Using Gold to Diversify

Many investors turn to gold for security during times of market volatility. Here's the outlook for the precious metal

Stock markets around the world have fallen off a cliff in the past month—and the price of gold, long seen as a safe haven in times of turmoil, has plummeted as well. After hitting an all-time high of more than $1,000 in March, gold dropped to $681 on Oct. 23 before bouncing back to $740 in early November. The bumpy ride has included three gold rallies—after the collapse of Bear Stearns, the seizure of Fannie Mae (FNM), and the collapse of Lehman Brothers. But each rally was followed by a sharp sell-off.

Gold's recent gyrations were caused mainly by hedge funds and other big investors desperate to raise funds to cover losses and meet creditor demands. In order to do that, they have been getting out of deals made during the past few years to buy gold and other commodities with money borrowed in Japan and the U.S. On a more fundamental level, the dollar's recent rise and the fall in the price of oil have turned off investors who buy gold when they are worried about runaway inflation as a result of higher consumer prices or a plunge in the value of the dollar.

Despite the short-term fluctuations, gold still has a role in portfolios as insurance against worst-case scenarios like a devaluation of the dollar due to spiraling government debt, argues John Hathaway, manager of the Tocqueville Gold Fund (TGLDX). While most economists have supported the government's bailout plans, the moves are likely to increase the federal debt by more than $1 trillion. The Federal Reserve isn't worried about inflation now—it's fighting off a massive bout of falling prices, or deflation, such as occurred during the Great Depression. "The Fed has created more money in the past three weeks than in the previous 28 years," Hathaway says.

Some Jumping In, Others Bailing

The crisscrossing patterns of long-term investors buying and short-termers getting out is best illustrated in the different markets where gold trades. At the Comex, where hedge funds typically buy and sell futures contracts on gold, the number of contracts in active use fell from more than 483,000 contracts in July to 319,000 in October, a 34% decline. At the same time, $2.8 billion poured into exchange-traded funds that buy gold and tend to be used for longer-term investments. Individual investors have bought so much gold directly from government mints that the U.S., Austria, and South Africa have had to suspend sales of gold coins until they can make more.

The recent moves fit with research showing that investors benefit more by holding gold over long periods to help diversify portfolios rather than moving in and out of gold only in times of stress. A review of markets around the world from 1995 to 2005 found that adding gold to a portfolio of stocks slightly improved returns with less volatility. But when the study, written by two lecturers at Trinity College Dublin, looked at gold's short-term moves around moments of crisis, they found that the benefit of buying gold ended quickly—after about two weeks. Although a variety of asset classes can help diversify portfolios, Dirk Baur, one of the study's co-authors, notes that gold's diversification benefit is strongest when the stock market is falling. Other diversifiers, like emerging markets stocks, start acting more like U.S. stocks in times of trouble.

Owning gold may provide some peace of mind over the long run, but there's no consensus among analysts about what short-term path gold's price will take. Merrill Lynch's (MER) precious metals team predicts gold will hit $1,500 as government actions to end the credit crunch eventually spark inflation. J.P. Morgan (JPM) analysts think continuing turmoil in financial markets should support gold prices but predict it will trade at an average of $875 next year. At Barclays Capital, analysts reckon that a combination of a weakening dollar and a decline in hedging by gold producers will push gold to $970 by 2009's second quarter. Among the more bearish forecasters, Deutsche Bank (DB) analysts warned gold could hit $600 in the next few months and expect an average price of $750 next year because investors will continue to be more worried about deflation than inflation. And UBS (UBS) has cut its 2009 forecast to $700.

Nuggets of Safety

For investors seeking diversification, the simplest way to buy into the yellow metal is to purchase shares of an exchange-traded fund that owns gold, such as the SPDR Gold Trust (GLD). The ETFs own huge amounts of actual gold stored in vaults. The amount hit a record of almost 1,093 metric tons worldwide at the end of September, according to the World Gold Council.

But some of the most ardent gold bugs are wary of owning gold through ETFs. Concerned that elements of the financial system could break down and cripple the firms running the ETFs, they favor buying gold bullion either in coins or small bars that can be kept in a safe deposit box. Jim Cook, president of Minnesota precious metals dealer Rarity Investments, says he had his best week ever in the month of October, selling $6 million worth of coins and bars. "The financial system has created so much paper that it's becoming suspect," says Cook, who has been in the business for more than 35 years. Reputable dealers offer gold coins at a markup of only a few percentage points over the value of the gold itself. Investors should steer clear of coins being sold at huge markups.

Stocks of gold-mining companies have fallen much further than the price of gold and may offer compelling valuations. Will Danoff, manager of the $63 billion Fidelity Contrafund (FCNTX), who made a killing buying depressed gold stocks in 1999 and 2000, added shares of Goldcorp (GG) over the summer and, as of Sept. 30, had 3% of his fund in gold miners. His two biggest positions in mining outfits are Goldcorp, at 1%, and Kinross Gold (KGC), at 0.5%.

As you'd expect, mutual funds specializing in gold mining stocks have done poorly of late, with Morningstar's (MORN) precious metals category down 53% for the year. A thirst for assets probably sparked the Oct. 31 reopening of the Vanguard Precious Metals & Mining Fund (it closed in February 2006, when gold had almost reached $600). The fund is down 59% this year, trailing some 87% of its peers, but is a top performer over five- and 10-year periods.

Exaggerated Swings

Mining companies, which have fixed operating costs to get gold out of the ground, can see profits swing rapidly when the price of gold goes up or down, points out Michael Bradshaw, manager of the Evergreen Precious Metals Fund (EKWAX). So gold-mining stocks, down about 50% as a group in 2008, will see a more exaggerated gain in price from a recovery than will gold itself, he says. For example, when gold prices rose earlier in the decade from around $400 an ounce to more than $600, Goldcorp's net income shot up from $51 million in 2004 to $286 million in 2005 and $408 million in 2006. Top holdings in Bradshaw's fund, which can also own physical gold, include Kinross Gold, Rangold Resources (GOLD), and Agnico-Eagle Mines (AEM).

Whether owned as coins, through funds, or via individual stocks, gold should make up just a small slice of a portfolio. Rozanna Patane, a financial adviser in York, Me., says she will be putting a small amount—less than 5%—of her clients' assets in gold as a long-term hedge against inflation and dollar depreciation. In the short term, says Patane, "it may have some appeal as more bad news appears about profits worldwide."

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