Amount of gold notional equivalent | 2 oz. | 40 tr oz., equivalent to four Micro Gold contracts | 20 tr oz., equivalent to 20 1OZ futures contracts |
Value of a $50 move in gold | $100 | $2,000 | $1,000 |
Return on Investment | 2.0% | 40% | 40% |
Note, example assumes margin requirement of 5% and current price of gold of $2,500 per troy ounce. Exchange margin requirements are variable.
Minimizing tracking error
When compared to an investor trading Gold futures, an individual who invests in an ETF will be exposed to costs and fees in addition to brokerage and ETF creation/redemption fees. Many of the costs involved with owning an ETF revolve around management fees and the associated taxes. These sometimes hidden costs can affect the pricing of the ETF itself and have very little to do with the actual price of gold.
By virtue of the asset class, gold (a physical commodity) produces no income. This presents a problem for the ETF manager since the fund generates ongoing administrative expenses. Whether it is management fees, marketing fees, storage or general expenses, gold bullion from the fund must be sold to cover these expenses. When the fund does so, they may incur additional transactional costs. This sale of gold diminishes the overall holdings of the ETF and over time will erode its value, which results in what is known as a tracking error.
In contrast, Gold futures contracts do not experience any of these issues. Investors are able to buy or sell gold on the open market at their discretion and avoid the related management fees. Therefore, Gold futures, that are in many cases used for investment instead of acquiring physical bullion, can be arbitraged against gold bullion and have no measurable tracking error. Long-term investors should note futures positions may need to be rolled forward (exiting one contract and entering into a new one) to a contract with a deferred expiration to maintain a position longer than the expiration date of the original contract, which may result in additional brokerage costs and performance impact when rolling forward into more expensive deferred contracts.
Further tax implications
Another cost associated with owning shares in gold ETFs, as opposed to investing in futures, is the tax implication. Gold futures may also present tax advantages for certain investors. This is not intended to be advice regarding tax treatment and we advise that you contact your tax attorney or accountant for information that is applicable to your situation.
Taking physical delivery
Both the futures and gold ETFs provide a mechanism for the physical delivery of gold. Investors interested in obtaining gold through the purchase of Gold futures or gold ETFs should recognize that there are standard procedures and quantities used for delivery and redemption. For example, a large commercial bank, who acts as the trustee of the SPDR GLD ETF, deals with creation and redemption of gold from its London vaults in blocks of 100,000 shares (10,000 troy ounces). This trustee does not deal directly with the public, so any individual investor wishing to exchange shares for physical gold would have to come to the appropriate arrangements with a broker. In contrast, Gold futures (100 troy ounces) are available for delivery, in accordance with the details of the contract, from an exchange licensed New York Area depository.
There can be costs associated with security, transportation and insurance whenever you redeem shares and/or take delivery of physical assets, so be sure to consult an investment professional before doing so.
Summary
The information provided will hopefully help answer the question “Which gold investment is appropriate for me, gold futures or the gold ETF?” While there is a place for ETFs in any investment portfolio, there are several drawbacks that do not make them the first choice for individuals wishing to invest in gold.
When the goal is to simply benefit from a rise or fall of the price of gold, Gold futures are the logical choice. Gold futures, whether it’s the main GC contract or lower notional size related contracts, offer the investor a fast and accurate pricing mechanism, the ability to leverage their trading strategies and the security of doing business on an Exchange that has guaranteed the performance of each of its transactions for over 100 years.
References
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.