Gold-Stock-Benchmark Battle

The gold-mining stocks have enjoyed enormous gains in their young bull market this year, trouncing all other sectors.  Naturally this radical outperformance has led to surging popular interest in this usually-obscure contrarian sector.  New investors are wondering how to best track its performance, about which gold-stock benchmark is the definitive one to use.  Something of a battle is brewing over new versus old.

Benchmarks are very important for stock trading.  Their performances over any given span really help investors and speculators quickly understand how a sector is faring relative to others.  Just one easily-digestible number distills down the collective performances of many stocks.  Benchmarks also provide standards by which the performances of both individual stocks and individual traders can be objectively judged.

Good benchmarks are actively managed and appropriately updated on an ongoing basis.  Companies that are bought out or fall by the wayside are removed, while newer up-and-coming companies take their places.  Well-constructed benchmarks include the best stocks a given sector has to offer, and accurately reflect the underlying performance of that sector’s stocks as a whole.  They greatly aid trading decisions.

As a relatively-small and little-known sector, gold stocks have never had one definitive benchmark that has long been universally respected.  The first contender was the Philadelphia Stock Exchange Gold and Silver Index, which was traded as XAU.  It was created way back in January 1979 heading into a massive secular-gold-bull climax, but didn’t become widely-followed and quoted until December 1983.

While XAU reigned supreme for over a decade, it started falling out of favor in the mid-1990s.  That was about a decade-and-a-half into the subsequent secular gold bear.  With gold prices falling on balance for years on end, mining companies naturally increasingly hedged their production.  With gold expected to keep on grinding lower, they wanted to lock in current selling prices for their future mine production.

You can’t blame the miners for hedging deep in a gold bear when they expected lower gold prices, it’s a rational decision to maximize cash flows.  But by the mid-1990s, growing numbers of contrarian investors were expecting the secular gold cycles to turn.  They were looking for a new secular gold bull to arise like a phoenix from the ashes of the long secular bear.  So they hated miner hedging with a vengeance.

Locking in future selling prices makes sense in gold bears, but proves disastrous during gold bulls.  Hedging literally sells away the future upside potential of gold-mining profits driven by rising gold prices!  And that happens to be the only reason to own gold stocks.  Investors rightfully shun them during gold bears since miners’ stocks follow gold lower.  They’re only worth buying if their profits can leverage gold’s gains.

And that’s only possible if they are unhedged.  So with XAU dominated by heavy hedgers that would enjoy little profits leverage from higher gold prices, a new upstart unhedged gold-stock index was launched in March 1996.  It was originally called the American Stock Exchange Gold BUGS Index, which stands for Basket of Unhedged Gold Stocks.  That clever wordplay always brings a smile to my face.

This new gold-stock index’s symbol was HUI, which has always been horribly unintuitive.  After the American Stock Exchange was acquired by the New York Stock Exchange in January 2008, the HUI’s name was changed to the NYSE Arca Gold BUGS Index.  It kept that yucky symbol, which had become widely known among gold-stock investors in the previous decade or so as it usurped and replaced XAU.

Provocatively calling the HUI unhedged isn’t technically true, despite its name!  To be considered for HUI inclusion, a gold miner only has to not hedge its gold production beyond a year-and-a-half.  But relative to the high general hedging levels in the late 1990s, that was essentially unhedged.  In the early years of the new gold-stock bull between late 2000 and mid-2002, the HUI’s performance obliterated the XAU’s.

In June 2002 I wrote an essay “Gold Stock Investing 101” where I looked at the bull-to-date gains in the HUI and XAU.  The HUI had soared 278% by that point compared to mere 95% gains in the XAU!  I called that vast delta a “hedge tax”.  Hedging gold production, locking in future selling prices today, is incredibly foolish and bad for shareholders when gold prices are rising on balance.  I still despise hedging.

Publicly-traded gold miners’ sole reason for existence is to provide investors with upside profits leverage to gold prices.  Hedging robs shareholders of the growing future profits they are rightfully entitled to.  So there is no reason to ever own a gold miner that is considerably hedged.  With its upside to rising gold prices sold away, investors have no significant profits growth or appreciating share price to look forward to.

