Gold funds post glittering performance

Far ahead of stock funds this year, the precious metal can diversify a portfolio but remains too volatile to serve as a mainstay

Amid fears of terrorism, inflation, growing US deficits, and a sagging dollar, many investors have gone in search of gold - and found glittering returns. The precious metal has been on a tear recently. And gold mutual funds, which invest in companies that mine it, are posting impressive gains for the second straight year.

According to fund tracker Lipper, gold funds were the best-performing US fund sector in the third quarter, gaining 25 percent. For the year, gold funds are up 26.4 percent, nearly double the gain in the Standard & Poor's 500 stock index. "For the past 20 years, gold was seen by investors as a hedge," says Andrew Clark, a senior research analyst at Lipper. "But what we're seeing now is uncertainty, fear, and fundamentals helping to power gold funds to some pretty impressive levels."

In fact, one of the reasons that fund managers have been so impressed with the recent run-up in gold, is that over the long term, the funds have looked very unimpressive. The average annualized 10-year return for gold funds is only about 2.6 percent, according to Lipper. And the price of gold is notoriously volatile. Although it has bounced back from a low of $321 an ounce earlier this year to $385, it's still well below its peak of $850 in January 1980. Because investors typically turn to gold as a haven, it tends to move up as stocks move down.

But much of gold's recent strength has been fueled by a weakening US dollar. A decline in the greenback makes gold, which is sold in dollars, more affordable for foreign buyers. "We are currently in a perfect environment for gold," says John Embry, president of Sprott Asset Management and manager of the Sprott gold fund. "We believe gold will go markedly higher."

Experts say there are encouraging signs that could continue to support gold. One reason is that while demand for gold is probably going to rise, production won't anytime soon. After a long decline to historic lows, annual production stabilized in 2001, and it's not expected to increase over the next five to seven years.

In fact, the supply available for sale had dipped even lower because mining companies had sold much of their future production, a practice known as forward selling. Since then, the companies have had to reverse course - buying gold to fulfill their commitments - which has further boosted prices. The market may get an additional bounce from Chinese investors, who are now allowed to buy, sell, or hold gold bars for the first time since the founding of the People's Republic of China in 1949.

"A weaker dollar and strong jewelry purchases from East Asia - typically the growth engines for gold - could help push the price of gold over $400 an ounce very soon," says Mr. Embry.

Still, gold is hardly a sure thing. In fact, it is considered a risky investment. Future gains might be limited, given the already huge run-up in price. If you're willing to take on the risk associated with gold funds, adding gold makes sense only if you're diligent about rebalancing your portfolio, many experts say. They suggest devoting 5 to 10 percent of a portfolio to the metal. Gold can be a good way to diversify risk away from movements in stocks, bonds, or real estate.