- Gold mining stocks don’t faithfully follow gold price rallies
- They have had more loss-making years than physical gold
- Gold ETFs work as a portfolio hedge to smooth out returns
- Gold mining funds, like other themes, are tactical return boosters
The 62% return on domestic gold prices (and gold ETFs) since the end of 2018 has left many Indian investors who are invested in equity and debt mutual funds with a let-down feeling.
To them, news that Warren Buffet’s Berkshire Hathaway has acquired a stake in Barrick Gold Corp, one of the world’s largest gold mining companies, presents a temptation. If Buffett who has always said nasty things about gold has now bought a gold mining stock, can they also catch up on the gold rally by doing the same?
There is a good fund – DSP Gold Mining Fund – for Indian investors looking to bet on gold mining stocks. This is a feeder fund which channels your money into the Blackrock World Gold Fund, which has a very well-regarded natural resources team that cherry-picks the best gold mining stocks from across the world. Trailing returns on DSP Gold Mining Fund look impressive today – a 1-year gain of 56%, 3-year CAGR of 23% and 5-year CAGR of 21% as of August 17, 2020.
But before investing on the strength of this alluring recent performance, it helps to understand that gold mining stocks (and funds that invest in them) are very different animals from physical gold investments (via gold ETFs).
Gold ETFs perform the role of portfolio diversifier by shielding your returns from the worst of stock market falls. But gold mining funds, like other thematic equity funds, are essentially short-term return boosters. They deliver high returns in short bursts for investors who know when to enter and exit them. But they don’t do much good to your portfolio as a long-term holding.
Here’s how they differ.
Gold mining stocks: Not a hedge
The main reason for Indian investors to have a gold allocation in their portfolio is downside protection during turbulent phases for stocks. During times of stock market turmoil, not only do global gold prices shoot up, the Rupee also depreciates against the dollar, propping up Indian gold ETF returns. But gold mining funds aren’t a good choice for such hedging because they do not always move in the same direction as physical gold.
The market performance of gold mining stocks, like that of other commodity stocks, depends not only on gold price moves but also on the earnings performance of gold miners which tend to be highly volatile. When gold prices soar, miners try to ramp up their gold output to max out their revenues and profits at high realisations. When they slump, higher-cost miners are forced to shutter their mines, take impairment charges and report huge losses.
During extended downturns in gold prices, many gold miners in fact go under or get acquired by rivals at distress prices because they can’t recover even their fixed costs. Only miners with globally diversified operations, an active hedging strategy and extremely low costs of production have survived the past two downcycles in gold and Barrick Gold is one of them. Because of the severity and length of bear markets in gold, it often takes a sustained uptrend in gold prices for most gold miners to break even and turn a profit.
This is why, when you bet on a gold mining fund there is no guarantee that it will faithfully mirror every rally in gold prices. The table below, comparing returns on the FTSE Gold Mines Index (an international index of gold mining stocks and benchmark for DSP World Gold Fund) against global gold returns in USD shows that while physical gold has delivered losses in only 4 of the last 21 years, the FTSE Gold Mines Index has delivered losses in 9 of those 21 years.
There have been several years where global gold prices have gained but gold mining stocks have posted sharp losses (2008, 2011, 2012). Yes, there have been a few phases (2001-2003, 2016) where mining stocks have outperformed physical gold, but they’ve been short-lived. This effectively shows that if you’re looking for a portfolio hedge, physical gold is a better bet than funds that invest in gold mining stocks.
Not a diversifier
The other key function of gold ETFs is that they smooth out your portfolio returns during periods of stock market turmoil. Analysing domestic gold price returns over the last 30 years (https://primeinvestor.in/what-can-you-expect-from-gold-returns-data-says/), the correlation between the Nifty 50 and domestic gold prices for 1-month, 3-month, and 6-month periods in the past two decades was at a minus 0.01, minus 0.04 and 0.05, respectively. This shows that gold ETFs often deliver returns when stocks don’t and vice versa, making them a good portfolio diversifier.
But gold mining funds have not proved to an effective diversifier. The table below shows that negative years for the DSP World Gold Fund often coincided with big bear markets for stocks (Nifty50). Check out its performance in 2008, 2011 and 2015. Gold ETFs in contrast (Nippon Gold Bees) have managed good gains in two of three big bear years.
Yes, DSP World Gold Fund has managed stellar returns too in some years when the Nifty50 gained – in 2010, 2016 and 2019. But this only goes to show that a gold mining fund, like other thematic equity funds, mainly acts as a kicker to your portfolio returns if you time your investment right.
Not for the long run
Finally, rolling returns on gold suggest that it’s a good long-term holding with returns of 9-10% CAGR of held for 5 and 10 years. This makes it a good strategy to add a gold allocation to your portfolio as a hedge against equity risks. But gold mining funds, like other thematic funds, mainly work as tactical allocations.
Daily rolling returns since inception show that the probability of high returns from DSP World Gold Fund are higher with shorter holding periods (maximum returns are highest for one year). Holding the fund for 5 or 10 years doesn’t necessarily eliminate negative returns (the average return is negative for both periods).
Despite the fund’s impressive returns in the last 1, 3 and 5 years, its returns over 10 years are at a modest 3.4%. This shows that the current good spell has been preceded by a long period of sub-par returns.