Gold Mutual Funds

How to find out if a gold mutual fund is right for your investment needs.

If you have decided on investing in gold, you have four broad investment vehicle choices: gold mutual funds, gold ETFs, gold stocks and gold bullion. Which one you choose will depend on your objectives as each option will have a different result, even though they are all based on gold. That's why it is important that you are quite clear about why exactly you want to invest in gold and what you want the investment to do for you. As with anything else, each option has its pros and cons and here they are in brief:

A gold mutual fund is defined by Morningstar (a leading mutual fund rating and research service) as one "that pursues capital appreciation by investing primarily in equity securities of companies engaged in mining, distribution, or processing of precious metals (ie. gold stocks)" under the classification of precious metals mutual funds. This is why they are sometimes referred to as gold mining mutual funds and almost never as gold bullion mutual funds.

A gold mutual fund, like a gold stock, is considered a leveraged play on gold because the underlying mining companies have fixed costs and any increase in the price of gold can increase the percentage of profit quite dramatically. For example, suppose it costs a mining company $700 to mine an ounce of gold, when the price of gold is $900, the profit is $200 but when the price goes up to $1000, the profit is $300--a 50% increase in profits caused by a 11% rise in the price of gold. Of course, the opposite would be true if prices go down. For this reason, the prices of mutual funds that invest in gold mining companies tend to move about twice as much as the gold price. Other events which can affect the prices of these funds are company-specific issues like operational problems or just the overall stock market--if the market goes down, all stocks go down, including gold stocks regardless of the price of gold. But overall, this might be the option you would choose if you believed that gold prices were going to have an extended bull run and the best gold mutual funds for you will be the ones that have the best balance of leverage for your risk profile.

Gold mining stocks are a way to own gold based on one's opinion of the prospects of individual mining companies, their management and their mine holdings. Unlike mutual funds or ETFs, gold stocks don't offer broad diversification but they do offer greater leverage on the price of gold--both up and down. Besides, they also offer healthy dividend income unlike most funds and ETFs. If one does one's homework well, it is possible to uncover a gem of a gold mining company and avoid others that are not as attractive. In a mutual fund or ETF, one does not have the capability of targeting an investment as precisely.

While simply buying gold bullion bars or coins may sound like a conservative enough investment strategy, you will run into some real problems after you cross a certain threshold in value. It is fine to own a few pieces of physical gold for the pleasure of it but you will soon become concerned with safety and safe-keeping issues. Where will you store your hoard and be able to sleep soundly at night? And if you do choose a professional custodian, like a local bank, you will need to find out how secure they are both physically and financially, and how much they charge for their services. Bottom line: depending on your investment objectives, bars or coins may not be a good idea beyond a few pieces.

What about jewelry? Well, one of the first considerations about an investment is liquidity--how quickly it can be sold to raise cash if and when required. On the liquidity front, you will not be able to sell jewelry as quickly as you might be able to sell a gold coin, gold bar or share of a gold mutual fund for a whole lot of reasons: the buyer may or may not like the gold content, the styling, the workmanship or all of these and you could end up either not selling or selling for a lower price than you expect and deserve. Also, when you buy jewelry, you are paying for the jewelry store with all its overhead (rent, salaries, security, insurance, profit etc), the design of the piece and the workmanship which can add up to a nice chunk of the value of the piece beyond the actual gold. So besides the practical needs of vanity, jewelry may not a good "investment" either if one thinks objectively.

An excellent alternative to holding gold bars and coins are gold ETFs (exchange traded funds) that trade like stocks and have prices that are closely correlated to the price of gold at any given moment. They are also as liquid as any common stock and can be bought and sold at any time during market hours. However, there are a couple of things you need to watch out for. Being based on the same commodity, it is a common belief that one gold ETF is exactly the same as any other but this is far from the truth and the difference is in how those prices are arrived at. For instance, some will own their own gold bullion (bars and coins) while others will base their prices on gold futures contracts that they trade in. And yet others will have a combination of the two. Obviously, those that own the bullion will track gold prices much more closely than those that invest in futures. To compensate for this, the bullion based ETFs will aim to even out price fluctuations but will still suffer from market driven aberrations. If you are unsure of the price of gold going forward and just want a hedge against market movements and to smooth out the value of your overall portfolio that includes stocks and bonds, gold ETFs are probably a better choice for you than gold mutual funds.

As always, please consult your financial professional before you make any investment decisions.