How to Build Your Own Junior Gold ETF — Part 1

How to Build Your Own Junior Gold ETF — Part 1

The Australian reported over the weekend:

It has been variously described as “the single greatest wealth destruction event in index history” and a “f..king scandal of the highest order”.

The decision by New York-based Van Eck to dramatically restructure its exchange-traded fund of junior gold stocks has had massive ramifications for the share prices of Australia’s gold producers over recent months, with savvy investors gleefully taking advantage of Van Eck’s shift in strategy and positioning themselves to profit from the change.

The net result is estimated to have cost Van Eck hundreds of millions of dollars in lost value, while the CEOs of the gold producers smashed by the situation have been left to lament their powerlessness over the direction of their share prices.

You may have read about Van Eck’s issues recently. There’s a lot worth discussing. For that reason, I’ll tackle the analysis over two days. Today, I want to provide a bit of an introduction to ETFs (exchange traded funds).

ETFs are extremely popular. That’s why I want to spend some time explaining how they work. That should give you a better understanding when investing in them.

Perhaps you’ve heard that they’re a ‘simple’ way to invest in the market. But trust me, there’s a lot more to ETFs than most people consider…

Why ETFs are more complex than people realise

An ETF is a derivative. It’s a synthetic index that tracks the performance of a portfolio of stocks.

Van Eck is one of the world’s largest ETF players. The firm has virtually turned into a fund manager, selecting stocks for its ETFs. Yet, unlike other fund managers who use fundamental or technical analysis to make their decisions, Van Eck merely relies on price.

The Junior Gold Miners ETF [NYSE:GDXJ] is one of the fund’s most popular products. The ETF seeks to replicate, as closely as possible, the performance of the MVISä Global Junior Gold Miners Index. The fund normally invests at least 80% of its total assets in securities that comprise that index.

Take a look at GDXJ’s monthly chart, dating back to 2011:


Source: Interactive Brokers
[Click to enlarge]

GDXJ has been a great trading stock over the past few years…provided you got in on the lower part of the upturns, and out during the higher end of the upswings.

That said, it’s been a terrible investment vehicle. The price has virtually gone sideways. Of course, that should change during the next gold bull market. GDXJ should generate superior returns for investors.

Now, I wouldn’t go rushing out to buy GDXJ shares today. My view is that the ETF could still make new lows when gold hits US$931 per ounce. Furthermore, a potential issue has arrived — GDXJ has already become too popular.

That might not seem like an issue. But fund flows into GDXJ have been astronomical over the past few years. For that reason, Van Eck has hit the 20% ownership level in many of its stocks.

This level is important, because if the fund exceeds 20% of ownership, it must issue a formal takeover bid.

That’s a big problem…

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If GDXJ is encountering this issue today, imagine how things will play out during the next gold bull market when investors pile into the ETF.

ETFs offer massive potential problems

Remember, Van Eck isn’t actually a fund manager. It doesn’t want to take over any company. It merely creates an ETF with the goal to mirror a portfolio of stocks. When a company is included in an ETF, Van Eck physically buys and sells that stock to replicate its exposure. The transaction is normally completed at the start and end of each trading day.

That presents liquidity risks…

As mentioned above, GDXJ is a derivative that replicates an underlying asset — in this case a portfolio of gold stocks. Today, GDXJ has become more popular than the underlying assets themselves. Investors prefer the ETF instead of the individual gold stocks that it’s meant to track.

It’s easy to see why that’s the case.

GDXJ offers lower transaction costs. It also tracks 85 gold companies across the world. That’s not bad from a diversification point of view. But a big risk arises when the majority choose to sell their shares at once.

What price will you get for your shares?

The ETF may become more illiquid and nosedive during that phase.

Remember, GDXJ has become more liquid than its underlying assets. And while that’s the key part of the next update I’ll bring you on Friday, it’s worth noting there may be cash flow issues regarding liquidation during a crash scenario.

ETFs were born from the global financial crisis of 2008. They have never experienced a financial crisis. That poses a more serious risk than capacity, as discussed in The Australian article above, which few people consider.

Stay tuned for details on how you can combat both risks in Friday’s Markets & Money

Regards,

Jason Stevenson,
Editor, Markets & Money

Jason Stevenson

Jason Stevenson

Analyst at Markets & Money
Jason shares his extensive knowledge of Australia’s mining sector as Markets and Money’s dedicated resource analyst. Whether it’s iron ore, gold, copper or lithium, you can rely on Jason to give you in-depth analysis of the biggest and most important sector of our economy. Jason provides in-depth research to Resource Speculator, Australia’s premier resource investment advisory. If you’d like to know more about Jason’s financial world view and investing philosophy then we recommend you join him on Google+. It’s where he shares investment insight, commentary and ideas that he can’t always fit into his regular Markets and Money essays.

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