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.

To spread your bets, consider buying a mix of bullion and precious metals funds. To hold bullion, buy an ETF that owns gold, such as SPDR Gold Shares ( GLD).

To own mining stocks, try a fund with a relatively steady long-term record. A top choice is Van Eck International Investors Gold ( INIVX), which returned 17.1% annually during the past five years, outdoing 98% of peers.

The fund holds stocks of all sizes, including large established companies as well as smaller operations. Some holdings are in the development stage, which means that they have not yet begun selling gold.

Van Eck portfolio manager Joe Foster varies the mix. During periods when gold prices are sinking and mine profits are low, he sticks with blue-chips that have the wherewithal to survive. In bull markets, he owns smaller miners that can skyrocket as gold prices rise and investors worry less about risks.

Bullish on the industry, Foster currently has 30% of assets in small companies, a big position for the fund.

"The stock valuations are low, and the companies are generating tremendous earnings because gold prices are high," he says.

A favorite small-cap holding is Guyana Goldfields (GUY:Toronto), which is developing a mine in Guyana. Foster, who is a geologist, says that the ore is high-quality, and the company is proceeding smoothly to build roads and other infrastructure that will enable production to begin soon. A large-cap company that he likes is Goldcorp ( GG). The company is reporting earnings growth, with operations in Canada, Mexico and Chile.

Another solid performer is Oppenheimer Gold & Special Minerals ( OPGSX), which has returned 16.2% annually for the past five years, outdoing 90% of competitors.

The fund aims to find companies that can report increasing revenues. Although the portfolio includes some large stocks, Oppenheimer typically emphasizes small companies that can develop new finds and grow faster than Wall Street expects.

One holding is Extorre Gold Mines ( XG), which is developing a mine in Argentina. "This is an excellent early-stage operation with higher-quality reserves than the market expects," says John Corcoran, Oppenheimer's client portfolio manager.

For a fund that excels in bull markets, consider Franklin Gold and Precious Metals ( FKRCX), which returned 14.7% annually in the past five years and outdid 66% of peers.

When gold prices were around $300 in 2001, the fund emphasized large companies.

"Starting up a new mine is a risky proposition, and there isn't much room for error when prices are low," says portfolio manager Stephen Land.

As prices topped $400 in 2005, mine profits climbed, and Franklin began shifting to smaller stocks. This year, up to 25% of assets were in development companies that had not started production.

A holding is Osisko Mining (OSK:Toronto), which is developing a property in Canada. "When the development is completed, this will be the biggest gold mine in Canada," says Land.

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