A New Way to Mine Gold

Gold has regained some of its luster over the past few years. Since hitting a low of about $256 per ounce in early April, 2001, the price of the yellow metal climbed steadily to more than $435 at the end of February, 2005 — a sparkling 70% gain. By comparison, the S&P 500-stock index edged up just 10.7% cumulatively over that period.

The metal has historically provided a safe haven for investors spooked by market volatility and political and economic uncertainties. Moreover, given the low-to-negative correlation between the price movements of gold and the performance of virtually all other conventional asset classes, gold offers investors nice portfolio diversification, as well as high liquidity and risk control within a larger portfolio of stocks and bonds. However, the gold market itself can be extremely volatile.

SLIPPERY TREASURE. Leo Larkin, Standard & Poor’s equity metals and mining analyst, sees the positive environment for gold and gold stocks that began in the spring of 2001 continuing. Larkin cites several primary reasons for the favorable climate: the continuing weakness of the U.S. dollar, signs of inflation entering the economy, lackluster returns from the overall equity markets, and the widening gap between the production and consumption of gold as demand increases and supply remains stagnant or decreases.

Nonetheless, many investors have found it difficult to invest in the shiny metal, while others dislike its unpredictability and volatility. Prospective investors had a handful of ways in which to enter the gold markets: buying an individual gold stock (risky, because investors bet on not only higher gold prices but also the good performance of the selected company’s management), buying a gold mutual fund (more stable than owning a single stock, but still highly volatile), and purchasing physical gold, usually in the form of coins or bars (very expensive to store, transport, and insure).

Now, investors have a novel way of dipping into gold’s bounty: exchange-traded funds (ETFs) focused on gold. StreetTRACKS Gold Shares (GLD ) launched in November, 2004, the first U.S.-based gold ETF. The portfolio has already attracted more than $2 billion in assets, including $1 billion alone in its first three days. With gold on the rise, the timing has been good. Another gold ETF, the iShares COMEX Gold Trust (IAU ), came on the market in late January, 2005.

BULLION VS. STOCK. Both these ETFs own actual gold bullion and make no investments in stocks of gold companies. In terms of objective, they simply seek to track the price performance of the commodity, minus fees and expenses.

Investing in gold bullion differs significantly from owning gold-mining stocks. Whereas buying a gold producer represents a leveraged play on the price of gold, the investor also has to select the right company and weigh geopolitical risks. Also, when gold prices decline, gold stocks tend to fall faster and harder than the underlying commodity price. In calendar 2000, the last “down” calendar year for gold, the price of bullion declined from $290.25 per ounce to $274.45 per ounce, a 5.4% drop. The average gold stock fund plummeted 17.8%. On the flip side, returns on gold stock funds often outpace the rise in bullion price.

Interestingly, in the most recent 12-month period through Feb. 28, 2005, the average gold stock fund edged up only 0.5%, while the price of gold rose about 10%. Over the three-year period, though, the average precious-metals fund showed a healthy 26.6% annualized gain, while gold itself returned 13.6%.

HIGHER TAX RATE. Larkin believes gold stocks’ performance will likely “track the overall market this year, though not necessarily outperform it.” He currently has a “neutral” outlook on gold stocks as a group.

Despite the bull market gold is currently enjoying, investors should recall that prices were uninspiring for much of the 1990s, leading mining companies to cut production. Also, gold has a long way to go to reach its all-time peak price of $800 per ounce, achieved in the early 1980s.

Investors should also understand the tax consequences of owning gold ETFs. The IRS categorizes gold investments held for more than one year as “collectible,” and taxes it at a higher long-term capital-gains rate of 28%, instead of the 15% rate applied on other investments.