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Gold or Miners: Which Investment Shines Brighter?

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Gold mining stocks have been in the headlines lately as their share prices have moved significantly higher.

Between early March and mid-May the Market Vectors Gold Miners ETF (GDX) increased over 17%. The Market Vectors Junior Gold Miners ETF (GDXJ), which tracks smaller-capitalization miners, ticked up over 25% in the same period. Both funds’ result dwarfed the underlying metal’s return of roughly 6.4% during that time.

Historically, advisors and fund investors have used gold miners as one of the few ways to get exposure to the precious metal, says John Gabriel, ETF strategist with Chicago-based Morningstar. That’s changed over the past 10 years or so with the arrival of physical-gold ETFs, which provide direct exposure to the commodity’s price movement.

Client Motivations

As a result of this development, advisors and investors can allocate funds to gold in three distinct ways: by buying the physical metal, by purchasing ETFs (or ETNs) that hold the metal and by acquiring mining stocks. The methods aren’t directly interchangeable, however, Gabriel says, and the client’s investment goal plays a critical role in deciding with path to take.

Commodity holdings are often used as a hedge against inflation, general macroeconomic risk or currency devaluation. Investing for these reasons usually lead to longer-term positions.

“For the most part, when you look at the gold bullion and advisors who use it in portfolios, it’s a strategic long-term position,” he explained. “But, on the other hand with the gold miners, that’s almost a speculative play. You know, they historically have been poor asset allocators and poor performers. That’s not to say they can’t go through periods of good performance, but that makes it more of a tactical play vs. the strategic holding in gold.”

An investor’s ability to tolerate volatility is another factor for advisors to consider, and owning mining stocks can be a roller-coaster ride.

Gabriel cites the past year’s returns for the SPDR Gold Shares (GLD) and Market Vectors Gold Miners ETF. The standard deviation of GLD’s returns was about 12%, while GDX came in at 45%. Even on a three- to five-year basis, he adds, the GDX standard deviation is more than double GLD’s.

Dual-Market Participation

The New York-based Tocqueville Gold Fund (TGLDX) participates in both markets. As of mid-May, just over 12% of the fund’s $1.1 billion in assets was invested in physical gold.

John Hathaway, CFA and co-manager of the fund, compares the gold holdings to an anchor that also provides flexibility. If he believes mining shares are expensive, he can invest new money flows into the metal.

It’s not a trading position, he emphasizes. “We basically have just continued to accumulate physical metal over the last 15 years or so,” he explained. “So, we now have around 3.5 tons of it, and it’s physical metal stored in a vault. It has nothing to do with price appreciation or price depreciation. It’s simply financial insurance for fat-tail events, which we’ve seen reasonably frequently in the last couple of decades.”

While changes in the share prices of gold-mining shares are correlated with the metal’s price, they are operating businesses as well, Hathaway notes, and their prices reflect a wider range of influences.

He gives a generic example. Assume that it costs $1,000 to produce an ounce of gold, and the current market price is $1,200 per ounce. If gold’s price increases by 10%, or $120, that boosts the miners’ profit margin disproportionately.

“That would give you more than 50% margin expansion, and that gets reflected fairly quickly in the share price,” Hathaway said. “So, a 10% rise in the gold price could give you as much as a 50% increase in the share price in today’s world.”

Still, he points out, if gold’s price drops 10%, the impact on mining shares miners can be a “substantial downside risk under those circumstances.”

Time for Glitter?

Gold last approached the $1,800-per-ounce price range in October 2012. Since then, it’s been trending lower; as of mid-May it was about $1,200.

Do the recent price moves in the metal and the miners signal the long-awaited bottom? Hathaway points to several supporting considerations. The first is what he calls radical monetary policies of “one form of another of printing money and zero interest rates.”

An excessive valuation of bonds and stocks and the risk of corrections in both asset classes are other factors. A modest portfolio allocation to gold and miners can provide a hedge should those markets correct significantly, he says.

Finally, for investors willing to take a contrarian stance, gold and its miners certainly qualify as out-of-favor.

“Gold has been so beaten up over the last three to four years,” the investment expert said. “It has no friends and, so, I think the downside risk is less a matter of price risk than it is a matter of time before it starts to generate a positive return.”

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