How to Protect Against Possible Gold Decline

Gold is soaring, but a drop could come at any time for the mercurial precious metal. These funds can buy you some protection.
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NEW YORK (

TheStreet

) -- With bullion prices climbing, gold mining stocks have soared. During the past year, precious-metal funds have returned 52%, outpacing every other category tracked by Morningstar. Can the funds continue to shine? That's hard to know. Gold prices are notoriously difficult to forecast.

But there is a compelling case for owning a small stake in precious metals. For starters, gold can act as an insurance policy. While prices may bounce up and down, gold has always retained some value. In contrast, the price of a stock can drop to zero.

Gold can help to diversify a portfolio because it sometimes rises when stocks are falling, says Frank Holmes, a portfolio manager of

U.S. Global Investors Gold and Precious Metals Fund

(USERX) - Get Report

. Gold typically does best during periods when Washington is running a big budget deficit, Holmes says. Deficit spending can lead to inflation, a menace that causes investors to seek shelter in gold.

During the late 1990s, the U.S. ran a surplus, and gold funds lagged behind the S&P 500 Index. But, lately, gold has climbed as the deficit has exploded. During the past five years, precious-metal funds returned 18% annually, compared with 0.6% for the S&P 500.

To bet on gold, investors can hold either mining stocks or bullion. Mining stocks are more volatile, rising steeply when gold prices climb and dropping sharply when prices soften. To appreciate why the stocks can soar, consider that it currently costs some companies $500 to mine an ounce of gold that now sells for about $1,000. If the price of bullion climbs 10% to $1,100, mining profit margins would climb 20% as operating earnings rise from $500 to $600. When bullion prices fall, the process reverses. Margins narrow sharply, and the stocks can collapse.

To achieve diversification, consider holding both stocks and bullion. Say you decide to put 5% of assets in gold. Divide the position equally between stocks and bullion. If the mining stocks continue soaring, trim your position periodically to maintain the target allocation.

To bet on bullion, you can use exchange traded funds, such as

SPDR Gold Shares

(GLD) - Get Report

and

iShares COMEX Gold Trust

(IAU) - Get Report

. To own solid mining stocks, try Franklin Gold and Precious Metals Fund (FKRCX), a conventional mutual fund that has returned 23% annually over five years. Portfolio manager Steve Land focuses on large companies with track records for steady production. He favors mines with low production costs, since they can survive periods when gold prices sink.

A big holding is

Randgold Resources

(GOLD) - Get Report

, which has operations in Mali and other African countries. "They have a great record for finding deposits and bringing them into production," Land says.

Another holding is

AngloGold Ashanti

(AU) - Get Report

, the biggest producer in South Africa. The company has been diversifying by obtaining low-cost operations in Latin America.

For a limited exposure to gold, consider

First Eagle Global

(SGENX) - Get Report

. The fund aims to protect assets by holding a cautious portfolio of gold, fixed income and stocks. The approach has enabled the fund to avoid big losses in downturns. During the past decade, First Eagle has returned 13% annually, outperforming 97% of world allocation funds.

The fund typically has 5% to 10% of assets in a mix of bullion and gold-mining stocks. But, recently, First Eagle has raised its gold position to 12%. "We have increased the gold holdings as we have become more concerned about the outlook for the global monetary environment," manager Abhay Deshpande says.

First Eagle favors miners that trade for less than the value of their gold reserves. Holdings include

Lihir Gold

(LIHR)

, which has mines in New Guinea, and

Gold Fields

(GFI) - Get Report

, a South African producer.

Another fund with a gold stake is

IVA International

(IVIOX) - Get Report

, which has 6% of assets in bullion. Portfolio manager Charles de Vaulx says gold can offer some protection at a time when so much is uncertain about financial markets. "If you do not necessarily trust the wisdom of policymakers and central bankers, then it is prudent to have a little bit of gold," he says.

Worried that the global economy could be headed for an extended period of poor performance, de Vaulx has most of his portfolio in precious metals and fixed income. He holds only 40% of assets in equities, a low position for a fund in Morningstar's category of foreign small- and mid-cap value. IVA would likely lag in a bull market for equities. But the fund's defensive posture will protect shareholders if stocks suddenly sink.

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