Mining for a Heart of Gold

04/02/2009 11:25 am EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Paul Justice, ETF strategist for Morningstar, says a gold mining fund is a good hedge against future inflation and a weaker US dollar.

While selective buying opportunities exist following the sector’s sharp downturn at the end of 2008, for better managing geopolitical, currency, and operation-specific risks, we continue to favor gold-related exchange traded funds over individual stocks.

Market Vectors Gold Miners ETF (NYSEArca: GDX) differs from other gold ETFs in an important respect: Rather than own bullion directly, as funds like SPDR Gold Shares (NYSEArca: GLD) and iShares Comex Gold (NYSEArca: IAU) do, it invests in the shares of firms that mine the precious metal. This fund tracks the Amex Gold Miners Index, a market-cap-weighted benchmark of US-listed gold miners with market capitalizations of at least $100 million.

Although the index purports to invest solely in firms that are involved “primarily in the mining of gold,” the index includes a clutch of diversified miners. Because these firms have enormous fixed operating costs, their cash flows—which is what you’re ultimately investing in when you buy these funds—can swing much more dramatically than metal prices.

That operating leverage, coupled with currency gyrations (virtually all of the world’s gold reserves can be found only abroad), have made this fund’s index roughly twice as volatile as the spot price of gold.

Of course, the shares of these miners can get cheap from time to time as they trail gold prices, and we believe that they are underpriced as of this writing. We expect gold bullion and related proxies to do well in 2009 as long as the US dollar remains in its current trading range.

Longer term, though, it is difficult to ignore the inflationary impact of the currently dramatically increased monetary base—running at approximately tenfold its historical average growth rate of some 7%. The Federal Reserve has no choice but to do all it can to preserve the financial markets and worry later about the consequences of its policy. In short, the Fed is currently fighting deflation, but this leads to the long-term risk of inflation. Given that, we believe a small position in gold should be considered as a small insurance policy.

Of course, the fortunes of gold miners are inextricably linked to the trajectory of gold prices. In that sense, the fund offers a not-so-indirect play on gold. Buying this fund gives you exposure that exhibits significantly greater leverage to gold prices than buying the commodity directly. Keep in mind, however, that leverage can cut both ways. If gold prices fail to rise, or if the cost of mining outpaces the rise of bullion prices, these companies will suffer.

Further, given the potential negative impact on the US dollar of a monetary base on the tear, we remain of the opinion that a weaker dollar is in the cards, which would lift gold bullion higher, thus maintaining our $1,250 forecast for the bullion.

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