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Gold Stocks vs Gold ETFs: Which Is Better for You?

You want to invest in gold – but you know that you don’t want to buy physical gold. That leaves you with gold mining stocks, gold streaming stocks, gold futures contracts, and gold exchange-traded funds. Each gives you exposure to gold prices, mining, streaming, and/or futures contracts. Let’s see which one offers you the best way to backstop your portfolio.

Gold Stocks

Gold stocks are generally divided into three categories: gold mining, gold streaming, and gold futures contracts. When investors buy shares of these companies, they are betting that the company they invested in will provide a good return on investment (ROI). Investors also accept the risk that comes with investing in specific companies: They may lose money on their investment.

Gold Mining Companies

Large gold mining companies, like VanEck (NYSE: GDX), have diversified holdings and are able to maintain stock performance by using their profits from base metal and precious metal production to offset any losses or lackluster performance in gold mining. In addition, they have mining activities all over the globe, so they are somewhat protected from catastrophic events that might cause their overall performance to disappoint investors’ expectations.

The biggest concerns with gold mining companies are mine accidents, mine shutdowns, or lower-than-expected production. The price of gold may also fall, further reducing any potential company profits.

Gold Streaming Companies

Gold streaming companies help finance gold mining companies. In exchange for providing funds to miners before they produce any gold, the financing firms receive a set amount of gold from that subsequent production. The streaming companies also make more money when mining companies produce more gold than expected, and/or the price of gold rises.

That said, the mining companies may not produce enough gold to recoup the streaming company’s investment. In addition, streaming companies will only produce so-so performance if gold prices don’t rise, or if miners don’t produce significantly more gold than expected.

Gold Futures Contracts

Gold futures contracts are highly speculative agreements between two parties to exchange a future asset (i.e., gold), at a future date, for a price agreed on today. The party agreeing to exchange their capital for a future gold delivery is going “long” on the investment – betting that the price of gold will rise in the future, making the gold delivery worth more than the price paid now. The party agreeing to deliver the gold in the future is said to be “shorting” gold – believing that the prices of gold will be lower in the future, making that shipment worth less than the agreed-upon price of the futures contract.

Gold futures contracts allow you to make leveraged investments in gold without paying the entire cost of the contract up front. Instead, you only pay a margin – 5% to 15% of the contract value. If the price of gold goes against your position, your broker will incur a margin call, requiring you to put a larger deposit down on the contract.

In addition, gold’s price volatility can affect these contracts. If the price of gold rises significantly, investors will be required to put down a larger deposit to maintain their position. The larger an investor’s deposit, the less leverage he or she has in the deal. In extreme situations, like a severe shortage of precious metals, the amount of money the investor is required to deposit to hold his or her position may be greater than the value of the futures contract.

Finally, a financial crisis might spur regulatory authorities to intervene in the contract, potentially costing one of the parties a serious loss of profit or capital. For example, in the event that there is a shortage of gold or a financial crisis, the regulatory authorities may suspend or limit gold trading. If that happens, investors will not be able to open/close their positions and they will be trapped in the position that they had before the intervention by the regulatory authorities. Being trapped in a position is problematic because it may cause investors to lose their potential profits and possibly rack up huge losses.

Gold ETFs

Gold ETFs, like SPDR(NYSE: GLD / SEHK:2840) and iShare(NYSE: IAU), allow investors to invest in gold mining, streaming, and futures contracts for far less money than they would be required to spend if they were to purchase the companies’ stocks or gold futures contracts themselves. They also spread their risk among many investors and a large number of investments.

Ultimately, investors in gold ETFs are betting that this more diluted risk will protect them from a lower return. And since you’re risking less money than you’d need to buy gold company stocks or futures contracts, your potential loss is smaller and more controlled.

Gold ETFs’ security means that investors don’t need to research every single company the ETFs hold, and that they have a hedge against losses. Gold ETFs are less likely to have the spectacular returns sometimes seen with stocks and futures contracts. Indeed, their performance is more likely to lag behind the overall market, because the funds’ performance is affected by multiple investments and factors that may not influence the market or indexes those funds track.

Best investor option . . .

For new, inexperienced, cash-poor, and/or conservative investors, gold ETFs offer the best way to get into the gold market. Investors can benefit from the risk spread and the knowledge of experienced brokers, while limiting their potential losses. After starting there, investors can invest in riskier, higher-ROI gold ETFs as they become more savvy about the gold market.

Experienced, risk-tolerant investors who are willing to do the work to find the best performing and most promising companies are advised to make investments that best complement their portfolio.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Hong Kong contributor Alisa Hopkins doesn’t own shares in any companies mentioned.