How Do Gold ETFs Work?
Gold ETFs work by pooling investor money and using it to invest in gold. Some gold ETFs invest buy phsical gold bars held in a bank vault. They enable investors to earn returns that match the price of gold before fees. Others will invest in gold mining stocks. These ETFs enable investors to collect passive income from dividends paid by mining stocks and potentially earn returns that exceed the rise in gold prices as the underlying miners expand production and grow profits.
What to look for in gold ETFs
Investors considering an ETF focused on gold should look for the following characteristics:
- Large size: The ETF should have at least $200 million of assets under management (AUM). A larger size makes the ETF less likely to fall prey to market manipulation or trade at a significant premium to its net asset value.
- Reasonable expense ratio: Look for an expense ratio of less than 1%. Any expense ratio above 1.5% is considered excessive.
- Non-leveraged ETFs: A leveraged ETF borrows money or uses derivatives, such as options and futures contracts, to magnify its returns. These carry much higher risk, and leverage in a down market can amplify losses.
Pros and cons of investing in gold ETFs
Investing in gold ETFs has its share of benefits and drawbacks. Some pros of investing in gold ETFs include:
- Lower risk: Investing in a gold ETF is less risky than buying physical gold and storing it at home, where it could be stolen, or investing in individual gold stocks.
- Easy access: Gold ETFs make it easy to invest in physical gold or broadly in gold mining stocks.
- Passive investments: Gold ETFs are passive investments. You don't need to buy gold or a safe to store it in, or manage a portfolio of gold mining stocks.
However, investing in gold ETFs isn't without its drawbacks, which include:
- Potential for underperformance: A gold stock ETF could potentially underperform the price of gold or the top gold mining stocks.
- No physical possession: While gold ETFs own physical gold, you wouldn't have physical possession of the gold if you needed it during an extreme emergency situation.
Finding the best gold ETF for your portfolio
Gold ETFs allow investors to speculate on gold prices without buying physical gold. The benefit of owning a gold mining company ETF over a gold price ETF is that it can generate higher returns.
Gold miners can use the cash flow generated by gold production to expand production, repay debt, pay dividends, and repurchase shares. Those investments and shareholder returns position gold mining companies to potentially deliver total returns higher than the long-term price gains of gold.
How Are Gold ETFs Taxed?
Taxes on gold ETFs depend on their legal structure and the investment account in which you hold them. Most physical gold ETFs are grantor trusts and taxed as collectibles. As a result, the top capital gains tax rate on the sale of one of these ETFs is 28%. Meanwhile, gold ETFs that aren't structured as trusts (typically gold mining stock ETFs) get taxed at the long-term capital gains rate (0%, 15%, or 20% depending on your tax bracket), assuming you hold the shares for at least a year. You'd also pay dividend taxes on any dividends received.
However, any gold ETFs held in retirement accounts are either tax-deferred (Traditional IRA or 401(k)) or tax-free (Roth IRA).
