Gold Funds Shield Investors When Stocks Fall

Gold mutual funds and ETFs can help investors protect their investments when stocks fall. Here's how to add gold to your portfolio.
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NEW YORK (TheStreet) -- With gold prices soaring, precious metals funds have climbed, returning 61% in the past year, according to Morningstar (MORN) - Get Report.

Will

gold prices

keep rising? That's hard to know.

Gold

is notoriously volatile, and short-term traders could be disappointed this year. But long-term investors may want to hold some precious metals as insurance. Precious metals can help diversify portfolios because gold sometimes rises when stocks fall. While the value of a stock can drop to zero, gold always holds at least some value.

To own precious metals for security, consider putting a fixed percentage of your assets, such as 5%, into gold and precious metals funds, says Frank Holmes, manager of the

U.S. Global Investors World Precious Minerals Fund

(UNWPX) - Get Report

. If gold skyrockets and your holdings grow to 6% of assets, you can sell the gold until the position reflects your target allocation. If stocks surge, and you slip below the target gold allocation, buy some more precious metals.

By rebalancing, you're more likely to buy low and sell high. That should boost long-term returns, says Holmes. Avoid trying to time the market by buying gold when it seems like its about to rise. Investors who chase performance often end up buying securities when they're near their peaks. "When people try to second guess the market, they usually lose," Holmes says.

To stabilize returns, Holmes suggests putting half of a portfolio's precious metals stake in bullion and half in precious metals funds that own mining stocks. Compared to bullion, mining stocks are volatile, rising sharply during bull markets and sinking when gold prices fall. By rebalancing, you buy the stocks when they are cheapest.

To build your precious metals portfolio, start with a fund that holds bullion. The most popular choice is the

SPDR Gold Shares Fund

(GLD) - Get Report

, an exchange traded fund that owns $42 billion of bullion. Investors who want to move slowly should consider the

Permanent Portfolio

(PRPFX) - Get Report

, a mutual fund that keeps about 20% of its assets in gold bullion and coins. The rest of the portfolio is in a mix of Swiss francs, natural resources stocks and high-quality bonds.

The Permanent Portfolio's cautious strategy lagged during the booming stock markets of the 1990s. But during the past decade, the fund has returned 9.8% annually and outdid all of its conservative allocation peers.

To invest in mining stocks, try a precious metals fund. There are two types: conservative portfolios that focus on established mining companies and aggressive funds that bet on fledgling operations. Investors seeking to diversify should consider holding both funds.

A relatively cautious choice is the

Evergreen Precious Metals Fund

(EKWAX) - Get Report

, which has returned 24% annually during the past five years, outdoing 73% of its competitors. Holdings include

Barrick Gold

(ABX)

, a large Canadian company that operates 26 mines. The fund also owns

Newmont Mining

(NEM) - Get Report

, a Colorado company with 90 million ounces of gold reserves.

The U.S. Global Investors World Precious Metals, which has returned 20% annually during the past five years, holds fledgling companies. Holmes looks for companies with experienced management teams that have recently found gold. He aims to buy the stocks when the mines have lined up financing and are about six months away from starting production.

At that stage, the stocks typically sell for about 10% of the value of the gold reserves. The market insists on the discount because the young mines may never become profitable. If the businesses proceed smoothly, the stocks can triple after the mines establish records of steady production.

A holding is

Medoro Resources

, a Canadian company that's modernizing an old mine in Colombia. Holmes says that new finds should enable Medoro to increase production.

He also likes

Romarco Minerals

, a Canadian company that's developing a mine in South Carolina. The mine has more than 1 million ounces in reserves, and Holmes expects the company to find more gold as it drills.

A new fund that specializes in riskier gold stocks is the

Dynamic Gold and Precious Metals

(DWOGX)

. A holding is

San Gold

, a Canadian company that recently began increasing production at an old mine in Manitoba. Manager Robert Cohen says the company should produce about 60,000 ounces this year. He estimates that the company will soon increase annual production to more than 200,000 ounces. "I am willing to hold the stock and wait patiently while they increase production," he says.

--

Reported by Stan Luxenberg in New York

.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.