Metals ETFs: Store of Value or Non-Productive Asset?

Gold and other precious metals are at the center of a major macroeconomic debate. On the one hand, a ballooning federal deficit and a dollar in terminal decline may mean that inflation is coming, and higher metal prices. On the other hand, recent dollar strength and the promise of higher interest rates suggest that a non-productive asset class like precious metal will lag.

ETFs offer easy access to precious metals like gold, silver, platinum, and palladium. These ETFs, like the metals themselves, trade on the dollar, interest rates, and inflation.

When the dollar is strong, gold tends to be weak, and vice versa. The 3-month chart comparing GoldShares (NYSEArca:GLD), which holds gold bullion, with PowerShares US DB Dollar Bullish (NYSEArca:UUP), which provides exposure to the dollar, shows that this age-old dollar-gold relationship is still in place.

UUP holds dollar futures contracts and is designed to replicate being long the dollar in relation to a basket of euro, yen, pound, Canadian dollar and Swedish franc. As the chart shows, GLD and UUP (or gold and the dollar) are inversely correlated over this period. The effect is similar with other precious metals, such as the iShares Sliver Trust (NYSEArca:SLV). The correlation is clear here in part because there is little interference from interest rate changes.

ETFs also offer exposure to base metals, like copper, nickel, and lead. Precious metals tend to be lightly counter-cyclical, tied to interest rates and the dollar. Base metals are different. They are usually highly cyclical. They tend to do well in a strong economy. They perform similar to basic materials such as oil, chemicals, or wood products.

Precious and base metals therefore often have different price performance. The chart below compares PowerShares DB Base Metals Fund ETF (NYSEArca:DBB), which has exposure to copper, aluminum and zinc with PowerShares DB Precious Metals Fund ETF (NYSEArca:DBP), which has exposure to gold and silver. The equity benchmark Standard and Poor's S&P 500 Index (NYSEArca:SPY) is also shown.

The chart shows that base metal fund DBB is more correlated with the SPY than with the performance of precious metals fund DBP. DBB ran up with the equity market, outperforming in the last couple months of 2009. As the equity market faltered in 2010, DBB fell sharply. The story of the performance of DBP, which performed very similarly to GLD over this period, is in the appreciating dollar.

Metals funds use three distinct strategies to provide exposure to the physical commodity: ownership of the metal itself, ownership of futures contracts to buy the metal, and the ownership of a note to track the price of the metal. All strategies have advantages and disadvantages. None is perfect.

A good example of the direct ownership strategy is GLD. The fund provides investors with advantages: a sense of security and a clear and unwavering sense of what is owned-- a physical commodity, a metal. The gold held in GLD is the real stuff, bullion stored in the fund's custodian's vault, in the main London branch of J.P. Morgan Chase Bank. But after calculating the storage fees (expressed in the expense ratio) GLD not only does not pay interest but is a depreciating asset. And there are tax consequences. Whereas the long-term tax rate on equity ETFs-- for example the Market Vectors Gold Miners ETF (NYSEArca:GDX) is 15%, bullion trades are taxed by the IRS at the collectibles rate of 28%.

An alternative to direct ownership of bullion is the ownership through futures contracts to buy bullion. PowerShares has a line of ETFs which take this tack: PowerShares DB Gold Fund ETF (NYSEArca:DGL), PowerShares DB Silver Fund ETF (NYSEArca:DBS), PowerShares DB Precious Metals Fund ETF (NYSEArca:DBP) (80% gold, 20% silver). Like other commodity products, this family of ETFs is structured never to take delivery of the actual metal, so technically speaking no metal is owned. Instead, these ETFs own futures contracts to buy the metal. These contracts are rolled over: before the contract comes due, the fund sells that contract and buys another contract further out in time. This generates trading fees but no storage costs. Futures contracts are also taxed at a lower maximum rate of 23%. Problems with this structure include difficult tracking the spot price and possible SEC regulation.

A third general strategy involves exposure 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.

Following are a list of metals ETFs and expense ratios:

Bullion Ownership

SPDR GoldShares (GLD), 0.4%

iShares COMEX Gold Trust (IAU), 0.4%

iShares Silver Trust (SLV), 0.5%

ETFS Physical Platinum Shares (PPLT), 0.6%

ETFS Physical Palladium Shares (PALL), 0.6%

Futures Based

PowerShares 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%

Short/Leverage

Ultra Gold ETF (UGL), 0.95%

ProShares UltraShort Gold (GLL), 0.95%

ProShares Ultra Silver (AGQ), 0.95%

ProShares UltraShort Silver (ZSL), 0.95%

Exchange Traded Notes

Diversified

ELEMENTS 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

iPath 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

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%