HardAssetsInvestor

Written by Julian Murdoch  |

October 21, 2008

Gold Vs. Miners

Details

It's a timeless question in commodities circles: milk vs. cow. And the question comes up more often in gold than anywhere else.

• Getting at gold
• Mining indexes for dummies
• The pros and cons of equity

 

In times of economic crisis - such as the plummeting stock market of fall 2008 - the idea of holding gold is attractive. But the status of the market also opens up opportunities for investment in the pick-and-shovel enterprises that bring us that gold.

If you haven't yet read our piece, Spot, Stock Or Future, you may want to check it out before reading further. In that article, we outline the basic differences between physical ownership (or more realistically, owning physical gold through an ETF gold trust, like GLD), futures and equities. The purpose of this article is to get beneath the surface of the mining sector - pardon the pun.

 

Indexing Gold

The easiest way to make the miner bet is to just buy them all. But just like every other sector, you have a choice of ETFs and underlying indexes to choose from, and they're not all identical. Amex currently sponsors two: the Amex Gold Miners Index (GDM) and the Amex Gold BUGS Index (HUI). The Philadelphia exchange has long sponsored their own version, the Gold & Silver Sector Index (XAU). While there is a lot of overlap, there are some differences.

First up, the Amex Gold Miners Index comprises public companies primarily mining gold and silver. It is a modified market-cap-weighted index that can be invested in via Market Vectors Gold Miners ETF (GDX). As of October 15, the index contained 33 companies from all over the world. A current list of constituents and their weightings can be found on Van Eck's Index overview site. (Note: Van Eck is a sponsor of HardAssetsInvestor.com.)

Amex's second option is their Gold BUGS Index (HUI). There are two rather enormous philosophical differences between the two. The first difference is that BUGS is a "modified equal" weight index. The quote marks are there because while the equal-weighting sounds good, Newmont, Goldcorp and Barrick are still all above 10%, with the other dozen companies each making up between 4 and 5 percent at the time of this writing. The more important difference is that HUI is made up of companies which explicitly do not use long-term hedging (defined as hedging gold prices for a period of greater than one and a half years.)

Some of the companies included do no hedging of their gold production at all, instead selling everything on the open market, or theoretically warehousing excess. Thus, they're completely exposed to any gains or losses in the price of gold. One of the biggest examples of a nonhedger example is Newmont Mining Corp. (NYSE: NEM), which in 2007 closed its hedging book, taking a pretax loss of $531 million to get out of its futures contracts. CEO Richard O'Brien released the following statement in the press release about the strategy change:

 

 

The advantage of this type of no-hedge philosophy is the ability to take advantage of high and rising market prices. And if you believe that gold has nowhere to go but up, this strategy makes sense - after all, futures aren't free. The other advantage of this type of strategy means that when you invest in a nonhedger, you're investing directly in how well that company runs its primary business - getting gold out of the ground - and not its ability to hedge correctly. However, a no-hedging philosophy also leaves a company like Newmont completely exposed to downturns in gold price. And gold's price is influenced by far more than day-to-day supply and demand. As a monetary proxy, how much gold really costs, in terms of Newmont's bottom line, is based on the strength of the dollar, the strength of the global economy and the breeding patterns of European ferrets. It seems like pretty much anything can swing the price of gold.

There's no quick and dirty ETF on HUI.

The Philadelphia Gold & Silver Sector Index (XAU) is another miners index, and one that often gets the quotes in mainstream newspapers. It is a capitalization-weighted collection of currently 16 companies involved in mining precious metals, hugely concentrated. At the time of this writing, over 20% of the index was in Barrick Gold, with Freeport McMoRan, Goldcorp and Newmont making up another 45%.

No quick and dirty ETF on XAU either.