ETF

ETFs on gold

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ETFs on gold

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management (MiM), 2021-2024) provides an overview of ETFs on gold, the major types gold ETFs in market, and the advantages and disadvantages of investing on gold ETFs.

Introduction

Gold ETFs are financial instruments that track the price of gold and allow investors to buy shares representing a fraction of physical gold holdings. The first gold ETF was launched in March 2003. Later, State Street Corporation launched SPDR Gold Shares (NYSE: GLD) in 2004, which became the largest gold-backed ETF in the world by 2019. In 2020, the Royal Mint issued the first gold ETC issued by HANetf Securities Plc, from a European sovereign entity. And after that, Wilshire Phoenix launched the wShares Enhanced Gold Trust (NYSE: WGLD) in 2021. This ETF tracks the Wilshire Gold Index, which automatically rebalances physical gold and cash based on market conditions.

Types of Gold ETFs

There are two types of gold ETFs, namely Physically Backed Gold ETFs and Synthetic gold ETF’s.

Physically Backed Gold ETFs: These ETFs invest in physical gold, held in a secure vault by the ETF provider. The units of the ETF represent a specific amount of gold. For example, one unit of a physically backed gold ETF might represent 1 gram of gold. Examples include SPDR Gold Shares (GLD) and iShares Gold Trust (IAU).

Synthetic Gold ETFs: These ETFs do not invest in physical gold. Instead, they use financial instruments, such as futures contracts or swaps, to track the price of gold. This means the ETF provider does not need to hold any physical gold.

Major Gold ETFs in the Market

SPDR Gold Shares (GLD)

SPDR offers investors an innovative, relatively cost-efficient, and secure way to access the gold market. Originally listed on the New York Stock Exchange in November of 2004, and traded on NYSE Arca (the top U.S. exchange for the listing and trading of exchange-traded funds (ETFs) ) since December 13, 2007, SPDR Gold Shares is the largest physically backed gold exchange-traded fund (ETF) in the world. SPDR Gold Shares also trade on the Singapore Stock Exchange, the Tokyo Stock Exchange, The Stock Exchange of Hong Kong, and the Mexican Stock Exchange (BMV).

Figure 1 below gives GLD share price dated from January 1, 2024, to October 11, 2024.

Figure 1. SPDR share price
SPDR share price
Source: Yahoo Finance

iShares Gold Trust (IAU)

With a global lineup of 1,400+ Exchange Traded Funds (ETFs), iShares has been a leader in the ETF marketplace for more than two decades, and as a part of BlackRock, their products are engineered by investment professionals with discipline and deep risk management expertise. It has a lower expense ratio (It is the fee that investors pay to own a mutual fund or exchange-traded fund (ETF)) compared to GLD.

Figure 2 below gives the IAU share price dated from January 1, 2024, to October 11, 2024.

Figure 2. SiShares Gold Trust (IAU) share price
SiShares Gold Trust (IAU) share price
Source: Yahoo Finance

Aberdeen Standard Physical Gold Shares ETF (SGOL)

SGOL is designed to track the spot price of gold bullion by holding gold bars in a secure vault in Switzerland. The company also posts the serial numbers of the bars, giving investors further security over the status of their investment. While SGOL isn’t the most liquid way to gain exposure to gold, it could be a solid choice for investors seeking greater peace of mind regarding their precious metals investment.

Now how do we trust the data here? To maintain the authenticity of the gold ETF’s the data is monitored in three ways, independent audits, periodic physical verifications or regulatory oversights. By ensuring the accuracy of the fund’s financial reporting and the security of its gold holdings, audits help to protect investors from fraud, mismanagement, and other risks. For example, SGOL is Audited twice a year.

Figure 3. Aberdeen Standard Physical Gold Shares ETF (SGOL) share price
Aberdeen Standard Physical Gold Shares ETF (SGOL) share price
Source: Yahoo Finance

Comparative Analysis of Gold ETFs

Gold ETFs provide a convenient way to invest in gold without the need to physically own it. They offer benefits like easy trading, lower costs, and the ability to diversify your portfolio. However, not all gold ETFs are created equal. Here’s a comparative analysis of key factors to consider when choosing a gold ETF:

  • Expense Ratios: The annual fee charged to manage the ETF. A lower expense ratio means more of your investment goes towards buying gold, rather than paying fees. Compare the expense ratios of different gold ETFs to find one with the lowest cost.
  • Liquidity and Trading Volume: The ease with which an ETF can be bought or sold at a fair price. High liquidity means you can buy or sell shares quickly without significantly affecting the price. Look for ETFs with high trading volumes to ensure liquidity.
  • Tracking Accuracy: The difference between an ETF’s performance and the performance of its underlying benchmark (usually the spot gold price). A lower tracking error indicates the ETF is more closely following the gold price.
  • Tax Considerations: How efficiently an ETF is taxed, Tax-efficient ETFs can help you minimize your tax burden. So researching the tax implications of different gold ETFs to find one that aligns with your tax strategy is highly beneficial.