The HUI proved a great gold-stock benchmark for a long time.  But unfortunately after the NYSE bought AMEX, its obscure sector indexes including the HUI fell into neglect.  The necessary updates to the HUI component list and weightings to account for individual gold miners’ production waning and waxing to different levels of importance relative to their peers went from seldom to almost never.  This was a real shame.

Gold stocks were the best-performing stock-market sector of the 2000s by far.  Between November 2000 and September 2011, the HUI skyrocketed an astonishing 1664.4% higher!  Great fortunes were won by smart contrarian investors.  Over that same secular 10.8-year span, the benchmark S&P 500 general-stock index actually lost 14.2%.  Keeping the HUI updated and current should’ve been a high priority.

But in the midst of that mighty secular bull, investors’ approach to gold stocks was starting to shift.  Since the 1970s, the focus had been on picking the best individual gold stocks to own.  But the 2000s saw the exchange-traded-fund industry explode in popularity.  Rather than buying individual stocks, investors could instead buy diversified portfolios holding an entire sector’s worth of stocks through a single ETF.

This really appealed to investors for obvious reasons.  Instead of doing the hard research work that’s necessary to uncover a sector’s superior individual stocks with the best fundamentals, investors could have professional analysts working for ETF companies do that work for them.  And with ETFs holding many companies, individual-stock risks were largely diversified away yielding pure sector trading performance.

Playing into this ETFs-rising trend, Van Eck Global launched its Market Vectors Gold Miners ETF back in May 2006.  Trading under the symbol GDX, this early gold-stock ETF gradually grew in popularity to totally dominate the new gold-stock-ETF realm.  Known today as the VanEck Vectors Gold Miners ETF, its net assets are running a staggering 33.9x higher than its next-closest normal-1x-gold-stock-ETF competitor’s!

Today when gold stocks are discussed on mainstream financial media including CNBC, the HUI almost never gets mentioned.  GDX has become the de-facto gold-stock benchmark of choice for investors that are newer to the gold-stock realm.  While both the HUI and GDX were left for dead during the recent dark bear years (  https://www.gold-eagle.com/article/absurd-gold-stock-levels-3 ) , gold stocks’ dazzling new bull thrusting them back into the limelight has created a battle of benchmarks.

Investors with long experience in the gold-stock realm generally prefer the HUI they’ve spent decades now getting familiar with.  Old-school traders like me simply think of gold stocks in HUI terms since we’ve spent so long viewing this sector through that index’s lens.  But many newer investors never had any significant HUI exposure, so they prefer GDX since that’s the gold-stock metric the mainstream now uses.

So how do these battling gold-stock benchmarks stack up?  They are paradoxically both surprisingly similar and very different!  Benchmarks live or die by the component stocks their managers choose to include.  And since the gold-mining sector is pretty small, there really aren’t that many major gold stocks to pick from.  So there’s naturally going to be an overwhelming overlap in positions across sector benchmarks.

This table compares the latest component stocks and weightings of GDX and the HUI.  Each company’s absolute and relative market capitalizations are included.  The latter is based on the entire pool of GDX component stocks, since it is far larger than the HUI’s list.  GDX’s weightings are diverging more from the HUI’s since the last time I examined these competing gold-stock benchmarks back in April 2014.

GDX’s gold-stock component list is massive, now running at a staggering 49 companies!  This compares to only 14 for the HUI.  So GDX is inarguably far more diversified than the HUI.  GDX’s weightings also more closely follow its component gold stocks’ individual market caps, which is the most-logical way to construct a sector benchmark.  Bigger companies should naturally have more impact on sector pricing.

But diversification is truly a double-edged sword.  On the good side it definitely reduces the considerable individual-company risk the gold miners face.  With gold mines immovable, gold miners face exceptional risks of local-government meddling through excessive regulations and taxation.  And since these mines costs hundreds of millions to billions of dollars to construct, gold miners can’t walk away when problems arise.

