Can you still cash in on the gold rush?

There’s an old English proverb that goes, in part: “When we have gold we are in fear.” These days you could easily turn that notion on its head. Recent events seem to show that “When we are in fear, we must have gold.”

Certainly there have been a lot of jittery investors dumping their American greenbacks and flooding into the ultimate currency lately. That influx has prompted gold to roar back to life after its 2008 slide, and it recently topped US$1,200 an ounce. Now, as Europe plunges deeper into debt, some respected analysts are saying it could reach US$3,000.

So should you buy in and ride the wave? It’s hard to say. There are many good reasons why gold could continue its ascent for a while longer. On the other hand, gold is volatile right now and when it does fall, it tends to fall fast. To help you decide, I’ll take you through the cases for and against sprinkling a bit of bullion in your portfolio. Then I’ll take a look at some interesting mutual funds in the precious metals sector (see table on page 2).

The case for gold largely revolves around three current trends in the global economy. The first is the “flight to safety” that tends to occur during uncertain times. Right now, the world is looking for an alternative reserve currency to the faltering American dollar, and thanks to the European debt crisis, it doesn’t look like it will be the Euro. The resulting migration from U.S. dollars to gold has helped push up the price.

The second trend is the slow build of economic forces pushing us towards inflation. The current budget deficits reported by many struggling European countries (not to mention that reported by the U.S.), don’t look sustainable. Yet the drastic cuts required to balance budgets will be extremely unpopular. So what’s the alternative? Some say inflation. By tolerating some moderate inflation (say 4% to 5%), and eroding the value of money by as much every year, Western governments could reduce their debt burdens. This may take another year or two to start happening, but it’s a real possibility. If it does, gold could soar, as it is widely seen as a hedge against the risk of surging inflation.

Thirdly, it’s worth noting that central banks, which were dumping gold in the late 1990s and the early 2000s, are now buying again, mainly in a bid to diversify their foreign reserve holdings. The serious troubles in Europe make me feel that this could continue for some time. If it does, gold still has room to appreciate further.

Before you start burying gold bars in the backyard, though, it’s worth taking a moment to consider the risks. For starters, remember that buying into any investment that’s trading at such a high valuation is dangerous. Dot-com stocks looked just as fantastic in 1999 before the bust, and U.S. real estate was a sure bet in 2006.

Gold is a risky investment because when it loses investors’ interest, there is nothing to support it. Industrial demand for the metal is limited, so its fundamentals are purely based on investors’ appetite. People who invested in gold in the 1980s lost two-thirds of their capital. Those who stayed invested had to wait 30 years to break even. That’s why I don’t recommend that you hold precious metals funds in the core of your portfolio. Instead restrict them to a speculative portion of no more than 10%.

If you do decide to increase your exposure to gold, the first question you will face is whether you should buy pure gold (be it in the form of coins, bars or exchange-traded funds with real gold holdings), or a precious metals equity mutual fund.

When you compare pure gold to a gold equity index fund, you find that there’s not much difference. If at the end of 2001 you invested $10,000 in pure gold, your investment would be worth $27,390 today. That compares to $25,900 if you had invested the same amount in a precious metals equity index fund. Pure gold would have outperformed the index fund by more, but gold prices are denominated in U.S. dollars. Because the U.S. dollar has been falling against the loonie, when you adjust your returns for currency, the returns are pretty similar.

But I think an actively managed precious metals equity fund can do better than either pure gold or the index. As “The gold standard” table underneath shows, several funds in the category have outperformed the S&P/ TSX Global Gold index by a significant margin, and with average returns of 20% per year on a 10-year basis. Such spectacular returns are usually achieved through exposure to junior gold miners. Investing in juniors by yourself is risky, but by investing with a smart fund manager who keeps a diversified portfolio, you can reap handsome short-term benefits while minimizing the risk.

Dynamic Precious Metals is a good example of an actively managed precious metals fund that has achieved above-average results on consistent basis. I attribute this performance to a solid stock selection with an emphasis on small cap issues. This fund was particularly adept at maintaining a liquid portfolio during the 2008-09 plunge in gold prices, which enabled it to contain its losses well below the average category loss.

RBC Global Precious Metals is another good choice. This fund has delivered excellent returns on a 10-year basis, and again, the portfolio manager was good at containing losses during the 2008 fall, this time by maintaining a high cash balance and holding some gold futures.

Still, I must emphasize that if you choose any of the listed funds, be prepared for a drop if the market turns. Losses posted during the 2008 slide ranged from 25% to 55%, and as a rule, precious metals equity funds are twice as volatile as regular equity funds. In short, if you’re an active and bold investor who wants to buy into the gold rush, you need to remain alert to market trends and be ready to exit when you reach your target price. On the other hand, if you’re a buy-and-hold investor looking to add a new asset class, gold may not be an ideal choice.

The gold standard
Precious metals funds have returned 20% a year over the past 10 years

Suzane Abboud, CIM, is president of FundScope Ltd., a mutual fund research company located in Toronto.