A Fool's Gold Play

I have written several times on RealMoney.com's about gold's role in a diversified portfolio.

My primary reason for owning gold is that over longer periods of time, it tends to have a low correlation to U.S. equities. It also tends to go up in the face of short-term crises, and this can serve to reduce a portfolio's volatility.

That gold has doubled in the past couple of years has provided a nice lift, although I did reduce exposure slightly in February as it grew into too big of a position for my comfort level.

The two well-known ETFs that correlate to the price of gold are streetTRACKS Gold (GLD Quote) and iShares Comex Gold Trust(IAU Quote).

A possible alternative to a gold ETF that often gets media attention is iShares MSCI South Africa(EZA Quote), but I don't believe the comparison holds water.

As the chart below shows, the GLD (the bigger of the two gold ETFs) and the EZA have a high correlation most of the time. That shouldn't be a shock -- South Africa is the world's largest producer of gold, and of platinum too, for that matter. The composition of the EZA is heavily tilted to the materials sector (25%), which includes mining companies.

The rest of the fund consists of what you might expect from an emerging-market ETF, with 22% in financials and 10% in telecom. What you might not expect to see is that energy -- mainly Sasol(SSL Quote) -- accounts for 12% of the fund, and Sasol is the largest single holding.

A big advantage of the EZA over owning gold directly is that it yields almost 2%, which is a lot if you are thinking about the EZA as a proxy for the metal.

I believe it is this line of thinking that has led many investors into the EZA. Its assets have grown to $342 million (although that is down from over $400 million before the recent correction).

The problem is that the EZA may not actually be a proxy for gold, and it may not go up in the face of an extreme crisis like you might expect with gold. In fact, the EZA might be better thought of as an other emerging-market fund.

Close Correlation: The GLD and EZA

Source: Big Charts

EZA is, first and foremost, a proxy for the South African market. My litmus test for the EZA as a gold proxy is the trading immediately after the Sept. 11 terrorist attacks. While gold miners such as Newmont Mining (NEM Quote) and Barrick Gold (ABX Quote) rallied 10% to 15% right away, the Johannesburg Stock Exchange All Share Index actually bottomed out worse than the S&P 500.

JSE vs. S&P 500 after 9/11/01

If the EZA is not a proxy for gold, but instead just an emerging market, it is a reflection of an emerging market that has no doubt benefited from the renaissance in commodities, and so it is better studied in that context.

South Africa is one of the current-account-deficit countries, like Turkey and Hungary. It has decent GDP growth (4.6% in 2005), inflation is low (April CPI annualized at 3.3%), and monetary policy is expected to be steady for the time being, with overnight rates at 7%.

EZA has generally outperformed the broader iShares Emerging Markets (EEM Quote) fund on the way up over the past few years, but in the last month it has done worse on the way down.

South Africa seems like a good bet to participate in any further emerging-market rally, but I would discount its ability to serve as a proxy for gold.