By Palash R. Ghosh It's no secret that gold flourishes during periods of economic and political strife. Current geopolitical risks, coupled with a weak global economy and falling U.S. dollar, have presented the perfect scenario for a gold boom.
In fact, as the price of gold rises, shares of gold mining stocks held by precious-metals funds rise much faster. During 2002, for instance, the average gold fund soared 62.1%, while the widely used Philadelphia Gold/Silver Index gained 43%. The Standard & Poor's 500-stock index, in contrast, dropped 22.1%, and the tech-heavy Nasdaq plunged 31.5%.
But a fast and furious rise in gold mining shares spells a lot more volatility, especially when the price of gold turns down or sells off sharply. That's why gold is typically treated as an insurance policy or defensive measure: holding a small percentage in a portfolio can go a long way when everything else goes wrong. If the past is prologue, however, investors still have to be mindful of getting involved at the wrong time.
For instance, the price of gold reached a six-year high of about $385 per ounce in early February with war still looming in Iraq, but pulled back to about $345 per ounce. in mid-February. At the start of Gulf War in January, 1991, gold was valued at $403 per ounce, and dropped to $360 per ounce less than two months later when the war ended. It was down to $353 per ounce by the end of the year. That price movement underscores the metal's volatility.
Leo Larkin, precious-metals analyst at Standard & Poor's, says he expects the price of gold to decline near term as the war premium abates, but believes that by yearend the price "could range between $380 and $400." For comparison sake, gold stood at about $277 per ounce at the end of 2001. Fear of war, in fact, is just one of a handful of factors driving the price of gold, which also includes falling mine production.
A "war premium" is not the only driver of higher gold prices, says Thomas Winmill, manager of the Midas Fund (MIDSX). "The crises in Iraq and North Korea certainly will have had a short-term impact on the price of gold," he said. Winmill notes that during the last conflict with Iraq in 1991, the price of gold actually plummeted on the first day of the Allied air strikes. "If one is anticipating that hostilities will start again soon, it will probably make sense to sell gold at such time," he says.
Another important factor driving price is gold's traditional role as a safe-haven during periods of protracted weakness in the equity markets, Winmill says. "Of equal importance is that the Federal Reserve has enacted 12 consecutive reductions in interest rates since 2001, and a low rate environment boosts the price of gold because it reduces hedging by gold mining companies, cuts down on speculative short-trading, and makes the U.S. dollar weaker," he explained. "Indeed, rates are at their lowest level since gold became freely tradable in 1971."
Despite the current "boom" for gold, it should be remembered that except for a few brief spikes in the early 1980s and the mid-1990s, gold has endured a long 22-year bear market. As part of a balanced portfolio, Winmill cautions that an individual investor should keep no more than 5% of his total assets parked in gold.
Frank Holmes, chairman and chief investment officer of U.S. Global Investors, who oversees the US Global Investors Fds:Gold Shares Fund (USERX) and the US Global Investors Fds:World Prec Minerals Fund (UNWPX) is more bullish. He believes gold can represent anywhere from 5% to 10% of a diversified portfolio because of the metal's very attractive "counter-cyclical nature." A cost-averaging strategy, over time, is most effective in order to avoid buying when gold is at a peak.
Investing in gold requires close examination and understanding of the underlying risk profile, especially when other types of funds that display less volatility could be used as defensive plays. In truth, when the equity markets begin to pick up again, gold can start to lose some of its luster. High expense ratios for domestic precious-metals funds, which stand at 1.88% on average, coupled with high volatility, are important items to consider. Indeed, investors might find they already have some exposure to the metal in certain types of natural resources funds.
Two precious-metals funds have deomonstrated better-than-average risk-adjusted returns over the three-and five-year periods ended in January, and carry lower-than-average expenses. The $144-million First Eagle SoGen Gold Fund (SGGDX), managed by Jean-Marie Eveillard, had a 10.9% stake in gold bullion as of year-end 2002, making it the portfolio's largest individual holding. Top positions in USAA Invest Tr:Precious Metals & Minerals Fd (USAGX), managed by Mark Johnson, are weighted towards mining stocks Meridian Gold (MDG) and Freeport McMoRan Copper & Gold B (FCX).
The $537-million Vanguard Precious Metals Fund (VGPMX), attractive for its very low expenses (0.63%), is a steady and more conservative performer in gold booms and as well as downturns, but was closed to investors last June. Ghosh is a reporter for Standard & Poor's Fund Advisor