How to Profit From Rising Gold Prices

On December 18, the Federal Reserve announced that it was slowing down quantitative easing and would buy less Treasury and agency securities. This was the start of the much awaited "taper" that the markets had been expecting for a good portion of last year. Since that time, gold has significantly outperformed the S&P 500 index, a reversal from previous months in which the index outperformed gold.

GLD Chart

GLD data by YCharts

Why gold?
Gold's outperformance almost seems counter-intuitive. After all, one of the biggest arguments that gold bugs have presented is that the Fed's quantitative easing program is resulting in more fiat money circulating throughout the economy, leading to inflation. Gold is often used as a hedge against inflation. 

Therefore, we would expect the price of gold to fall as quantitative easing comes to a close. But, that hasn't happened. Instead, the fundamentals for the yellow metal have taken over as demand for it has surged. 

Gold trusts and ETFs
One of the easiest ways to profit off of a rising gold price is to buy shares in one of the various exchange-traded gold trusts. These are essentially closed-end funds that own physical gold bullion located in a vault. Each share of the trust represents a fractional ownership share of the physical bullion in the vault. Thus, these trusts could be an easy way to purchase gold exposure directly on an exchange. One example of a trust like this is the Sprott Physical Gold Trust (NYSEMKT: PHYS  ) .

There are also ETFs available that track the price of gold. These differ from the pure gold trusts because they are open-ended. What this means is that the custodian stands ready to both issue and redeem new shares as market demand dictates. ETFs such as SPDR Gold Shares (NYSEMKT: GLD  ) also consist of physical gold bullion stored in a vault. However, it is not a fixed quantity. Instead, the fund buys more physical gold whenever the demand for its shares increases and it sells off some of this physical gold whenever demand for its shares decreases.

Senior gold miners
Another way to profit from rising gold prices is to invest in the producers. One advantage that investing in mining companies can have over the purchase of physical gold is the ability to derive cash flow from your investment. The only way to profit off of an investment in physical gold is to sell it for a higher price than what you bought it for. Mining companies, however, do generate cash, and in many cases the mining company returns some of this cash to investors in the form of a dividend. For example, Goldcorp (NYSE: GG  ) , one of the largest gold miners in the world, pays a trailing dividend of $0.60 per share. This is a 2.10% yield at the current stock price.

For an investor looking to primarily bet on gold prices, it may make more sense to make a broader bet and invest in an ETF that owns shares in all the gold mining companies rather than trying to pick and choose between them. One ETF that does this is the Market Vectors Gold Miners ETF (NYSEMKT: GDX  ) . This ETF owns shares in the largest gold mining companies in the world, weighted by market cap.

Source: Yahoo Finance

The price of GDX tends to move with the price of gold. However, the ETF tends to make moves of a much greater magnitude, allowing the equivalent of leveraged exposure to gold prices without actually using leverage.

GLD Chart

GLD data by YCharts

Junior gold miners
It may be possible to profit further from a rising gold price by purchasing shares in smaller gold mining companies, termed junior gold miners. These mining companies are much smaller than the majors and many are much weaker financially. Therefore, junior gold miners are much riskier than the larger companies that make up GDX, so when gold prices fall, these companies tend to make a much larger downward move than in their larger peers.

GLD Chart

GLD data by YCharts

However, should gold continue to move upward then junior gold miners should deliver much greater returns than either physical gold or senior gold miners. This can be seen in the above price chart of the Market Vectors Junior Gold Miners ETF  (NYSEMKT: GDXJ  ) , which has outperformed any of the other gold investments discussed in this article.

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