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Gold Funds Have a Secret

Before you buy that fund to capture the rally in gold, find out what it actually holds.

Checking under the hood when you're shopping for a mutual fund is no less important than it is when you're buying a car.

After all, if you take a look at certain precious metals funds, you might be surprised to learn that their managers have been drifting toward holding assets that aren't closely tied to gold or silver.

With gold now hovering near its highest average price ever -- around $744 an ounce up from $640 in January -- the metal as an asset class is catching the limelight. So it should come as no surprise if retail investors flock to the precious metals funds.

"The problem is that small investors tend to chase performance," explains Joe Foster, portfolio manager for the $600 million

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Van Eck Gold fund and architect of the

Market Vectors Gold Miners

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exchange-traded fund.

"If you follow that logic, this year you would be buying the

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Vanguard Precious Metals & Minerals fund, which holds over $4 billion in assets and has a year-to-date return of 33%," he adds. "But then you may not be getting what you really want."

Or in other words, not enough gold. The problem is that Vanguard's fund is meaningfully invested in shares of companies involved in producing industrial metals.

So what, you might say. But know that in many ways gold is unique -- it is effectively its own asset class. And just as someone wouldn't make the mistake of including stocks in the bond allocation of a portfolio, they shouldn't want something that isn't gold in the gold slice.

"There will come a time when gold differentiates itself from the other metals," says Foster. "That's a big reason why I'm invested in gold and silver and nothing in base metals."

If the economy nosedives, then stocks in general could take a hit, with those of industrial materials feeling outsized pain. On the other hand, gold and gold stocks may continue to rise as investors seek out the metal thanks to its famed role as a store of value.

The good news is that Vanguard's fund is closed to new investors, so no one will be making that mistake with them. But that doesn't eradicate the larger problem of precious metals funds shunning gold.

A fund almost as well performing as Vanguard's, the $1.8 billion

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Oppenheimer Gold & Special Minerals, up 29% so far in 2007, has a similar base-metals issue.

Three of that fund's top five holdings are base-metals producers,

Freeport-McMoRan Copper & Gold

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,

BHP

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and

Companhia Vale Do Rio Doce

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, according to Morningstar.

BHP is a widely diversified mining stock, whereas CVRD is focused more on iron ore. And though Freeport has "gold" in its name, the bulk of its production is copper, and molybdenum makes up roughly the same percentage of its output as gold.

The fund is also invested meaningfully in platinum, which is often used in making catalytic converters and so is more like a super high-priced base metal.

To this point, the base metals strategy has worked well, with such funds leading the pack in terms of performance. The average specialty sector fund is up a healthy 19% through the beginning of October, wheareas the $1.1 billion

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First Eagle Gold, which religiously sticks with gold, lags slightly with gains of 17%.

Considering the raging debate about just how healthy the economy is, any slip-up that leads to a downturn could easily see those roles reversed if base-metal stocks stumble.

So what's an investor to do?

One answer is to buy only pure bullion, like

streetTracks Gold Shares

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or

iShares Comex Gold Trust

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, says Brian Hicks, co-portfolio manager of the San Antonio-based

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U.S. Global Investors Global Resources fund, with $1.5 billion under management.

But he says you don't get the leverage you get with gold stocks, or put another way, a rise in the price of gold is reflected disproportionately in gains in gold stocks.

"It's good to have a mix of bullion and stocks," he says.

For that reason he recommends mutual fund investors do a little investigating to see what really is in a portfolio. The key is to ascertain how much of the portfolio is dedicated to gold.

"I think I would tend to point toward the 80/20 rule," Hicks says, meaning that investors looking for a gold play should shy away from funds with more than 20% allocated to stocks of non-gold companies.

The easiest way to get an idea of what each mutual fund owns is to go to the fund's Web site and look at the offering documents or disclosures. You might be surprised at what you find.