Fool’s Gold

December 30, 2004

One inalienable rule in the mutual fund business is that funds with hot track records bring in the most money. Like it or not, this is a business of performance chasing. But occasionally this law of past performance does not explain investor excitement over a particularly popular fund.

A good example is when Merrill Lynch brought in over a billion dollars into their new internet fund, which they launched in early 2000 – just in time to destroy investor’s money. There was no hot past performance, just clients of the broker who were hungry for Merrill’s expertise in an area that made other investors rich. In this case, the past performance of other funds in the category was enough to bring in investor money.

This year we are seeing another illogical success story in new fund launches, and this one is not even in a particularly hot category.

One of most popular funds (in terms of asset gathering) of 2004 is not an international, small cap value, emerging markets, or microcap fund. It’s not a foreign bond fund, or a utilities fund, or some hot Latin American fund. While there are funds in many of these now hot categories that are bringing in huge dollars, one new fund stands out: streetTRACKS Gold Shares (GLD), loosely defined an exchange traded fund, or ETF.

How successful has the fund been at attracting new money? It was launched in mid November of 2004, and in a few days it reached some $1.5 billion in assets. While this is remarkable for any one fund, it is most startling for a precious metals fund where no fund currently has (or in all likelihood has ever had) over a billion in assets. Today streetTRACKS Gold stands at around $1.3 billion in assets.

Until now it has been impossible to reach the billion dollar mark in precious metals funds, because every time investors have poured significant quantities of new money into them, the funds have fallen, and have fallen hard. Investors in gold funds have historically bought in only when the price of gold has neared a peak – and shortly before a precipitous drop in both an ounce of the yellow metal, precious metal mining company stocks, and therefore the share price of precious metals mutual funds.

Technically, streetTRACKS Gold Shares is not a fund at all. It is an exchange-traded trust not registered under the investment company act of 1940 – the operating rule set foundation of mutual funds, also known as investment companies.

The fund falls under the category of precious metals funds – a category that probably shouldn’t exist at all as these funds are really just a subset of the natural resource category. We don’t have an automotive or semiconductor fund category, even though both of these industries have far more in revenues than all precious metals mines combined.

The new streekTRACKS ETF makes investing in gold easier then ever before. Most precious metals funds own shares in gold mining companies. streetTRACKS Gold Shares lets investors effectively buy gold bullion.

State Street, the people behind the fund, will have to sell gold in the trust to pay expenses of up to .40% a year. Unlike normal funds, which can pay fees from bond income and stock dividends, this trust will have to sell gold bars to pay management fees, because gold has no income stream, current or in the future.

Whatever investing legitimacy most precious metals funds had – owning real business that mined gold for a living – is out the window. streetTRACKS Gold investors can focus solely on the actual, honest-to-goodness, underlying shiny metal itself.

This may sound like a subtle difference, but imagine two energy funds: one owns stocks in companies like ExxonMobil and the other owns nothing but barrels of oil.

The fund does very well to make owning a gold bar a relatively simple affair. Gone are the hassles and costs of storage and insurance, as well as commissions to brokers and transportation.

Not gone are the poor tax consequences of investing in gold bars. The IRS does not consider gold an investment, but rather taxes any gains from trading the yellow metal as profits from selling a collectible. This means if you own gold bars – or shares of this new trust – for over a year, gains could be taxed at 28% and not the new low 15% long term capital gains rate applicable to real investments (real investments which include, by the way, shares in gold mining companies).

Owning raw gold bullion was apparently something many investors wanted to do. It is unlikely there will be other similar trusts to own other commodities like pork bellies or steel, and not simply because commodities offer lousy long term returns. The real reason other single commodity trusts would likely fail to bring in money is that investors do not see gold bullion as a commodity at all. Gold appears to have magical properties. It is a commodity masquerading as an investment, or worse, as better than money – and the only true world currency. This gold fever has historically lead to some ill timed investing decisions.

If investors bought gold (or just about any commodity) and left it alone for, say, fifty years, they wouldn’t do so badly – they would underperform investments like stocks and bonds, but they probably wouldn’t lose money and should keep up with the rate of inflation. But they don’t. They buy gold after it has done well (gone up in price), then sell it after it falls.

Would this new gold ETF have brought in any money if it were launched when Merrill Lynch was bringing in billions to their new internet fund? Considering gold was around $170 per ounce cheaper in price, it would have been a good time. But it is unlikely that investors would have flocked to this fund in 2000.

Investors don’t like cheap. They don’t like contrarian. They like past performance and a good story of why that past performance is bound to continue. While gold funds have been the weakest fund category over the last twelve months, raw gold has climbed around 60% since 2000, and it seems to offer a magical way to make money from global turmoil, a falling dollar, bear markets, and inflation (even though the last year has been unimpressive).

Reporters and analysts are just as guilty as performance-chasing investors. In 2000 there was nary a mention of gold in the financial press (too busy writing about opportunities in tech and telecom stocks) other than the occasional quoted rant by a crazed gold bug still holding on to gold bought at $800 an ounce in early 1980 in an otherwise negative article about gold.

CNBC is as infatuated with gold as oil these days. Gold as an investment has been legitimized by recent short term performance – just as it was in 25 years ago. The vague notions of gold as an inflation fighter, a cure for the falling dollar, or a hedge against global turmoil, are all reasons used to rationalize the natural attractiveness of strong, recent past performance.

As if investors needed another gold option, Barclay’s has a similar gold fund planned.

When a new fund is this attractive to investors the future returns are likely to turn sharply negative. In fact, gold seemed to peak at almost $460 an ounce just 11 trading days after this new fund launch – a level that could prove the high for the next several years.

The only way this fund would be a good investment over the next few years is if nobody wanted to buy it today – call it the great irony of investor infatuation. This brings us to one of the great rules of investing: whatever is most saleable today will perform the worst tomorrow.