GDX
Gold-Stock ETF
Adam Hamilton
Archives
Dec 7, 2007
Investing and speculating in
gold stocks is a very risky business. While they tend to greatly
leverage the underlying gains in gold during a secular gold bull,
individual stocks face a wide variety of perils on their journey
to legendary gains. As a scary recent example illustrates, sometimes
these perils can be catastrophic.
In late November, long-time
junior-gold market-darling NovaGold (NG) shocked investors with
a stunning announcement. This company said that its flagship
Galore Creek project, which it only started construction on six
months earlier, was suddenly uneconomical. NovaGold was shutting
it down! As the markets opened after this news, NG gapped down
27%. It ended that single trading day down 53% from the previous
day's close! Talk about a catastrophe for its owners.
Traditionally traders deal
with this company-specific risk by being well-diversified. If
you own a single gold stock, and something like this happens,
it will crush your portfolio. But if you own ten or twenty of
them, with capital allocated roughly equally among all, freak
single-stock plunges will barely even make a dent in your overall
portfolio. But prudent diversification often requires too much
capital for small traders.
If you have $20k+ allocated
to gold stocks, it isn't too difficult to own ten to twenty different
positions. But as you scale down from here, relative commission
costs balloon. A $10 trading commission on a $1000 stock trade
is acceptable (1%). But that same flat $10 commission on a $100
stock trade is ridiculous (10%). So traders new to gold stocks
with small capital allocations often have a very difficult time
adequately diversifying away company-specific risk.
Thankfully exchange-traded
funds offer a solution to this dilemma. Stock ETFs are baskets
of many stocks that are traded through your ordinary stock-trading
account with a single symbol. The most well-known stock
ETF is the PowerShares QQQ, which is a basket of every individual
stock in the NASDAQ 100 index. By simply buying the symbol QQQQ
in one single trade, traders can indirectly own a stake in
all 100 NASDAQ 100 stocks.
After years of waiting, we
finally have a QQQ-equivalent in the gold-stock world. Administered
by Van Eck Global, it is known as the Market Vectors Gold Miners
ETF. It currently contains 34 component gold-mining and silver-mining
companies. It trades under the symbol GDX. So by simply buying
GDX, traders are granted instant sector diversification through
indirect stakes in 34 gold and silver companies.
I have been closely watching
this ETF since its May 2006 launch, observing how it performs
and actively trading options on it. Always skeptical of new trading
vehicles, I wanted to wait at least a year to see how it performed
relative to headline gold-stock indexes like the HUI. Now, over
a year and a half after launch, I am finally comfortable that
GDX is doing exactly what it advertises. I have even become a
fan of this ETF.
In this essay I want to explore
the young GDX Gold Miners ETF, from its composition to its life-to-date
performance. Investors and speculators alike need to be aware
of GDX because it is such a wonderful trading tool. It not only
grants instant intra-sector diversification at all capital levels,
but it is growing into the ultimate way to trade stock options
on gold and silver stocks as a sector.
In order to understand any
ETF, we first have to consider its composition. GDX is based
on a little-known index called the AMEX Gold Miners Index (GDM).
GDX simply imitates GDM's internal structure in terms of weighting
individual component companies. According to the American Stock
Exchange, the GDM is "a modified market capitalization weighted
index comprised of publicly traded companies involved primarily
in the mining for gold and silver. The Index divisor was initially
determined to yield a benchmark value of 500.00 at the close
of trading on December 20, 2002."
In order to be eligible for
inclusion in the GDM, a company must first meet three criteria.
First it must have a market capitalization exceeding $100m, which
eliminates the hyper-risky micro-cap stocks. Second it must have
an average daily volume of at least 50k shares over the past
six months, which means it is liquid and easy to trade. Third,
it must be involved primarily in gold mining and/or silver mining.