The more gold stocks a benchmark tracks, the lower the overall portfolio impact from any individual-stock selloff resulting from some adverse development.  And since gold stocks are a small and volatile sector, the stock downside when something bad happens at a mine is considerable.  So GDX’s extensive gold-stock holdings make it safer than the HUI, diversifying away virtually all company-specific mining risks.

On the other hand, diversification also reduces upside.  During a gold bull, the stocks of the elite gold miners with superior fundamentals are going to far-outperform their sector average.  These outsized gains will be largely diluted away in an over-diversified portfolio.  Diversification reduces risks, but it also reduces potential returns.  The markets never give something for nothing, there are always tradeoffs.

A big advantage GDX has over the HUI is its component list is actively managed by expert analysts.  So while HUI component changes are rare to nonexistent, GDX’s are constantly being shuffled around.  I see this on a quarterly basis as I analyze the top GDX component stocks’ quarterly operating results.  There’s no doubt GDX is a more-accurate ongoing reflection of this dynamic sector than the static HUI.

But GDX has other disadvantages in addition to extreme over-diversification.  By virtue of including so many stocks in such a small sector, GDX also has to include plenty of primary silver miners.  While their stocks generally mirror gold-stock action, the substantial silver weighting among GDX’s top components makes it more of a precious-metals-stock benchmark than the pure gold-stock one it is often advertised as.

For many contrarian investors gold stocks and silver stocks are synonymous and interchangeable, they own both.  While gold price action overwhelmingly drives silver, occasionally silver disconnects from gold and its miners’ stocks follow.  Such divergences weaken GDX’s gold-stock tracking, and I’ve heard from plenty of investors not happy their “gold-stock ETF” also includes most of the major silver miners as well.

The HUI on the other hand is a pure gold-stock benchmark, including no silver miners that dilute its core mission.  Ideally gold-stock benchmarks should only include primary gold miners since that’s what they are supposed to track.  Silver stocks can go into other silver-stock ETFs.  This separation helps investors more easily tailor their specific gold and silver exposure via their respective miners exactly how they want it.

The HUI has another major advantage over GDX in the form of no management fees.  As a pure index, the HUI simply tracks underlying stocks without owning them.  But GDX’s managers actually buy shares in all its component companies proportional to their weightings, shunting stock-market capital directly into the underlying gold stocks.  This process naturally takes considerable expertise, effort, and expense.

So GDX’s managers justifiably charge a management fee currently running about 0.52% of assets every year.  This gradually skews GDX’s returns over time, shrinking them by a half-percent annually compared to a gold-stock index.  Like a small course change by a ship in the middle of the ocean, this deviation isn’t noticeable in real-time.  But as GDX ages and the years pass, its reflection of gold stocks grows more distorted.

Because of this and the far-longer track record of the HUI, I’ve always preferred it when doing most gold-stock analysis.  The longer-term the time horizon being considered in any study, the better the HUI is for a cleaner view of gold-stock price action.  Rather interestingly though, despite their major differences GDX has always mirrored the venerable HUI very closely.  This chart shows both over most of GDX’s lifespan.

Despite their dissimilarity, the historical price action of GDX and the HUI is functionally identical and interchangeable.  Without vertical axis labels, virtually no one could tell these charts apart!  Due to the relatively-small world of gold stocks necessitating any benchmarks have similar concentrations in the biggest miners, GDX and the HUI perform very similarly.  Their price action is nearly perfectly correlated.

Statisticians measure data correlations through a construct known as the coefficient of determination.  It is also called R squared, because it is calculated by multiplying the correlation coefficient, symbolized as R, by itself.  I bastardize this to r-square, as it flows better in writing.  R-square effectively reveals how much movement in one dataset is directly mathematically related to movement in a different dataset.

Since the dawn of 2007 as GDX stabilized after its launch, it has enjoyed a staggering 99.3% r-square with the HUI!  And that’s over a secular span encompassing the first stock panic in a century, mighty bull markets, and brutal bears.  In other words, during the most extreme times imaginable for gold stocks.  And the r-squares rise even higher in individual bulls and bears, running 99.4%, 99.9%, and 99.8%.

