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Gold Is Hot Now, but Don't Be Blinded


Given their phenomenal performance in recent weeks--and the new weakness in the dollar--gold mutual funds are all the rage again.

But investors thinking of getting in now should tread carefully, fund managers and sector analysts say, because all that glitters in these portfolios isn't necessarily gold.

Indeed, the vast majority of gold funds, which are still the second-worst-performing fund category over the last decade, don't own a single ounce of gold.

Instead, they invest in gold mining and exploration companies, whose shares are often more volatile than the actual commodity.

Recently, this has worked to their advantage.

While gold prices have moved up only about 8% since the end of August, the Standard & Poor's gold stock index has shot up nearly 76%. Mutual funds that invest in these shares are up, on average, 48.5%, during this time, according to the fund tracker Morningstar Inc.

"The problem, as always, is that if gold prices should go down 10%, these stocks could go down 20%, 30% or 40%," said Jean-Marie Eveillard, manager of the SoGen Gold fund.

What's the chance that gold prices will fall?

Few expect a significant drop in gold prices right now.

Indeed, Merrill Lynch & Co. precious metals analyst David Christensen believes gold could rise from its current price of about $300 an ounce to as much as $310 or $315 in the near future, especially if the dollar further weakens and loses its place as the currency market's haven.

But analysts say a small drop isn't out of the question.

That's because gold producers have been selling into recent rallies, notes Morgan Stanley Dean Witter & Co. gold analyst Douglas Cohen. And rumors persist that the International Monetary Fund will soon sell off some of its reserves, raising the supply and pushing down prices.

Should the commodity fall in price just 1%, that could translate into a 4% drop in earnings for gold-related companies because virtually all of their revenues are tied to this single commodity, fund managers say.

And in this market, companies that can't meet earnings expectations can expect to be punished.

Gold prices have been improving since late August as the global financial crisis worsened and as the dollar began showing signs of weakness, especially against the yen.

"The U.S. dollar serves as a global reserve currency as long as the U.S. economy is strong," said James Stack, editor of the InvesTech Mutual Fund Advisor in Whitefish, Mont. "But now, with some initial fears of recession appearing and with the U.S. economy's feet firmly planted in midair, there's a likelihood that gold could retain its status as the currency of last resort."

On Wednesday, for instance, when the dollar suffered a record decline against the yen, gold prices rose $4.60 an ounce to $300.70 in New York.

Expectations for gold also rose as hedge funds that shorted the metal began to unwind those positions--that is, they had to buy gold to close out their short positions.

Bill Martin, lead manager for the $169-million American Century Global Gold fund, said most hedge funds have finished doing that. Yet, "we're still at about $300 an ounce," he said. "That I view as negative."

For gold prices to break out of this trading range--prices have been stuck between $275 and $315 an ounce all year--Martin believes interest rates would have to fall significantly, renewing concerns about inflation. Historically, investors held gold as an inflation hedge.

What does all this mean for gold fund investors?

Fund analysts say those investors who are buying into gold funds for defensive purposes--and not to speculate on gold prices--ought to stick to one of the following categories:

* Funds that own some gold bullion. "The presence of gold bullion in a fund tempers moves both on the up- and downside," said Christine Benz, a mutual fund analyst with Morningstar. For conservative investors, she recommends the Lexington Goldfund, which recently held nearly 20% of its assets in bullion.

* Funds that invest in larger stocks. Not only do more established firms have predictable earnings, their shares are more liquid, fund managers say. So, if investors who recently moved money into gold funds turn around and redeem, fund managers who invest in larger companies will have an easier time managing their portfolios, Benz said. One example: American Century Global Gold invests more than two-thirds of its assets in medium and large companies.

* Funds that invest more in North American mining stocks as opposed to South African companies. Stack notes that South African companies are known for running the highest costs in the industry. Should gold prices fall, then, South African mining firm margins would be hurt well before those of North American outfits. Stack recommends Fidelity Select American Gold, which invests more than 90% of its assets in North America.


The Metal vs. the Stocks

When gold prices rise, gold stocks and the mutual funds that invest in them soar, as they have since the end of August. Likewise, when gold prices fall--even a little, as they did in the first eight months of this year--gold stocks and gold funds tumble.

Jan. 1 to Aug. 31

Gold price: --4.6%

Avg. gold fund (Morningstar): --34.1%

Gold stocks (S&P gold index): --35.9%

Aug. 31 through Tuesday

Gold price: +7.9%

Avg. gold fund (Morningstar): +48.5%

Gold stocks (S&P gold index): +75.8%

Sources: Morningstar, Bloomberg News

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