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SGOL: A Strong ETF For Playing The Rally In Gold

Summary
  • SGOL is a strong alternative to other ETFs in that it has a very low expense ratio while maintaining physical holdings of gold.
  • Prior to investing in SGOL, we need to formulate an outlook on gold prices.
  • Gold prices, and therefore SGOL, are likely to rally over the coming year due to the elevated fear levels seen in the equities markets.

 

Over the past month, shareholders of the Aberdeen Standard Physical Gold Shares ETF (SGOL) have been rewarded with returns turning positive once again.

 

 

In my opinion, SGOL is heading higher. I believe that the instrument makes for a solid play on gold at this time due to its methodology and holdings as well as the underlying fundamentals for gold.

 

About SGOL

If you’re unfamiliar with SGOL, it is actually a fairly simple ETF. It holds gold in its vaults in London and Zurich in line with the AUM parked into the ETF. The vaults are inspected twice per year as well as one yearly random inspection and it currently has about $2.7 billion in holdings. In other words, it’s a fairly straightforward ETF which is frequently audited so that investors can be assured of the integrity of their holdings.

 

In the plethora of gold lineups, what is the appeal of SGOL? In my opinion, one of the strongest appeals of this ETP is its expense ratio. At present, SGOL has an expense ratio of 0.17%. If you compare this to the incredibly-popular GLD of 0.40%, this is a reduction of over half. While these expense ratios are small, if you are parking a sizable percentage of your capital into either of these ETFs, the benefit is clearly in SGOL’s favor.

 

Another key benefit of holding SGOL as opposed to other alternative funds like say, UGL, is that SGOL has physical holdings instead of financial paper. Most investors are likely at least somewhat aware of this, but gold physical holdings have a sizable advantage compared to holding futures contracts in the form of roll yield.

 

For example, take a look at the following futures curve for COMEX gold.

 

 

This chart shows a very consistent trend: the price of gold increases as you look further out along the futures curve. In fact, if you get into the numbers, you’ll find that most data points are basically calculated by taking the spot price of gold and compounding it at a 2% annualized rate until the date of expiry.

 

So what’s the magic behind this 2% number? Good question. This 2% figure essentially represents the cost of borrowing for trading net of the fees for storage of gold. What is interesting about this figure is that if we see gold futures in any of the above months trade above this figure, traders could borrow month, buy physical gold, and agree to sell it in the month which steps beyond these costs. This is called arbitrage and results in relatively risk-free profit for traders able to make this transaction.

 

If you think through the math, you’ll realize that as we proceed through time, the price of futures contracts will decline in value in relation to the spot price. This is because interest rates are a function of time and as time narrows, so will the prices which are derived from these interest rates. This means that as time advances, we will see futures prices slowly roll down towards the spot price.

 

If you think through the holdings of futures traders, this means that they are losing money in the form of this convergence. For example, if they are holding a futures contract which is for delivery 1 year from now and is priced 2% above the spot market, at the time of delivery, this difference will have narrowed to be zero. In other words, you would have been holding a futures contract that fell 2% in relation to the spot price and if the spot price of gold went nowhere, you would have lost 2% of your money.

This is why SGOL is such an appealing alternative to gold ETFs: with financial holdings it allows investors the ability to hold gold without any roll yield / futures convergence concerns. Additionally, its expense ratio is less than half the expense of popular alternatives which essentially means that you’re getting strong exposure for substantially less cost.

 

Gold Markets

While I believe that SGOL makes for a strong investment vehicle, the key question as always is timing. If gold falls by 50% over the next year, it doesn’t matter how low the expense ratio is or how favorable its holding structure because investors will see losses on their holdings. So prior to investing in SGOL, we need a firm view as per the outlook for gold prices.

 

At present, I am very bullish gold based on a few studies I’ve created. I believe that several key price relationships are strongly suggesting that gold is going to rally over the next year. One of these relationships is that between the VIX and changes in gold.

 

 

If you’re unfamiliar with it, the VIX is essentially a measure of fear in the equities markets. It is calculated using a basket of options on the S&P 500. Investors tend to buy options when markets are weak or volatile which essentially drives up the price of options and therefore drives up the VIX.

 

What I believe the above chart captures is the key relationship between fearful equity investors and future returns of gold. When investors are fearful with their equity holdings, they tend to shift capital into alternative assets like gold to seek higher returns. This process results in a strong pattern which can be seen in the above data.

 

So what is this data saying today? Well, within the last 6 weeks or so, we have seen the VIX trade as high as 38 and within the last week we have seen the VIX over 30. Historic analysis suggests that given a VIX at these levels, on average gold rallies by 14-20% over the next year. In probabilistic terms, when we’ve seen the VIX trade in this range, there’s been a 65-80% chance that gold will trade higher over the next year. When gold has rallied, it historically increases by 16-30% and when it has fallen it has only done so by 4-9% over the year.

These numbers are a bit dense, but what they essentially say is that there’s a fairly strong chance that gold will rally over the next year. Additionally, even if we were just flipping a coin as per if gold were to head higher or lower, history shows that on average the upside is much stronger than the downside with average rallies exceeding average declines by 2-3 times. In other words, from a quantitative perspective, now is a great time to buy gold.

 

For investors looking for a more rule-based approach for holding SGOL, here is the chart of the performance of the prior analysis. This chart shows the return of buying gold when the VIX is above 25 and holding for 1-year.

 

 

It’s hard to understand how this performs against buy-and-hold purely from a chart, so here’s some statistics:

  • Buy and hold: average monthly return of 0.75% with a standard deviation of 4.92%
  • VIX strategy: average monthly return of 0.78% with a standard deviation of 1.77%

While this strategy doesn’t add much to the average monthly return, it substantially drives down the volatility of returns. I believe that the reason for the lower volatility of returns is that this VIX strategy is capturing the dynamic of fearful investors fleeing into gold assets which leads to consistent inflows into the commodity. Given that the VIX is above 25, this strategy is giving a loud-and-clear buy signal at this point.

 

If you’d like to implement this strategy in SGOL, the process is pretty simple: buy SGOL and examine your holdings in 1 year. If the VIX is still above 25 in one year, hold SGOL for another year. This simple strategy has historically sizably reduced the volatility of holdings as compared to buy and hold and I believe it’s a great way to trade SGOL at this time.

 

Conclusion

SGOL is a strong alternative to other ETFs in that it has a very low expense ratio while maintaining physical holdings of gold. Prior to investing in SGOL, we need to formulate an outlook on gold prices. Gold prices, and therefore SGOL, are likely to rally over the coming year due to the elevated fear levels seen in the equities markets.

 

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