Barron’s on new Sprott ETF: ‘a gold ETF for the paranoid’

It’s hard to talk about gold nowadays without sounding like a conspiracy nut. “I don’t have a bomb shelter at home stocked with canned soup,” says Norman MacDonald, manager of the Invesco Gold & Precious Metals fund. “And I don’t believe in the demise of the world financial system. But definitely something odd is happening to the price of bullion.”

If you look at the state of the world, gold should be up. “Would you like to travel to Liberia, Ukraine, or Syria right now?” MacDonald asks. “The six o’clock news is not painting a very nice picture.” Usually, when geopolitical risk rises, gold is perceived as a haven. Since gold’s most recent peak of $1,340 an ounce on July 9, its price has fallen to $1,233—an 8% decline. And that’s nothing compared to the shellacking suffered by the Market Vectors Gold Miners exchange-traded fund (GDX), down 24.7% in the same period.

What happened? The dollar did. During the same stretch, the U.S. Dollar Index, which compares the greenback to a basket of other currencies, was up 7.1%. The dollar has rallied on expectations that interest rates may rise in the U.S. because of the economic recovery.

That hurts gold because many investors use it to hedge against a weaker dollar, and they’ve been selling into the buck’s strength. Moreover, gold is less attractive as a store of value compared to, say, Treasury bonds or CDs, if their yields rise with interest rates.

YET EVEN IF GOLD’S PRICE GOES NOWHERE, gold-mining stocks remain undervalued. “Many miners’ stocks are being priced at discounts to what it would cost them to mine their gold and sell it,” says David Cohen, who as manager of the Eudora fund, holds positions in individual gold stocks, as well as the Market Vectors ETF. Cohen estimates that the average miner in his portfolio currently trades at a 20% to 30% discount to its bullion assets.

The problem with traditional gold-mining ETFs is that some miners are ineptly run. “This has been one of the most poorly managed industries I’ve ever seen,” says MacDonald. “The money some of these mining executives make for [generating] negative value in this business has been shocking.” Yet, he also sees operational improvements at behemoths like Barrick Gold (ABX), which has been cutting costs, and efficiencies at well-run companies like Randgold (GOLD).

With the typical ETF, you own the good miners with the bad. But there is hope. Launched in July, Sprott Gold Miners ETF (SGDM) is the first exchange-traded fund to weight miners on factors other than size. It starts with 25 stocks with “the highest gold beta,” i.e., sensitivity to gold’s price movements, ranks them by market capitalization, then adjusts the ranking based on the companies’ one-year revenue growth and debt-to-equity ratios, penalizing slow-growing overleveraged outfits and rewarding the opposite.

Sprott U.S. Holdings Chairman Rick Rule argues that gold companies with high revenue and low debt are increasing their gold resources efficiently and should be overweighted. Consequently, Wall Street favorite Randgold has a 15.9% weighting in the ETF, while Barrick, which still has room for improvement, merits just 4.2%.

Sprott’s seems a rational approach. But, ultimately, miners’ fate will still be determined by the metal’s price. And that price is set by the paranoid.

LEWIS BRAHAM is a freelance writer, based in Pittsburgh.

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