Will Gold Add Some Shine to Your Portfolio?

The roller-coaster ride experienced by gold investors during the past year shows no signs of stopping. Still, many investors consider gold a safe haven from inflation or a hedge against financial calamity, and consider a small allocation to gold as a prudent diversification tool. This article will explore a few different vehicles that investors can use to gain exposure to gold.

Two Views on Gold
There are generally two schools of thought when it comes to investing in gold. None other than Warren Buffett suggests staying away from gold investments, as he prefers assets that generate cash flows for him to reinvest:

"When we took over Berkshire, it was selling at $15 a share and gold was selling at $20 an ounce. Gold is now $1,600 and Berkshire is $120,000. Or you can take a broader example. If you buy an ounce of gold today, you can go to it every day and you could coo to it and fondle it and a hundred years from now, you'll have one ounce of gold, and it won't have done anything for you in between. You buy 100 acres of farm land and it will produce for you every year. You can buy more farmland, and all kinds of things, and you still have 100 acres of farmland at the end of 100 years. You could buy the Dow Jones Industrial Average for 66 at the start of 1900. Gold was then $20. At the end of the century, it was 11,400, and you would also have gotten dividends for a hundred years. So a decent productive asset will kill an unproductive asset."

Not all investors see it like Buffett though, including some value-investing heavyweights. Jean-Marie Eveillard probably agrees with Buffett on most things, but he and his team at First Eagle believe strongly in the use of gold as a safety net against runaway inflation and other unforeseen events. First Eagle argues that gold bullion is not tied to any specific currency nor is it dependent on the health of any one government. Also, since gold has very few industrial uses, its price is not tied to economic cycles. Ironically, gold's lack of industrial use is part of the reason Buffett shuns the metal.

First Eagle invests a small portion of each of its funds in gold bullion and launched a dedicated gold fund, First Eagle Gold (SGGDX) in 1993. The First Eagle managers are quick to point out, though, that they do not make any attempts to forecast the price of gold, staying true to its use as a hedge against financial calamity rather than a speculative investment. They also note that gold probably shouldn't take up more than a 5% to 10% allocation in a well-diversified portfolio, and I tend to agree with this advice.

Options
For those that do want to add gold to their portfolios, there are a wide variety of open- and closed-end funds and exchange-traded funds focused on the asset. Some people also purchase gold directly in the form of gold bars or jewelry, for example. As my somewhat traditional Indian mother would tell you, gold jewelry carries significant cultural importance both as a store of value and for its aesthetics.

Even across similar investment vehicles, different funds may employ different strategies, and investors should understand these differences before putting money to work. Some funds, like the SPDR Gold Shares (GLD) and iShares Gold Trust (IAU) ETFs and the closed-end fund Sprott Physical Gold Trust (PHYS), invest only in physical gold bullion. Other funds, like ASA Gold and Precious Metals (ASA) and Market Vectors Gold Miners ETF (GDX) invest directly in the stocks of gold miners. Finally some funds, like the First Eagle Gold, Vanguard Precious Metals and Mining (VGPMX), and Fidelity Select Gold (FSAGX), invest in a combination of both the bullion and equities. Coincidentally, both First Eagle Gold and Vanguard Precious Metals and Mining experienced manager changes at the end of 2013, causing us to lower our Morningstar Analyst Ratings of both to Neutral. That said, we like the process employed at both funds and would consider upgrading these ratings once the new managers get situated.

Recent Trends
Last year was one of the roughest years in recent memory for gold investors. Gold prices, as measured by SPDR Gold Shares, dropped 28% last year, following a massive five-year runup in price. As we mentioned earlier, many invest in gold as a hedge against inflation and declining stock prices, factors which helped gold prices increase 14% annually between 2008 and 2012. In 2013, despite historically low interest rates, the runaway inflation that many feared never materialized. What's more, domestic growth has been on the uptick, boosting stocks significantly and causing gold investors to second-guess their need for a hedge against calamity. Most funds that invest in gold or gold miners fared terribly, as the typical open-end fund plunged just more than 48% last year and the average closed-end precious-metals fund declined almost 34%. In this difficult environment, the funds that turned in better relative performance in 2013 were those that owned more gold bullion and stayed away from less-established junior and exploratory mining firms. The top performing open-end precious-metals fund in 2013, Vanguard Precious Metals and Mining, beat its peers not because of its investments in gold, but rather because it held other nongold industrial firms like Umicore (UMICY) and Johnson Matthey.

So far in 2014 we've seen a sharp rebound in gold-oriented investments. While we're less than two months into 2014, gold funds have performed exactly as one would expect. Following strong gains in 2013, the S&P 500 is about flat through Feb. 18, 2014, but also experienced significant volatility since the year started. Gold funds, however, have finally experienced gains, and the biggest losers of 2013 have led the charge so far in 2014. Gold prices have climbed about 10% so far this year, while Market Vectors Gold Miners has jumped an impressive 25%. Market Vectors Junior Gold Miners ETF (GDXJ), which focuses on the smaller, less-established miners, and led the plunge in 2013, has increased an eye-popping 41% in less than two months.

To summarize recent trends, when investors are concerned over falling equity markets, inflation, or other financial turmoil, many look to gold as a safe haven to park cash. On the other hand, in times of strong economic growth and upward climbing stock prices, risk tolerances tend to increase and investors often pull away from gold in order to participate in bull markets. Just as it's difficult, if not impossible, to predict how stocks will perform in the short term, it's equally difficult, if not even harder, to predict gold prices. For these reasons, I don't think investors should speculate on gold prices. However, those who want to diversify their portfolios with an asset that's weakly correlated with stocks could consider adding a small allocation to gold-related funds.

Closed-End Funds and Gold
Investors who want to access to gold via a closed-end fund have several options, but should note the differences between these funds. For example, Central Fund of Canada (CEF) invests directly in gold and silver bullion (about 58% and 41%, respectively), Sprott Physical Gold Trust is fully invested in gold, and ASA Gold and Precious Metals invests in gold miners rather than physical bullion. Some CEFs will occasionally trade at discounts or premiums to their net asset value, which could create an enticing incentive over a similar ETF, for example, that trades at its full asset value. On the flip side, investors may consider avoiding funds trading at a premium if a similar ETF is available. Either way, discounts and premiums for CEFs can persist for longer than expected, and timing the narrowing of a discount or premium can be as difficult as predicting the direction of gold prices. Below is a table highlighting many of the precious metals closed-end funds, along with a comparison of similar ETF alternatives.

Sumit Desai, CFA, does not own shares in any of the securities mentioned above.