All that glitters

If you had been asked back in early 1998 to choose the mutual fund category that would be the number one performer over the next decade, which one would you have picked?

Most people would probably have selected Science & Technology. The boom was just starting to take hold and high-tech appeared to represent the wave of the future. Fund companies were scrambling to get approval for new S&T offerings in an effort to get a jump on the competition.

Only the most dedicated gold bugs would have picked the Precious Metals category as the most likely to succeed. The price of bullion had been steadily declining for the previous three years, from around $400 an ounce in early 1995 to about $285 an ounce at the beginning of 1998 (London Gold Fix, figures in U.S. dollars). Speculation focused on how low the price would fall. Bullion at $1,000 was just about the last thing on people’s minds.

The price of gold continued to bump along the bottom for the next few years, with the average monthly price in London falling all the way to $260.48 in April 2001. Then the turnaround began. By late 2003, bullion was trading at over $400 an ounce. In fall 2005, the average monthly price broke through $500. By late 2006, it was pushing $700. Then last year, bullion took off, propelled by a steadily declining U.S. dollar. By year-end, the price was in the $900 range and in March the spot price of the metal cracked through the $1,000 barrier.

Precious metals mutual funds, which hold most of their assets in bullion and mining stocks, responded accordingly. Over the three years to March 31, the average Precious Metals fund generated an annual compound rate of return of 27.4 per cent. The strong performance lifted the 10-year average annual return for the category to 16 per cent, the highest in the industry. (For the record, the 10-year average for Science & Technology funds was -2.1 per cent.)

Long a wasteland from a profit perspective, gold funds suddenly became a hot ticket. Unfortunately, the Investment Funds Institute of Canada (IFIC) does not track the sale of Precious Metals funds as a separate category but anecdotal evidence suggests that many people have been adding them to their overall mix. According to Globefund, the 15 distinct funds in the Precious Metals category currently have total assets under management in excess of $5.6 billion. Of course, that’s a drop in the bucket compared to the total industry – IFIC members reported assets under management of almost $680 billion at the end of February. But interest in Precious Metals funds will continue to grow if bullion reaches the $1,200 mark later this year, as many predict.

So what to you need to know if you’re considering putting some money into one of these funds? Here are some key points.

They’re volatile. After trading as high as $1,030 in mid-March, the price of gold nose-dived as investors took profits and the U.S. dollar stabilized. Bullion fell below US$900 an ounce in late April, down more than $100 from the March peak. Precious Metals funds reacted accordingly as every one of them lost ground. Of course, all that can change in the space of a few days if bullion takes off again. If you decide to invest in a Precious Metals fund, you must be prepared to live with these ups and downs. They’re not for the faint of heart.

There’s no cash flow. If you want steady income, look elsewhere. You won’t find it in a gold fund. At best, you might receive a year-end distribution but even that is not guaranteed. You invest in these funds for potential capital gains, pure and simple. That’s one reason why I do not recommend them for registered plans – any profit made inside an RRSP or RRIF will be taxed at your marginal rate when it comes out. And any capital loss can’t be claimed as a deduction.

They could be dead money. The gold bugs are now predicting that we’ll see bullion at $2,000 an ounce within two years. Maybe they’re right. But it could also languish at current levels for an extended period and even drift lower, leaving you with dead money in your account. It happened back in the 1990s and it could happen again. It’s just one more risk to consider.

So what are the near-term prospects? There are several good arguments in favour of a new upward movement in the price. One is the inverse relationship between bullion and the U.S. dollar. When the greenback falls, the gold price tends to rise and vice-versa. With the U.S. economy in weak condition and the Federal Reserve Board poised to cut interest rates again, the outlook for the greenback isn’t healthy.

Another factor to consider is falling gold production. South Africa, once the world’s biggest gold producer, has been steadily reducing its output. In 2007, it lost its long-time leadership position to China and January production was down 16.5 per cent over the previous year.

Inflation also needs to be considered since bullion is considered to be an inflation hedge. The U.S. has been printing money at an alarming rate in an effort to deal with the liquidity crunch, which is contributing to that country’s soaring cost of living rate.

So there are a lot of pros and cons to consider. Think them through and talk to a financial advisor before you decide.