Today GDM is trading in the
1250 range, so it has outperformed most other sectors since late
2002. GDM is a fine index, but curiously it has never really
seemed to catch on. I have been actively trading gold stocks
since this bull began in late 2000, along with doing much research
and writing on them. Back in the early days, the XAU was the
gold-stock index of choice. Gradually the HUI replaced it though
due to the HUI's unhedged nature. GDM was almost never discussed.
This is even odder considering
that the AMEX is not only the GDM custodian, but it administers
the flagship HUI as well. Why would one exchange make two competing
indexes for a single rather obscure sector? Perhaps someone from
AMEX will be kind enough to write in and enlighten me, because
I have no idea why both GDM and the HUI exist. If I get a solid
answer, I will write about it in a future essay.
Regardless of the GDM and HUI
mystery, the HUI has become the gold-stock index of choice for
investors and speculators. The HUI is to gold stocks like the
NASDAQ is to tech stocks. Its unhedged nature really appeals
to traders burned by companies hedging their gold production
earlier in this bull. Provocatively though, while the HUI is
advertised as unhedged, AMEX's formal definition of "unhedged"
probably differs from that of most investors.
The AMEX declares, "The
HUI Index was designed to provide significant exposure to near
term movements in gold prices by including companies that do
not hedge their gold production beyond 1.5 years." So HUI
components can still be lighter hedgers! Despite this, the HUI
is still up 1167% bull-to-date since November 2000. This light-hedging
revelation always provides good shock value for those who aren't
yet aware of it.
Anyway, in order to compare
GDX with the HUI, and also the XAU (which has no hedging restrictions),
I built a table with the relative component weightings in each
index as of this week. Each of the 34 component companies of
the GDX is listed, followed by its market capitalization and
relative weight by market cap. This provides a good benchmark
off of which to consider the index weightings. While none of
these indexes is truly market-cap weighted, they all approximate
such a scheme reasonably well.
As you can see, the gold and
silver miners remain pretty small in market-cap terms compared
to the general stock markets. All 34 GDX components added together
only had a market capitalization near $163b earlier this week.
To get perspective, Google's market cap alone ran around
$220b! And as of the end of last month, the entire S&P 500
had a market cap of $13,369b which utterly dwarfs the gold stocks.
Thus the gold-stock sector
only weighs in at the equivalent of something like 1.2% of the
broader US stock markets. This is one key reason why gold stocks
will skyrocket when the public gets enamored with them. This
sector is just too small to accept a flood of new capital. And
as the HUI is already up nearly 1200% in its bull at this stage
despite being totally ignored by the mainstreamers, imagine where
it will go when the mainstream inevitably starts getting interested
in chasing this stellar performance.
As is evident in this table,
despite generally following a loose market-cap weighting scheme
all three indexes have plenty of discrepancies. GDX, for example,
gives Yamana Gold (AUY) a massive 8.4% weighting despite its
2.8% weight by pure market cap. The HUI currently assigns Northgate
Minerals (NXG) a 4.7% weighting although it only comprises 0.5%
of this sector as measured by the 34 GDX stocks. So realize that
all of these indexes are just rough approximations of a true
market-cap weighting.
Interestingly, all 15 HUI component
companies are also included in the GDX. Together they account
for 74.4% of the GDX. This percentage has actually been rising.
Back in late June when I did a similar GDX/HUI analysis for our
newsletter subscribers, all the HUI components only made up 70.3%
of the GDX. With so much in common internally, for all intents
and purposes GDX may as well be the HUI.
The XAU is not as well-represented
in the GDX. Of its 16 components, 2 are not included in the GDX.
The main one, Freeport-McMoRan (FCX), weighs in at a massive
20.7% of the XAU. While I love this company as a general commodities-stock
investment, it is a primary copper miner, not gold. So
I am glad it is no longer included in the HUI or the GDX. Overall
the 14 XAU components included in the GDX represent 78.4% of
the GDX's weightings (74.5% in late June). So the GDX is also
a decent XAU proxy as well. But with FCX as the XAU's largest
component, copper has a disproportionate impact on the XAU compared
to the HUI and GDX.