The annual management fees are different for different ETFs, which is also a key factor for the investors to choose a certain ETF to invest in. For example, SPDR Gold Shares and iShares Gold Trust charge 0.25%, Invesco Gold ETF charge 0.15% and WisdomTree Physical Gold ETF charge 0.20%.

Advantages and disadvantages of Investing in Gold ETFs

Whether the advantages or disadvantages outweigh each other depends on your circumstances and investment goals.

Advantages of Investing in Gold ETFs

High liquidity: Gold ETFs are easily tradable on stock exchanges, providing investors with quick entry and exit options. They offer a convenient way to invest in gold without the need to physically store or transport the metal.

Low costs: Investors don’t need to worry about storage and security issues associated with physical gold. Additionally, the expense ratios are generally lower than mutual funds.

Diversification: Investing in gold ETFs offers a way to diversify portfolios with exposure to gold prices, often serving as a hedge against inflation and market volatility.

Disadvantages and Risks of Gold ETFs

Counterparty Risk: If the issuer of the ETF becomes insolvent, investors may face losses.

Taxes: Capital gains taxes may apply when you sell your ETF shares.

Volatility: The price of gold can be highly volatile, and gold ETFs are no exception. Investors should be prepared for potential price fluctuations.

Storage: While gold ETFs typically store their gold in secure vaults, there’s always a risk of theft or loss.

Considerations for gold investment strategies

In the end, the best investment strategy for you will depend on your circumstances and risk tolerance. By carefully considering these factors and the potential benefits and risks associated with gold ETFs, you can make informed decisions about how to incorporate them into your investment portfolio.

Portfolio diversification: A common strategy is to add gold ETFs to your investment portfolio for diversification. Gold’s price movements often correlate negatively with stocks and bonds, providing a potential haven during market downturns. By including gold in your portfolio, you can reduce overall risk and potentially improve returns over the long term.

Hedging Against Inflation: One popular strategy is to use gold ETFs as a hedge against inflation, as gold prices tend to rise when inflation is high. This can help protect your portfolio from the eroding purchasing power of your currency. Note that academic studies (see Erb and Harvey, 2013) have shown that gold may not be a good hedge against inflation.

Conclusion

Gold remains the top choice for many investors for portfolio diversification or protection against economic instability. This precious metal has held (more or less) its value over centuries. While market prices fluctuate, many still choose to buy gold to secure their financial future.

Why should I be interested in this post?

Gold has been a key financial asset for centuries, acting as a store of value, a hedge against inflation, and a safe-haven asset during economic crises. Understanding its investment options helps students grasp fundamental market dynamics and investor behavior, especially during periods of economic uncertainty.

Related posts on the SimTrade blog

   ▶ Nithisha CHALLA History of Gold

   ▶ Nithisha CHALLA Gold resources in the world

   ▶ Youssef LOURAOUI ETFs in a changing asset management industry

   ▶ Micha FISCHER Exchange-traded funds and Tracking Error

Useful resources

Academic research

Erb, C.B., and C.R. Harvey (2013) The Golden Dilemma. Financial Analysts Journal 69 (4): 10–42. Erb, C.B., and C.R. Harvey (2024) Is there still a Golden Dilemma Working paper.

Business

Gold Avenue What is a gold ETF?

SPDR Gold shares Bringing the gold market to investors

iShares gold trust (IAU) Why IAU?

Other

Wikipedia Gold

About the author

The article was written in October 2024 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management (MiM), 2021-2024).

Exchange-traded funds and Tracking Error

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Exchange-traded funds and Tracking Error

Micha FISHER

In this article, Micha FISHER (University of Mannheim, MSc. Management, 2021-2023) explains the concept of Tracking Error in the context of exchange traded funds (ETF).

This article will offer a short introduction to the concept of exchange-traded funds, will then describe several reasons for the existence of tracking errors and finish with a concise example on how tracking error can be calculated.

Exchange-traded funds

An exchange-traded fund is conceptionally very close to classical mutual funds, with the key difference being, that ETFs are traded on a stock exchange during the trading day. Most ETFs are so-called index funds and thus they try to replicate an existing index like the S&P 500 or the CAC 40. This sort of passive investing is aimed at following or tracking the underlying index as closely as possible. However, actively managed ETFs with the aim of outperforming the market do exist as well and typically come with higher management fees. There are several types of ETFs covering equity index funds, commodities or currencies with classical equity index funds being the most prominent.

