Time to exit gold mining funds

Buying gold mining stocks, and funds that invest in them, seemed like a good idea as global gold prices rose continuously for the last five years. Rising gold prices were expected to improve these companies’ sales and profit margins, lifting the low valuation multiples for their stocks.

But that bet has backfired. And with the rally losing steam, the argument for gold mining stocks is weaker than before. Investors should sell their units in funds such as DSP BlackRock World Gold and PineBridge (formerly AIG) World Gold Fund and switch instead to gold exchange traded funds. Three factors support our changed stance.

Underperformers

Stocks of global gold mining companies have failed to capitalise on one of the longest gold price rallies in recent years. These companies have been hit by multiple risks — regulatory activism that has impacted operations, chronically low investments which have kept output under check, rising cost and labour issues. As a result of this, even as profits for some of the top quality miners improved, their stock prices haven’t kept up. This has led to gold mining stocks sharply underperforming physical gold.

Even after the recent fall, domestic gold prices have managed a 15 per cent annual return over the last five years. But DSP BlackRock World Gold Fund and PineBridge World Gold Fund have seen their NAV decline in the same period. The three-year or one-year picture is no better. In fact, after failing to match gold price returns during the rally, gold mining funds have lost much more value than physical gold in the recent fall.

Top miners such as Barrick Gold, AngloGold Ashanti and Newmont have seen stock prices fall by over 40 per cent in one year, while gold prices in rupee terms have dropped by 12 per cent. This rout on gold mining stocks has reflected in the two gold mining funds as well with both DSP BlackRock and PineBridge World Gold funds losing 40 per cent in value.

cloudy prospects

The de-rating appears justified because the recent retreat in gold prices clouds the prospects for gold miners. In recent years, as rising gold prices improved realisations for miners, the cost of mining soared too. Research by GFMS shows that total gold production costs have doubled from under $600/ounce to $1,211/ounce between 2007 and 2012. With global gold prices sinking by about 18 per cent this year to hover at $1,300-1,400 levels, margins for miners are expected to be squeezed and high-cost miners may shut capacities or go out of business. The resulting pressure on profits could see gold mining stocks fall out of favour. This argues against remaining invested in gold mining stocks. Even if global gold prices do recover from their present slump, price gains from here are unlikely to be as healthy as they were in the past. Betting directly on gold price gains, via gold exchange traded funds (ETFs), thus seems to be a better option today than investing in global mining stocks.

Higher risk

The third reason why gold ETFs offer a better bet than gold mining funds arises from their lower risk profile. As investment options go, gold doesn’t offer any regular cash flows; nor does it have proven intrinsic value.

The only reason to own gold comes from its value as a portfolio diversifier. If stocks or bonds don’t do well, that usually tends to be a good period for gold. However, betting on gold via gold mining stocks deprives buyers of such portfolio insurance. When gold prices rise and stocks don’t, gold mining stocks don’t seem to fare well. And when gold prices tank, mining stocks seem to plummet even more sharply. The value of gold funds as portfolio insurance is thus extremely limited.

Better to hold gold ETFs, so that a part of your returns are shielded from equity market volatility.

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