Looking through the GDX component
companies, the great majority are excellent gold and/or silver
miners. Together they have countless mines, development projects,
and exploration projects all over the world in almost all possible
geopolitical and geographical environments. They are also well-diversified
as evident by their weightings. If any one GDX company pulled
a NovaGold and collapsed 50%+ overnight, it wouldn't materially
hurt this index unless it was a top-three component. And even
then, GDX would only take a 5% to 7% hit.
So from a pure internal standpoint,
GDX is very closely related to the HUI. Yes the GDX has many
more components and no the weightings among the common ones are
not identical. Nevertheless, the similar modified-market-cap
construction approach means the GDX is an excellent proxy for
the headline HUI. Stock traders who want sector-wide exposure
via a HUI-like index will be well-served by GDX.
In its initial year of existence
concluding this past May, I received a fair amount of e-mails
asking about the GDX. All I could say by that time regarding
its utility though was "we'll have to wait and see".
The only way to really understand how well GDX tracked the familiar
HUI was to watch this ETF actually trade and compare it to the
HUI. Finally today with 18+ months of history, including one
major correction/consolidation and one young upleg, we have a
solid technical basis off of which to render judgment.
Since its birth, GDX has carved
a virtually identical price pattern with the flagship HUI gold-stock
index. Indeed, if I removed the vertical axis labels and substituted
one data series for the other, not even hardcore students of
the markets could tell the difference. Overall the GDX and HUI
had a stellar correlation r-square of 98.74%! This means that
nearly 99% of the daily price action in the GDX could be explained
statistically by the daily price action in the HUI.
I also wanted to look at actual
GDX-versus-HUI gains and losses over big swings in the sector.
These are marked above by the little blue arrowheads. From the
June 2006 interim low until July 2007, the HUI rallied 35.6%
compared to the GDX's 33.8%. During the gold-stock swoon this
past July and August, the HUI fell 19.1% while the GDX fell 20.0%.
In the young upleg since mid-August 2007, the HUI soared 51.9%
while the GDX followed closely at 51.5%.
While these big-swing returns
aren't identical, they are pretty darned close and plenty good
for me. Actually, like all ETFs, GDX will slightly underperform
its underlying assets by design. The reason is expenses.
It takes a lot of time and effort to manage an ETF, so its custodian
is granted a contractual management fee. In GDX's case, this
runs 0.55% of assets annually. So every year GDX itself will
be worth another 0.55% less than its underlying basket of stocks.
This disturbs some people,
as I recently discussed while looking at the GLD
gold ETF. But it shouldn't. Management fees, or expense ratios
as they are called in the ETF world, are just the nature of this
beast. ETFs really expand the horizon of what is possible for
individual traders. For all their benefits, we need to expect
some minor costs. For comparison, the elite QQQQ NASDAQ 100 ETF
has an expense ratio of 0.2% annually while the GLD gold ETF
runs 0.4%. GDX's is higher which makes sense because it is vastly
smaller than either QQQQ or GLD, so its expenses are spread across
a much smaller asset base.
Even after these necessary
expenses, GDX still tracks the HUI extraordinarily well as this
chart shows. This is all the more impressive because GDX isn't
designed to track the HUI, but the GDM. Nevertheless, its HUI-like
composition makes it an effective HUI tracker. Any investor or
speculator can buy GDX and expect his capital to move in lockstep
with the HUI and ultimately exhibit almost identical gains or
losses.
Because of this inadvertent
HUI parallelism, GDX is useful in many different ways for traders.
For smaller pools of capital, GDX offers instant diversification
among gold and silver stocks with a single trade. I often recommend
GDX for this very purpose to my consulting clients who don't
yet have $20k+ they are willing to allocate to gold stocks alone.