The total volume of global ETF portfolios has increased substantially over the last two decades. At the beginning of the century total asset volume was in the low triple digit billions measured in USD. According to research by the Wall Street Journal total assets in ETF investments surpassed nine trillion USD in 2021.

The continuing attractiveness of exchange-traded index funds can be explained with the very low management fees, the clarity of the product objective, and the high liquidity of the investment vehicle. However, although especially the market leaders like BlackRock, the Vanguard Group or State Street offer products that come extremely close to mirroring their underlying index, exchange-traded funds do not perfectly track the evolution of the underlying index. This phenomenon is known as tracking error and will be discussed in detail below.

Theoretical measure of the Tracking Error

Simply speaking, the tracking error of an ETF is the difference in the returns of the underlying index (I for index) and the returns of the ETF itself (E for ETF). For a specific period, it is computed by taking the standard deviation of the differences between the two time-series.

Formula for tracking error

Theoretically, it is possible to fully replicate an index in a portfolio and thus reach a tracking error of zero. However, there are several reasons why this is not achievable in practice.

Origins of the Tracking Error

The most important and obvious reason is that the Net Asset Value (NAV) of index funds is necessarily lower than the NAV of its underlying index. An index itself has no liabilities, as it is strictly speaking an instrument of measurement. On the other hand, even a passively managed index fund comes with expenses to pay for infrastructure, personnel, and marketing. These liabilities decrease the Net Asset Value of the fund. In general, a higher tracking error could indicate that the fund is not working efficiently compared to products of competitors with the same underlying index.

Another origin of tracking error can be found in specific sector ETFs and more niche markets with not enough liquidity. When the trading volume of a stock is very low, buying / selling the stock would increase / decrease the price (price impact). In this case an ETF could buy more liquid stocks with the aim to mirror the value development of the illiquid stock, which in turn could lead to a higher tracking error.

Another source of tracking error that occurs more severely in dividend-focused ETFs is the so-called cash drag. High dividend payments that are not instantly reinvested drag down the fund performance in contrast to the underlying index.

Of course, transaction fees of the marketplaces can reduce the fund performance as well. This is especially true if large rebalancing efforts are necessary due to a change of the index composition.

Lastly, there are also ways to reduce the effects described above. Funds can engage in security lending to earn additional money. In this case, the fund lends individual assets within the portfolio to other investors (mostly short sellers) for an agreed period in return for lending fees and possible interest. It should be noted, that while this might reduce tracking error, it also exposes the fund to additional counterparty risk.

Tracking Error: An Example

The sheet posted below shows a simple example of how the tracking error can be computed. To not include hundreds of individual shares, the example transformed the top ten positions within the Nasdaq-100 index into an artificial “Nasdaq-10” index. Although the data for the 23rd of September is accurate, the future data is of course randomly simulated.

By using the individual weights of the index components and their corresponding weights, the index returns for the next three months can be computed.

Figure 1: Three-months simulation of “Nasdaq-10” index.
Three-months simulation of Nasdaq-10 index
Source: computation by the author.

At this point our made-up ETF is introduced with an initial investment of 100 million USD. This ETF fully replicates the Nasdaq-10 index by holding shares in the same proportion as the index. In this example only the management and marketing fees are incorporated. Security lending, index changes and transaction fees and dividends are omitted. Also, all the portfolio shares are highly liquid and allow for full replication. The fund works with small expenses for personnel of only ten thousand USD per month. Additionally, once per quarter, a marketing campaign costs additionally fifty thousand USD.

Figure 2: Computation of ETF return and tracking error.
Computation of ETF-return and Tracking Error
Source: computation by the author.

Calculating the net asset value (NAV) gives us the monthly returns of the fund which in turn allows us to calculate the three-month standard deviation of the tracking difference. Additionally, the Total Expense Ratio can be calculated as the percentage of expenses per year divided by the total asset value of the fund.

This example gives us a Total Expense Ratio of nearly 0.3 percent per annum which is within the competitive area of real passive funds. Vanguard is able to replicate the FTSE All-World index with 0.2 percent. However, the calculated tracking error is obviously smaller than most real tracking errors with only 0.0002, as only management fees were considered. Exemplary, Vanguards FTSE All-World ETF had an historical tracking error of 0.042 in 2021, due to the reasons mentioned in the section above.

Excel file for computing the tracking error of an ETF

You can also download below the Excel file for the computation of the tracking error of an ETF.

