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Precious-metals funds emerge as a powerful leveraged gold play

The risk-on strategy when the market goes risk-off

Mar 29, 2016 @ 1:21 pm

By Jeff Benjamin

The stunning run so far this year by equity precious-metals mutual funds might be enough to temp some investors and financial advisers to try and jump on the bandwagon. A better strategy, however, would be to take a lesson from the rally in order to be prepared to catch the next one.

As a broad category, equity precious-metals funds have lapped the field since the start of the year, cranking out an average gain of more than 36%, according to Morningstar.

The category performance more than doubled the 15% gain by the next best category, commodities precious metals, which includes just one fund.

Latin America stock funds, with a 14% gain this year, represent the only other fund category to register a double-digit gain over a stretch that saw the S&P 500 Index gain nothing.

As should be expected, there is a bit of performance dispersion among the funds populating the equity precious-metals category, with Rydex Precious Metals (RYPMX) registering a gain of more 45% on the top end.

But even the gain of more than 27% from Tocqueville Gold (TGLDX) on the low end would probably be enough to satisfy most investors.

(Related read: Full list of equity precious metals)

Key to all of this giddy outperformance for a category that had long since fallen off most investors' radar screens is a confluence of events that seems blindingly obvious, especially when viewed in the rearview mirror.

For starters, keep in mind that we're talking about a fund category that hasn't produced a positive calendar year since 2010 when the funds averaged a 41.6% gain, which followed a 52.6% gain in 2009.

More recently, equity precious-metals funds dropped 23.3% last year, 10% in 2014, and 48.8% in 2013.

But what has happened in the category since the start of the year is essentially a direct byproduct of all the things that made investors so nervous about stocks in general during most of January and February.

As stock market volatility picked up, triggering the classically predictable risk-off mood, gold started to rally as the safe-haven asset it is widely believed to be.

The price of gold has since pulled back a little, but it's still up about 15% so far this year. Meanwhile, a lot of mining stocks, which represent the foundation of equity precious-metals funds, are sitting on year-to-date gains of 40% or more.

It is an odd kind of investment jujitsu when a rally in a safe-haven asset like gold fuels a high-octane spike for what many would consider a gutsy risk-on play in the form of mining stocks.

“As a general rule, every 1% move for gold bullion, represents a 3% move for gold stocks,” said Frank Holmes, chief investment officer at U.S. Global Investors.

In other words, mining stocks are the leveraged way to play a gold rally. But in order to do that you have to have the stomach for piling into a down-trodden category at a time when most of the market is running for cover in gold.

To be fair, the precious metals rally was about more than just a leveraged play on gold, although that was surely part of it.

“Mining companies have gotten really beat up on for almost five years, and from a valuation perspective they looked really cheap,” said Steven Dunn, executive director and head of U.S. distribution at ETF Securities.

While the rush toward gold might have been the spark, mining stocks were already set up for a rebound thanks to the relationship between the decline in energy prices and the surging strength of the U.S. dollar.

Mining companies, which are mostly based outside the U.S., can take advantage of the stronger dollar by paying expenses in local currencies while selling their mined metals for U.S. dollars.

The falling price of oil is another factor that played into the rally, because mining companies are extremely energy dependent.

Serious gold watchers like Mr. Holmes of U.S. Global Investors still sees some upside for gold, and believes a 5% allocation to both gold bullion and mining stocks is a prudent strategy.

But jumping into the equity precious-metals space in anticipation of more of the kind of performance we've seen so far this year might be overly optimistic.

“There are all kinds of things that can go wrong with mining stocks,” said Mr. Dunn. “What has really benefitted most miners is low energy prices, so if you start to see higher energy prices you have to wonder what kind of an impact that will have on those companies, and if the stock prices have run too far.”

Equity precious metals: total returns

Fund name Ticker YTD 1-year 3-year 5-year
Source: Morningstar

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