GDX is also useful for larger
pools of capital. Sometimes capital is locked in a vehicle that
either restricts trading or the number of individual positions
held. The owner can buy GDX in a single trade and know he has
instant diversified gold-stock exposure. GDX is also very valuable
for people who don't have the time or knowledge to research individual
gold stocks. They can deploy capital into GDX, own a basket of
gold stocks, and they are good to go.
As a speculator, I find GDX
the most exciting as an options vehicle. For years gold-stock
traders lamented the fact that no stock options traded
on the HUI. So in the past we had to resort to synthetic
HUI options, trading an individual stock like Newmont Mining
(NEM) that closely followed the HUI statistically. Although this
was an acceptable workaround, it was really risky. Any surprise
NEM-specific news could blow our options out of the water even
if the HUI was conforming to our expectations.
But GDX not only follows the
HUI nearly perfectly statistically, it is built much like the
HUI internally. So any company-specific news on a component will
barely be felt by GDX just like it would barely be felt by the
HUI. Today a robust options market has sprung up around GDX.
If you buy a GDX option today, it is effectively the same thing
as buying a hypothetic HUI stock option. GDX options are a godsend
for gold-stock options traders.
In addition to having good
volume and liquid prices, GDX options are very granular. You
can buy options with strike prices at every $1 of GDX's price,
which is very nice to precisely tailor options trades
to your expectations. Often individual gold stocks will have
options strike prices spread out over every $2.50 or even $5
of a stock's price. This makes it difficult to buy at-the-money
calls or puts. With nice tight $1 strikes, this issue is virtually
nonexistent in GDX though.
With GDX now the ultimate gold-stock-sector
options trading vehicle, and an avenue for instant sector diversification
for those who can't afford the capital or research time to buy
individual gold stocks, I am really impressed by this young ETF.
GDX really makes gold-stock trading a lot more accessible for
new traders. I really wish it would have launched earlier in
this gold bull, as it would have saved us early traders a lot
of angst.
For me personally, GDX is primarily
a synthetic-HUI-options trading tool. GDX essentially is
the HUI and trades as such. But in the markets, experienced and
prudent traders can often handpick a better superior-performing
group of stocks than any given index. If you are comfortable
with individual stocks rather than baskets, you can custom build
a tailor-made portfolio of elite gold and silver stocks that
should handily outperform the GDX and the HUI.
Thus at Zeal we spend a great
deal of time researching individual gold stocks to find our favorites
with the highest potential to soar along with this gold bull.
We just finished a deep research project looking into over 100
gold stocks worldwide. After four months and many hundreds of
hours, we whittled them down to our 20 favorite gold-producing
stocks. Our new fundamental report on these elite stocks is available
today for a nominal fee. Buy
it today and build your own custom portfolio of high-potential
gold producers!
With so much irrational fear
and pessimism swirling around gold stocks today despite the magnificent
$800 gold, it feels like mid-August right before this sector
soared. So if you want to buy GDX or individual gold stocks on
the widespread fear that often marks major interim lows, today
looks like a great time. The gold stocks will have to soar far
higher before greed once again returns to this sector near the
next major interim top. Take advantage of others' irrational
fears to buy bargains today. To see which individual gold stocks
we are buying now, subscribe
to our acclaimed monthly
newsletter.
The bottom line is GDX is a
wonderful tool for gold-stock traders. It has finally been in
existence long enough to prove its multi-faceted utility in the
crucible of real-world markets. It provides instant diversification
for small capital pools and those who cannot buy or are not interested
in owning individual gold stocks. It has also grown into the
ultimate gold-stock-sector options vehicle, a delight for speculators.
The GDX gold-stock ETF is composed
like the headline HUI, trades like the HUI, and offers returns
like the HUI. While it isn't designed to track the HUI explicitly,
it may as well be. Traders who have long longed for a HUI proxy
tradable in ordinary stock accounts can rejoice. Our wait is
over. GDX has the potential to accelerate and revolutionize gold-stock
trading much like the QQQs did for tech-stock trading.
Adam Hamilton, CPA
Dec 7, 2007
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
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