Download the Excel file to compute the tracking error of an ETF

Why should I be interested in this post?

ETFs in all forms are one of the major developments in the area of portfolio management over the last two decades. They are also a very interesting option for private investments.

Although they are conceptually very simple it is important to understand the finer metrics that vary between different service providers as even small differences can have a large impact over a longer investment period.

Related posts on the SimTrade blog

   ▶ Youssef LOURAOUI ETFs in a changing asset management industry

   ▶ Youssef LOURAOUI Passive Investing

   ▶ Youssef LOURAOUI Markowitz Modern Portfolio Theory

Useful resources

Academic articles

Roll R. (1992) A Mean/Variance Analysis of Tracking Error, The Journal of Portfolio Management, 18 (4) 13-22.

Business

ET Money What is Tracking Error in Index Funds and How it Impacts Investors?

About the author

The article was written in November 2022 by Micha FISHER (University of Mannheim, MSc. Management, 2021-2023).

ETFs in a changing asset management industry

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ETFs in a changing asset management industry

Youssef LOURAOUI

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2016-2020) talks about his research conducted in the field of investing.

As a way of introduction, ETFs have been captivating investors’ attention in the last 20 years since their creation. This financial innovation has shaped how investors place their capital.

Definition

An ETF can be defined as a financial product that is based on a basket of different assets, to replicate the actual performance of each selected investment. An ETF has more or less the same proportion of the underlying components of the basket, depending on the style of management of the asset manager. ETFs represent nearly 90% of the asset under management of the global Exchange Traded Products (ETP).

History

The first ETF was the Standard and Poor’s Depository Receipts (SPDR) introduced in 1993. It appears to be an optimized product that enables investors to trade it like a stock, with a price that fluctuates during the day (not like mutual funds whose value is known at the end of the day only). The main advantage of ETFs for investors is to diversify their investment with lower fees than buying each underlying asset separately. The most important ETFs in the market are the ones with the lowest expense ratio as it is a crucial point to attract money from investors in the fund.

Types of ETF

ETFs can be segmented in different types according to the asset class, geography, sector, investment style among other criteria. According to Blackrock’s classification (2021), the overall ETF market can be divided into the following classes:

  • Stock ETFs track a certain stock market index, such as the S&P 500 or NASDAQ.
  • Bond ETFs offer exposure to a wide selection of fixed income instruments.
  • Sector and industry ETFs invest in a particular industry such as technology, healthcare, or financials.
  • Commodity ETFs track the price of a commodity such as oil, gold, or wheat.
  • Style ETFs are devoted to an investment style or market capitalization focus such as large-cap value or small-cap growth.
  • Alternative ETFs offer exposure to the alternative asset classes and invest in strategies such as real estate, hedge funds and private equity.
  • Foreign market ETFs follow non-U.S. markets such as the United Kingdom’s FTSE 100 index or Japan’s Nikkei index.
  • Actively managed ETFs aim to provide a certain outcome to maximize income or outperform an index, while most ETFs are designed to track an index.

Figure 1. Volume of the ETF market worldwide 2003-2019.
Volume of the ETF market worldwide 2003-2019
Source: Statista (2021).

Figure 1 represents the volume of the ETF market worldwide over the period 2003-2019. With over 6,970 ETFs globally as of 2019 (Statista, 2021), the ETF industry is growing at an increasing pace, recording a thirty-fold increase in terms of market capitalization in the 17-year timeframe of the analysis. It reflects the growing appetite of investors towards this kind of financial instruments as they offer the opportunity for investors to invest virtually in every asset class, geographical region, sector, theme, and investment style (BlackRock, 2021).

iShares (BlackRock), Xtrackers (DWS) and Lyxor (Société Générale) can also be highlighted as key players of the ETF industry in Europe. As shown in Figure 2, Lyxor (a French player) is ranked 3rd most important player with nearly 9% of the overall European ETF market (Refinitiv insights, 2019). iShares represents nearly eight times the weight of Lyxor, which is slightly above the average of the overall European ETF volume in dollars.

Figure 2. Market share at the promoter level by Assets Under Management (March 31, 2019)
Market share at the promoter level by Assets Under Management (March 31, 2019)
Source: Refinitiv insights (2019).

It goes without saying that the key player worldwide remains BlackRock with nearly 1/3 of the global ETF market capitalization. According to Arte documentary, BlackRock is without a doubt a serious actor of the ETF industry as shown in Figure 2 with an unrivaled market share in the European and global ETF market. With more than 7 trillion of asset under management, BlackRock is the leading powerhouse of the asset management industry.

