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How Fund Investors Can Spread Gold Bets

NEW YORK ( TheStreet) -- Gold has been whipsawing investors lately, and shareholders of precious metals funds have special reasons to feel disappointed.

So far this year, gold prices have climbed 14% to $1,662, while precious metals funds have dropped 15.7%, according to Morningstar.

The performance is unusual because most often the funds rise along with bullion prices. Fund portfolio managers offer several theories about what has caused the poor returns.

The funds invest in stocks of mining companies. Those have faced rising costs for fuel and steel. In addition, some companies have struggled to find new reserves.

But the biggest cause of the weak showing could simply be that investors expect gold prices to sink in the next couple years. If that happens, mine profits could drop sharply.

"People are afraid that mining stocks could be at the top of the cycle," says Stephen Land, portfolio manager of Franklin Gold and Precious Metals (FKRCX).

Under typical conditions, the precious metals funds outperform bullion during bull markets and trail in downturns.

This happens because mining stocks are leveraged to the price of gold.

To appreciate how the leverage works, consider that it costs some miners about $700 to produce an ounce of gold.

Say the price of gold is $1,000; a mine then earns a profit of $300 an ounce. If the price climbs to $1,300, the mine's profits would increase 100%. But investors in bullion would only record 30% gains.

In a downturn, leverage works in reverse, and mining stocks suffer big losses when gold falls.

During the past decade, gold prices have climbed about 18% annually. Leverage has boosted precious metals funds, which have returned 23.5% annually and ranked as the top-performing category tracked by Morningstar.

If you like gold, should you buy a precious metals fund or hold bullion directly?

Some analysts argue that the funds have an edge because mining stocks look cheap. Many of the stocks have typically sold at price-to-earnings ratios of 20 to 30. But after the poor performance this year, the P/Es have slipped into the 10 to 20 range. Of course the multiples could fall more if gold prices plunge, as some analysts predict.

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