Ask MAX: Why Is My Gold Fund Down?

October 31, 2008

Stacey Asks:

Why did Evergreen Precious Metals A (EKWAX) tank so badly? Is there a bright side?"

After Monday’s drop, Evergreen Precious Metals had fallen about 68% since its peak in March 2008. That's more than the S&P 500, Dow, Nasdaq, MSCI EAFE Index, junk bond market, emerging market bond market, classic car market, housing market, and subprime loan market. Okay, maybe not more than subprime, but you get the point.

What's most surprising, and probably the root of your question, is that the fund has fallen far further than gold itself, that shiny metal that comprises the core of the precious metals funds. If you compare this fund to the Gold ETF (see streetTRACKS Gold Trust ETF [GLD]), you won't be impressed with your fund's performance. But if you compare it to other gold funds, you might feel a bit better. Popular gold funds like Vanguard Precious Metals And Mining (VGPMX), Fidelity Select Gold (FSAGX), Oppenheimer Gold & Special Miners (OPGSX), Franklin Gold And Precious Metals (FKRCX), and USAA Mutual Funds Precious Metals (USAGX) are in equally rough (or worse) shape.

As it turns out, gold-related companies are no more magical than any other commodity-related companies you'd find in a natural resource fund. We've just witnessed one of the fastest drops in broad commodity prices in history. The fact that the nosedive followed the launch of dozens of commodity funds inspired by investor fascination with 'hard assets' should come as no surprise.

Gold funds usually own mining companies like Barrick Gold (ABX) and Newmont Mining (NEM). These companies function as leveraged plays on gold itself, so if gold climbs, mining shares will climb even more. The flip-side is this: when gold slips, (as it has by about 25% since the roughly $1,000 peak earlier this year,) gold mining stocks can fall far further. Even worse, this year we witnessed the emergence of political risk associated with mining shares, which scared investors (we’d argue the political risk never went away, investors just ignored it). Traditionally, many gold mines are also poorly-run companies, which only adds to the problem.

So here's the bottom line: your fund tanked because gold mining shares fell much faster than gold itself. Many mining stocks (not just gold mines) collapsed, because leveraged hedge funds and other international funds of intrigue were forced to bail on increasingly stupid momentum bets.

This phenomenon left many fund investors scratching their heads, since they actually purchased gold funds to offset potential losses caused by "riskier" ordinary stock funds – gold is often called a “safe haven” in the financial press. Many doom and gloom experts have advised buying gold mining stocks as a way to "crash-proof" your portfolio. Few thought such a move could actually "crash-induce" their investments.

You asked us for a bright side, so we'll try to deliver. However, keep in mind that we can't get too optimistic about gold or gold funds until investors bail out and gold prices fall below the cost of production at say, sub-$500 an ounce. In fact, we've been shorting gold along with other commodities in our more aggressive Powerfund Portfolios.

Here's silver lining #1: if you bought the fund over four years ago, you might still be ahead of the S&P 500. Unfortunately, this isn't likely, since many gold funds brought in most of their current assets in recent years.

Silver lining #2: if gold prices don't fall significantly, this fund will likely do well, since most gold mining companies can turn a profit with gold prices around $750. However, it's also possible mining shares are down in anticipation of the inevitable (in our opinion) fall in gold prices.

We can't say we were caught off guard by the drop, only that it came much later than we'd anticipated. This fund is one of the better Precious Metals Sector funds (albeit a bit too enamored with more speculative mining names). But if you check out the MAXfunds page on this fund, we're forecasting a -21% return over the next 12 months (and had negative forecasts before this drop as well), along with a worst case peak-to-trough estimate for a 95% drop - among the worst on our site. Keep in mind these warning signs apply to precious metals funds in general. Unlike everybody else, our rating system looks at the future of the fund category as well as the fund itself.

* Note: At the time of this writing, the author of this article is short gold and gold mining shares in his personal accounts, and owns inverse gold ETFs in client accounts.