Benefits of ETF

The main benefits of investing in ETFs is the ability to invest in a diversified and straightforward manner in financial markets by owning a chunk of an index with a single investment. It allows investors to position their wealth in a reference portfolio based on equities, bonds or commodities. It also helps them to create a portfolio that suits their needs or preferences in terms of expected return and risk and also liquidity as ETFs can be bought and sold at any moment of the day. Finally, ETFs also allow investors to implement long/short strategies among others.

Risks

Market risk is an essential component to fully understand the risk of owning an ETF. According to the foundations of the modern portfolio theory (Markowitz, 1952), an asset can be deconstructed into two risk factors: an idiosyncratic risk inherent to the asset and a systematic risk inherent to the market. As an ETF are composed of a basket of different assets, the idiosyncratic risk can be neutralized by the effect of diversification, but the systematic risk, also called the market risk is not neutralized and is still present in the ETF.

In terms of risk, we can mention the volatility risk arising from the underlying assets or index that the ETF tries to replicate. In this sense, when an ETF tries to emulate the performance of the underlying asset, it will also replicate its inherent risk (the systematic and non-systematic risk of the underlying asset). This will have a direct impact on the overall risk-return characteristic of investors’ portfolio.

The second risk, common to all funds and that can have a significant impact on the overall performance, concerns the currency risk when the ETF owned doesn’t use the same currency as the underlying asset. In this sense, when owning an ETF that tracks another asset that is quoted in another currency is inherently, investors bears some currency risk as the fluctuations of the pair of currencies can have a significant impact on the overall performance of the position of the investor.

Liquidity risk arises from the difficulty to buy and sell a security in the market. The more illiquid the market, the wider the spreads to compensate the market maker for the task of connecting buyers and sellers. Liquidity is an important concern when picking an ETF as it can impact the performance of the portfolio overall.

Another risk particular to this instrument, is what is called the tracking error between the ETF value and its benchmark (the index that the ETF tries to replicate). This has a significant impact as, depending on the overall dispersion, the mismatch in terms of valuation between the ETF and the benchmark can impact the returns of investors’ portfolio overall.

Passive management and the concept of efficient market

Most ETFs corresponds to “passive” management as the objective is just to replicate the performance of the underlying assets or the index. Passive management is related to the Efficient Market Hypothesis (EMH), assuming that the market is efficient. Passive fund managers aim to replicate a given benchmark believing that in efficient markets active fund management cannot beat the benchmark on the long term.

Passive fund managers invest their funds by:

  • Pure replication of the benchmark by investing in each component of the basket (vanilla ETF)
  • Synthetic reproduction of the benchmark by replicating the basket with derivatives products (like futures contracts).

An important concept is market efficiency (also known as the informational efficiency), which is defined as the ability of the market to incorporate all the available information. Efficient market is a state of the market where information is rationally processed and quickly incorporated in the market price.

It is in the heart of the preoccupations of fund managers and analysts to unfold any efficiency in the market because the degree of efficiency impacts their returns directly (CFA Institute, 2011). Fama (1970) proposed a framework analyzing the degree of efficiency in a market. He distinguishes three forms of market efficiency (weak, semi-strong and strong) which correspond to the degree in which information is incorporated in the prices. Earning consistently abnormal returns based on trading with information is the opposite view of what an efficient market is.

  • The weak form of market efficiency refers to information composed of past market data (past transaction prices and volumes). In a weakly efficient market, past market information is already included in the current market price, and investors will not be able to distinguish any pattern or prediction of future prices based on past data.
  • The semi-strong of market efficiency refers to publicly available information. This includes market data (as in the week form) and financial disclosed data (financial accounts published by firms, press articles, reports by financial analysts, etc.). If a market is considered in the semi-strong sense, then it must be in a weak sense as well. In this context, there is no additional gain in determining under or overvalued security as all the public data is already incorporated in the asset price.
  • The strong of market efficiency refers to all information (both public and private). Markets are strongly efficient when they reflect all the available information at any time in the asset prices.

Related posts on the SimTrade blog

   ▶ Micha FISCHER Exchange-traded funds and Tracking Error

   ▶ Youssef LOURAOUI Passive Investing

Useful resources

Academic resources

Fama, E. (1970) “Efficient Capital Markets: A Review of Theory and Empirical Work” Journal of Finance 25(2), 383–417.

Business

Arte documentary (2014) “Ces financiers qui dirigent le monde: BlackRock”.

BlackRock (January 2021) ETF overview.

Refinitiv insights (2019) Concentration of the major players in the European ETF market.

About the author

The article was written in February 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2016-2020).