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How Safe Are Gold ETFs?

By understanding the risks associated with physically backed and futures-backed gold ETFs, investors can find the safest routes of access to this popular commodity.
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NEW YORK (TheStreet) -- As evidenced by the May 2010 ETF flow data compiled by the National Stock Exchange, gold continues to be one of the most popular investment themes around. Thanks to exchange traded funds like the SPDR Gold Shares (GLD) - Get Report and PowerShares DB Gold Fund (DGL) - Get Report, this yellow metal has been transformed into an asset class of its own.

While popular, not every gold-focused ETF is identical. By understanding the risks that can be associated with physically backed and futures-backed gold ETFs, investors can find the safest routes of access to this popular commodity.

Physically-Backed

Among the safest ways to gain exposure to gold is through the use of physically backed ETF products. Currently, there are three products designed in this manner: GLD,

iShares COMEX Gold Trust

(IAU) - Get Report

and

ETFS Physical Swiss Gold Shares

(SGOL) - Get Report

.

GLD tracks a collection of London Good Delivery Bars located in the London vaults of

HSBC Bank USA

(HBC)

. Investors not willing to take the company's word for it have the ability to see pictures of the inside of the vault and track a "gold bar list" on its

website

.

Unlike GLD, the gold underlying iShares' IAU is not concentrated in a single location. Instead,

Bank of Nova Scotia

(BNS) - Get Report

, the fund's custodian, has spread the gold bars across a number of locations including New York City, London, Montreal and Toronto.

SGOL, the newest player to the physically backed gold ETF game, tracks a collection of gold bars held by

JPMorgan

(JPM) - Get Report

in maximum security vaults located in Zurich, Switzerland.

While all three funds insist that investors are gaining access to actual gold, this has not stopped conspiracy theorists from proposing that the gold underlying these funds is actually being loaned out and is not actually held in the vaults. These fears, however, can quickly be displaced upon examination of the funds' respective prospectuses. In the case of GLD and IAU, the funds' sponsors promise that all but a miniscule portion of the gold (fractional portions of bars) representing the fund is considered allocated. Allocated gold is metal that can actually be delivered to the investor. SGOL's website explains that the bullion held in the trust is entirely allocated.

Still, if the claims from the funds' providers are still not enough to quell fears, investors should opt for SGOL. This fund is also the only gold-backed ETF which also consistently has a third-party auditor inspect the vault holding the fund's assets twice a year. Personally, I am not swayed by doomsayers and conspiracy theorists. I continue to hold IAU for money management clients.

From a tax perspective, physical gold ETFs are treated as collectibles. Under the tax code as it currently stands, gains recognized from the sale of collectibles held for more than one year are taxed at a maximum rate of 28%.

Futures-Backed

Futures-backed products aimed at providing investors with exposure to the actual price of gold through the use of derivative products face their own challenges.

The most recognizable of these instruments is DGL from PowerShares. By tracking futures contracts rather than a physical stockpile of gold, DGL is set up as a partnership and investors are taxed on gains and losses in the proportion of 60% long-term capital gains and 40% short-term capital gains, whether they sold the fund or not.

Although these products have their benefits when it comes to tax time, there are also considerably higher risks associated with holding them.

A fund like DGL faces liquidity issues not present in physically based products. Whereas IAU, SGOL and GLD trade well over 100,000 times per day, DGL only barely surpasses 50,000. Although this volume is suitable for an investor holding over the long term, traders moving in and out of this fund quickly may find the process tricky and dangerous.

Further, pressure from Washington may weigh on these products in the near future. Fearing that a futures-backed fund could get large enough to manipulate the price of the underlying commodity, the Commodity Futures Trading Commission has imposed position limits on these products which restricting the number of futures contracts the fund can hold. Position limits place a cap on how large a fund can get, threatening to turn an ETF into a closed-end fund. If DGL gets too close to its upper limit it will be forced to halt share creation and, like a traditional CEF, it will generate a premium.

A number of futures-based gold products are also designed as ETNs:

e-tracs CMCI Gold ETN

(UBG) - Get Report

TheStreet Recommends

;

e-tracs S&P 500 Gold-Hedged Index ETN

(SPGH)

;

PowerShares DB Gold Short ETN

(DGZ) - Get Report

face not only the CFTC's regulatory hammer but also the added credit risk inherent in these debt products.

Leveraged

Finally, there are a number of ETFs and exchange traded notes designed to provide investors with magnified exposure to gold futures contracts, allowing them to take bullish or bearish bets on their price movements. Because they employ leverage, use futures contracts, and in the case of the ETNs, face additional credit risk, these products are the riskiest of all gold-focused funds.

Once again, these products face added scrutiny from Washington. This time however, aside from the CFTC, the Securities Exchange Commission will also be interfering in these funds' business as it investigates the use of leverage in the ETF industry. Leveraged gold ETFs include:

PowerShares DB Gold Double Long ETN

(DGP) - Get Report

;

PowerShares DB Gold Double Short ETN

(DZZ) - Get Report

;

ProShares Ultra Gold ETF

(UGL) - Get Report

and

ProShares UltraShort Gold ETF

(GLL) - Get Report

.

Before adding exposure to gold or any other precious metals ETFs, investors need to be conscious of their investing

mindset

. To learn more about precious metals investing, be sure to check out parts

one

,

two

, and

three

of my Guide to Precious Metals.

At the time of publication, Dion Money Management owned IAU.

Don Dion is president and founder of

Dion Money Management

, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.