Metals ETFs: Perfect Storm

ETFZone

Precious metals ETFs climbed to new highs in 2010 on the Eurozone debt crisis and U.S. dollar uncertainty. This performance comes on the heels of a decade-long rally. Precious metals are now likely in a bubble phase. Current prices are supported by momentum and speculation. This increases the attractiveness of metals ETFs in the short term but raises questions about long-term price sustainability.Base metal ETFs stagnated in 2010 on lower inflation and stable industrial demand. Base metals ETFs look attractive on continued demand recovery from China and the U.S.ETFs and ETNs offer an exceptionally easy access to precious and base metals for both short and long positions. With ETFs investors can isolate allocation to gold, silver, platinum, palladium, copper, nickel, zinc, tin, lead, etc. Less specialized metals ETFs also allow access to baskets of precious metals or base metals as a class.The increase in popularity of metals ETFs is no secret. SPDR Gold Shares (NYSEArca:GLD - News) has amassed close to 60 billion in assets, more than any other ETF except for the S&P 500 indexed SPY. The introduction of platinum and palladium ETFs has arguably altered fundamental market demand for these metals.The introduction of metals funds like the "glitter," the "white" and the "dust," names of new metals ETFs have further productized and extended the metals meme. ("Glitter" is the ETFS Physical Precious Metals Basket Shares (NYSEArca:GLTR - News) offering exposure to gold, silver, platinum and palladium. "White" is ETFS White Metals Basket Trust (NYSEArca:WITE - News), which offers exposure into silver, platinum and palladium. Dust is Direxion Daily Gold Miners Bear (NYSEArca:DUST - News), a 2x leverage bear fund, not on the metals themselves but on the companies that mine and process them.Though all precious metals ETFs gained in 2010, silver and palladium were standouts, up about 80% for the year. The chart below compares the one-year performance of GoldShares (NYSEArca:GLD - News), with iShares Silver Trust (NYSEArca:SLV - News) and ETFS Physical Palladium Shares (NYSEArca:PALL - News).

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This popularity does not mean the rally is done but that the attractiveness of precious metals as a class is increasingly well-understood. Portfolios without exposure to precious metals have underperformed. Base metals ETFs have underperformed. The chart below compares the performance of PowerShares DB Base Metals Fund ETF (NYSEArca:DBB - News), which has exposure to copper, aluminum and zinc with PowerShares DB Precious Metals Fund ETF (NYSEArca:DBP - News), which has exposure to gold and silver:

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The chart shows base and precious metals diverging. This is a change from 2009 when both found a reason to rally. Like other commodities, metals do well when there is inflation. Otherwise precious and base metals often have different catalysts. The price of metals correlates well with interest rates. Metals tend to appreciate when treasury yields fall. For the last few years treasury yields have been falling. Precious metals are also attractive as a store of value in times of fear. Base metals on the other hand thrive on certainty. They tend to be highly cyclical and perform like basic materials such as oil, chemicals or wood products. They tend to do well in a strong economy or in a recovery.Metals are non-productive assets. They have negative free cash flow because of storage costs. When real short term interest rates are not enough to compensate for inflation, metals are attractive as an inflation hedge. Real short-term interest rates (interest rate minus inflation) are low or negative. This combined with a dollar declining, a euro in crisis and the cultural appeal of gold for an emerging middle class in China has been a perfect storm for precious metals. With inflation expectations contained, base metals have have traded on economic growth. In 2010, growth expectations came inline with expectations. Uncertainty in the currency and debt markets increased. This accounts for the divergence shown in the chart above.Not all metals ETFs take the same approach to asset allocation. The ETFS in the first chart above directly own metal bullion. Specifically, the metal is held in the fund custodian's vault on behalf of the ETF. By contrast, the PowerShares family of ETFs is managed like many other commodities products. They provide synthetic exposure. They hold futures contracts to buy the metal but never take actual delivery. The contracts are rolled over: before the contract comes due, the fund sells that contract and buys another contract further out in time.Although many investors seem to favor holding actual metal bullion, a futures-based allocation has advantages. ETFs like GLD and SLV pay storage fees (expressed in the expense ratio). There are tax consequences. Whereas the long-term tax rate on equity ETFs-- for example the Market Vectors Gold Miners ETF (NYSEArca:GDX - News) is 15%, bullion trades are taxed by the IRS at the collectibles rate of 28%. The Powershares ETF family avoids storage costs because technically no metal is owned. But problems with this structure include trading fees, difficulty tracking the spot price and possible SEC regulation. On the positive side, futures contracts are also taxed at a lower maximum rate of 23%.Most targeted exposure to specific base metals is available through notes or ETNs (Exchange Traded Notes). ETNs are taxed at the same rate as stocks (15% for long term holdings), which beats the other strategies. But ETNs are technically unsecured debt, promises to pay according to the performance of an index and therefore carry counterparty risk.When evaluating a metals fund, investors should consider these differing strategies and their implications on fund liquidity, tracking error, counterparty risk, tax implications, potential regulation, and performance in times of market stress.Below are key metal ETFs and their expense ratios:Bullion OwnershipSPDR GoldShares (GLD), 0.4%iShares Gold Trust (IAU), 0.25%iShares Silver Trust (SLV), 0.5%ETFS Physical Platinum Shares (PPLT), 0.62%ETFS Physical Palladium Shares (PALL), 0.62%ETFS Physical Precious Metals Basket Shares (NYSEArca:GLTR - News), 0.62%ETFS White Metals Basket Trust (NYSEArca:WITE - News), 0.62%Futures BasedPowerShares DB Precious Metals Fund ETF (DBP), 0.75%PowerShares DB Base Metals Fund ETF (DBB), 0.75%PowerShares DB Gold Fund ETF (DGL), 0.75%PowerShares DB Silver Fund ETF (DBS), 0.75%Exchange Traded NotesELEMENTS Rogers International Commodity Metal ETN (RJZ), 0.75%E-TRACS UBS Bloomberg CMCI Industrial Metals ETN (UBM), 0.65%iPath DJ AIG Industrial Metals ETN (JJM), 0.75%PowerShares DB Base Metals Long ETN (BDG), 0.75%Sub-Index ETNsiPath AIG Copper (JJC), 0.75%iPath DJ AIG Lead (LD), 0.75%iPath DJ-AIG Aluminum (JJU), 0.75%iPath DJ AIG Nickel (JJN), 0.75%E-TRACS UBS Platinum (PTM), 0.65%iPath DJ AIG Platinum (PGM), 0.75%Short/Leverage ETFs and ETNsUltra Gold ETF (UGL), 0.95%ProShares UltraShort Gold (GLL), 0.95%ProShares Ultra Silver (AGQ), 0.95%ProShares UltraShort Silver (ZSL), 0.95%PowerShares DB Gold Short ETN (DGZ), 0.75%E-TRACS UBS Short Platinum ETN (PTD), 0.65%PowerShares DB Base Metals Double Long ETN (BDD), 0.75%PowerShares DB Base Metals Double Short ETN (BOM), 0.75%PowerShares DB Base Metals Short ETN (BOS), 0.75%PowerShares DB Gold Double Long ETN (DGP), 0.75%PowerShares DB Gold Double Short ETN (DZZ), 0.75%Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.
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