Pedal to the Metal - How Precious Metal ETFs Work

Overview:

• Precious metals have delivered standout performances in 2024 with gold and silver both up.
• Exchange-Traded Funds (ETF) are a convenient way to gain exposure to these commodities, offering strong liquidity and eliminating challenges of physical storage.
• While physically backed ETFs remain the top choice for most investors, equity-based ETFs provide options for those seeking dividends.
• With fluctuating prices and rising demand, ETFs have become an increasingly popular option for diversifying portfolios and hedging against market volatility.

The Value in Precious Metals

Precious metals delivered very strong performance, ranking among the best-performing asset classes in 2024. Spot gold prices ended in 2024 at $2,625 per troy ounce, extending its annual gain to 27.2%, topping the U.S. benchmark S&P 500 stock index’s 23.3% gain. On the back of a gold rally, gold equities have also surged, delivering strong performances.

Gold is not the only standout among precious metals this year. Silver, often considered a "semi-precious" metal given its wide industrial and household applications, gained 21.5% in 2024. Other precious metals, including platinum and palladium, also posted positive returns in 2024. These strong performances have attracted investors seeking portfolio diversification and hedging opportunities. Exchange-traded funds (ETFs) served as a convenient way to gain exposure as evidenced by recent interest in North America.

Precious Metals are one of 2024's best performing asset classes

Why Precious Metal ETFs?

One of the biggest challenges of buying precious metals has always been that they're bulky and present storage challenges. Precious metal ETFs address these issues by providing exposure to precious metals without the hassle or expense of storage. Investors can also trade these ETFs easily on exchanges, offering strong liquidity.

Precious Metal ETFs fall into three main categories

Physical precious metals: In most cases, investors prefer physical-backed commodity ETFs, where available, over futures-based counterparts. This preference stems from the limitations of future contracts and the rolling cost of futures. Physical commodities do not have price limits, which allows physically backed ETFs to always track performance of the underlying asset regardless of volatility.

Precious metal futures: In contrast, commodity futures have price limits designed to protect the clearinghouses and its members from financial losses and to maintain market order. These price limits present a challenge for market makers and investors by causing ETFs to halt creation and/or decouple from their underlying assets. Future-based ETFs also must roll front-month futures to the next expiry in order to maintain their target commodity exposure. As with all futures-based products, this process often creates a natural drag on performance of the ETF if the futures remain in contango, resulting in significant underperformance in the long term.

Precious metal-involved company stocks: While most ETFs holding physical metals (except for covered call ETFs) do not distribute dividends, precious metal equity ETFs offer alternatives for investors seeking previous metal exposure with dividends. These ETFs invest in mining companies or companies engaged in related activities, such as providing financing to miners.

Digging Into Precious Metal ETFs

Physical gold ETFs have emerged as one of the largest beneficiaries of 2024's gold rally, attracting strong inflows year-to-date. In contrast, gold equity ETFs have seen muted fund flows despite strong performances.

It is worth noting that precious metal prices fluctuate significantly. For example, central banks' purchases heavily impact gold prices, but these purchases are often unpredictable. For investors looking to trade on the news, ETFs offer greater liquidity and potentially lower costs compared to physical precious metals. Long-term investors also benefit from the convenience for ETFs, which eliminate the hassle and expense of storage.

Overall, ETFs have grown increasingly popular among precious metal investors, providing a practical and flexible way to gain exposure to these valuable commodities.