Sprott SGDJ ETF: Underweight On Junior Gold Mining Stocks

Investing in junior gold mining stocks is a hot topic at the moment as many investors are chasing excess returns during 2023’s gold rush. The Sprott Junior Gold Miners ETF (NYSEARCA:SGDJ) lends researchers a challenging debate, as it is stuck in the middle of conflicting variables.

Despite numerous positives, we place the exchange-traded fund (“ETF”) in underweight territory; here is why.

A Brief Gold Price Argument

Bullion Exchanges authored a comprehensive article over the weekend, providing an overview of the current market dynamics within the gold trading landscape.

Bullion stated that gold demand is rising as many investors believe China is stockpiling to combat U.S. dollar reliance. Additionally, Bullion stated that gold demand growth is the highest in 11 years, partially caused by higher demand for coins and other discretionary products.

Although Bullion’s article and a 6-month rise in gold’s spot price might encourage investors to delve into gold stocks, a forward-looking argument provides an objective counterargument.

Sure, China’s reopening and the U.S. dollar’s weakness might support gold prices. However, a critical factor that could alter matters is moderating inflation. The U.S. yield curve displays lower implied interest rates, meaning inflation will probably continue to taper, consequently providing a headwind to gold.

Furthermore, storage costs are leveling after an abrupt increase in 2021 and 2022. Supply chains have eased, allowing for lower storage costs, which could soon be priced by derivatives speculators and commodity hedgers alike. As such, another headwind for gold exists.

Even though there is evidence that gold prices might proliferate, matters are far from clear-cut. Therefore, we suggest refraining from purely speculating on the mainstream narrative.

Underwhelming Risk-Adjusted Returns

Let us zone in on Sprott Junior Gold Miners ETF’s idiosyncrasies.

The ETF is benchmarked to the Solactive Junior Gold Miners Custom Factors Total Return Index, but its active risk implies that its mandate is relatively unconstrained. To draw a semi-relative comparison, we compared the ETF’s characteristics to VanEck Vectors Gold Miners ETF (GDX), a large-cap gold mining ETF tracking the NYSE Arca Gold Miners Index.

Disappointingly, the Sprott Junior Gold Miners ETF posts excess active risk and inferior active returns to the VanEck Vectors Gold Miners ETF. Thus, we could see many investors move to underweight on the prior while shifting to overweight on the latter if the recent gold hype continues.

Basic risk-adjusted return ratios convey the Sprott Junior Gold Miners ETF’s value additivity.

Starting on a positive note, the ETF possesses positive Sharpe and Sortino ratios, indicating that it produces reasonable risk-adjusted returns during both bull and bear markets. However, the ETF’s Sharpe and Sortino ratios lag those of the VanEck Vectors Gold Miners ETF, meaning investors could yield better risk-adjusted returns by investing in the large-cap gold mining ETF.

Although the Sprott Junior Gold Miners ETF’s basic risk-adjusted ratios are not overly undesirable, its information ratio is in negative territory. The information ratio summarizes a fund’s managerial value additivity relative to its active risk, concurrently conveying the ETF’s managerial skill. A negative IR is something you do not want to see as an investor because it means that you are paying a premium for sub-standard money management.

Constituent Analysis

A “top of my head” observation suggests that gold mining stocks are generally trading at slight price-to-book premiums, with P/B ratios from the likes of Newmont (NEM), Barrick Gold (GOLD), Harmony Gold (HMY), and Gold Fields (GFI) providing substance to the claim.

Again, based on mere observation, small-scale gold miners are carrying more favorable valuation metrics than large-scale miners. The Sprott Junior Gold Miners ETF has exposure to numerous stocks trading at desirable price-to-book values while also being invested in early-stage exploration projects.

However, we would rather invest in some of the ETF’s constituents individually instead of in a basket with an elevated net price-to-book ratio. Moreover, there are great individual opportunities, such as New Gold (NGD), which recently ramped up production.

So, in a nutshell, from an investors’ perspective, we would rather be nit-picky and select a few low P/B junior miners instead of opting for the Sprott Junior Gold Miners ETF.

Click to enlarge

Source: Seeking Alpha.

A Potential Counterargument

A potential counterargument to our bearish thesis relates to market sentiment and investor proclivity.

As stated before, there is a widespread narrative that gold prices could surge. And, as most of us know by now, sentiment is often more effective than reality in the financial markets. Thus, we could see the ETF sustain its 6-month cross-sectional momentum until the end of the year or possibly beyond.

A second consideration is that the Sprott Junior Gold Miners ETF has a favorable dividend profile, meaning investors could benefit from carry returns, phasing out some of the ETF’s price risk.

Final Word

In our opinion, most bullish calls on gold merely consider one side of the story and fail to intertwine counterarguments. As such, the Sprott Junior Gold Miners ETF could suffer from a gold price backdrop.

Furthermore, the Sprott Junior Gold Miners ETF hosts underwhelming quantitative risk-adjusted metrics coupled with numerous overvalued constituents.

Although Sprott Junior Gold Miners ETF presents a reasonable dividend and is experiencing cross-sectional momentum, we remain underwhelmed.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.