Gold Funds That Could Shine

NEW YORK ( TheStreet ) -- With gold prices sinking lately, precious metals ETFs have dropped. SPDR Gold Shares ( GLD) -- which holds bullion -- has lost 7.0% this year, according to Morningstar. ETFs that own stocks of gold miners suffered especially steep declines. Market Vectors Gold Mines ( GDX) lost 25.3%, while PowerShares Global Gold & Precious Metals ( PSAU) dropped 23.8%.

Can the miners continue falling? Yes, if the price of gold keeps slipping. But after recording heavy losses, the mining stocks now sell at modest prices, says Morningstar analyst Samuel Lee. Lee argues that the mining funds can be attractive long-term holdings because they sometimes rise when other industries are sinking. "You should not expect miracles from the gold funds, but they can help to diversify portfolios," he says.

Lee says that the miners began suffering losses in 2011. For the year, SPDR Gold gained 9.6%, while Market Vectors Gold Mines lost 16.1%. The gap in performance was particularly unnerving because mining stocks should normally outdo bullion in bull markets.

To understand why, consider a mining company that spends $800 to produce an ounce of gold at a time when the price of the metal is $1,000. If the price rises to $1,200, the miner's profit would double, while an investor in bullion would only show a 20% gain.

Despite their advantage, miners suffered in recent years because of poor management choices, says Dan Denbow, portfolio manager of USAA Precious Metals and Minerals ( USAGX), a mutual fund. "Many companies were spending on projects that produced low returns on capital," says Denbow.

Denbow says that the trouble started several years ago as the price of gold climbed, and companies scrambled to open more mines. With many of the prime locations already taken, developers turned to remote areas, such as high in the Andes and in northern Canada. To produce gold in such hostile environments, the companies had to spend heavily on infrastructure and personnel. Some operators suffered from cost overruns. The investments would have proved profitable if the price of gold continued rising. But prices flattened in the second half of 2011.

Denbow says that too many companies developed projects that would have been passed over in the past. He says that five years ago, miners only worked on locations that could produce several ounces of gold for each ton of deposits that was processed. But in the past year, companies worked mines that generated one ounce of gold per ton. Miners are now spending $1,200 to produce an ounce of gold, up from $800 two years ago. With gold currently selling at $1,538, profits have been skimpy.

As the profit margins dipped, shareholders dumped the mining stocks and ETFs. Many investors decided that they preferred holding bullion ETFs instead of the shares of companies that had poor track records for allocating capital.

Denbow says that the outlook for many companies is improving. Faced with stagnant gold prices, managements are cutting costs and canceling costly projects. Some companies are raising dividends, returning cash to shareholders instead of spending on chancy developments.

Denbow typically favors low-cost producers with good balance sheets and solid profits. Most often the cautious approach has enabled the actively managed USAA mutual fund to outdo competing index ETFs. During the past five years, the mutual fund has lost 4.0% annually, compared to a loss of 6.4% for Market Vectors Gold Mines ETF. During the past ten years, USAA returned 14.8% annually, ranking as the top-performing precious metals mutual fund.

To limit risk these days, Denbow is focusing on larger established companies. He worries that smaller operators may have trouble raising capital in the current environment. A favorite holding is Goldcorp. ( GG), a big Canadian operator with mines in North and South America. He says that the company is showing discipline about new projects. "They are talking about avoiding projects that can't deliver adequate returns on capital," he says.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.