So mathematically, GDX and the HUI both track gold stocks the exact same way!  Neither benchmark has a meaningful advantage over the long term, they both do their jobs very well.  Nevertheless, the HUI’s performance does edge out GDX’s due to the latter’s extreme over-diversification and ongoing management fees.  Their relative action in this year’s mighty new gold-stock bull is an excellent example.

Since GDX was only born in May 2006, it was bludgeoned to an all-time low of $12.47 back in mid-January.  That same day the venerable HUI was slammed to a 13.5-year secular low of 100.7.  That very day I recommended a half-dozen new gold-stock and silver-stock trades to our subscribers that have soared hundreds of percent since!  That week I wrote about the fundamental absurdity of those gold-stock prices.

In the brief 6.2-month span since then, GDX has rocketed 145.4% higher at best.  Such big and fast gains are incredible, and illustrate why everyone should have gold-stock exposure in their portfolios.  No other sector has even come close.  Yet the HUI fared even better over this same new-gold-stock-bull timeframe, with extreme 170.4% gains at best!  That’s an additional 25.0%, which is huge over such a short span.

So while the upstart GDX benchmark tracks the venerable HUI benchmark perfectly for all intents and purposes, the HUI still has a performance edge.  Not being over-diversified and not being saddled with a management fee makes a difference.  Nevertheless, GDX’s performance is close enough that investors shouldn’t think twice about using it to deploy capital into gold stocks if they prefer ETFs to individual stocks.

But neither benchmark can hold a candle to a carefully-handpicked portfolio of the elite gold stocks with the best fundamentals.  While GDX and the HUI both contain plenty of outstanding world-class best-of-breed gold miners, they are also burdened with many lesser companies.  Some are even outright dogs with such poor fundamentals that their serious underperformances will really retard entire benchmarks.

When researching individual gold stocks to find the winners with superior fundamentals and therefore upside potential in gold bulls, the component lists of GDX and the HUI are great places to start.  Each quarter I examine the latest operating results of the top miners of GDX, the GDXJ junior-gold-miners ETF, and the SIL silver-miners ETF.  Among their holdings are always found the world’s best precious-metals miners.

In order to be included in these leading ETFs, their component stocks have been heavily researched and vetted by teams of expert analysts.  Even better, top-ETF inclusion guarantees mining stocks will enjoy sizable-to-big capital inflows.  When stock investors buy these ETFs’ shares at faster paces than the underlying gold stocks are being bought, the ETFs shunt this excess demand directly into those stocks.

This essentially-blind buying by investors who haven’t researched individual gold stocks and don’t even know which ones ETFs hold amplify their upside compared to peers not included in major ETFs.  So it is a great boon for gold miners to be included in GDX.  And since the HUI isn’t directly tradable, GDX is the best way to trade the gold-stock sector as a whole.  Buying GDX shares is quick, easy, and cheap.

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At Zeal we’ve put in literally tens of thousands of hours of research on individual gold stocks, so we will always prefer smaller portfolios of this sector’s very best miners and explorers.  We build these portfolios in real-time as market trends allow and buying opportunities arise in our acclaimed weekly and monthly newsletters.  Since 2001 we’ve recommended and realized 833 stock trades in real-time for our subscribers.

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The bottom line is GDX and the HUI are both excellent gold-stock benchmarks, so a battle for supremacy isn’t necessary.  While they each have significant advantages and disadvantages, their actual trading performance is functionally identical.  The HUI has an edge in actual gains due to holding fewer components and having no management fees, but it isn’t tradable like GDX.  These benchmarks are complementary.

Far from being a competitive threat to individual gold stocks, GDX’s rise to prominence has proven a big boon for them.  Elite-ETF inclusion for the best of the gold stocks provides a major source of capital inflows for them as new investors and fund managers flood into GDX to gain some gold-stock exposure.  The HUI and GDX will likely continue to coexist peacefully and track gold stocks for many years to come.

Adam Hamilton, CPA

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