Precious metals funds were golden in 2010. The mutual funds in this category typically load up on the stocks of gold mining companies such as Randgold Resources and Goldcorp. The price of gold peaked at $1,432 an ounce on Dec. 7, while the companies held by precious metals funds enjoyed rising profits and the fund category gained 41.7%, according to Morningstar.

Why the big gain in 2010? "Some big miners took off hedges," explains Janet Yang, an analyst who covers the equity precious metals fund category for Morningstar. That is, they stopped entering into contracts to sell their gold at a preset price. Without the hedges, Yang explains, these mining firms' stock prices move more closely with gold prices, so they enjoyed hefty returns in last year's run-up.

What's more, the precious metals fund category's 10-year annualized return jumped to a startling 25% after a strong 2010. At that rate, a $10,000 investment grows to around $93,000 in 10 years. To put that in perspective, the best 10-year record for large-cap stocks (the S&P 500 and a predecessor index) occurred in the post-World War II boom of 1948-1957, according to Morningstar's Ibbotson subsidiary. That annualized return was just over 20%, so $10,000 would have grown to about $62,000.

Precious metals funds have had a run during this century that topped anything recorded by blue-chip stocks in the last century. Are they still worth buying? Perhaps, for planners who have not held gold or diversified precious metals in clients' portfolios. Longtime investors, though, might want to take some winnings off the table, rebalancing back to target allocations while this sell-high opportunity exists.



Gold advocates insist that prices may rise from current levels, especially after a 7% pullback from last year's peak. Nevertheless, it's unrealistic to expect another decade of 25% annualized returns. From 2001 to 2010, gold went from $256 to $1,431 per ounce, a gain of over 450%. Even if gold reaches $2,500 an ounce in the next 10 years, the gain would be less than 100%. A reprise of the last 10 years is unlikely.

Of course, mutual funds don't have to return 25% a year to be good investments. As long as gold prices keep rising, the funds probably will stay in positive territory, and supporters point to many reasons why this may be the case. Frank Holmes, CEO of U.S. Global Investors in San Antonio, says that both a "fear trade" and a "love trade" exert upward pressure on gold prices.

As might be expected, the "fear trade" refers to investors' purchases of gold to protect their portfolios in case of a catastrophe. Gold prices ascended in the 1970s, a decade when the term "misery index" was coined. (That index, the sum of the unemployment and inflation rates, peaked at 21.98 in June 1980, the same year that gold peaked at $850 an ounce.)

Holmes says the fear trade is driven by negative real interest rates-where inflation is greater than the nominal interest rate-and increased deficit spending. Gold tends to rise whenever these two are coupled together.

In Holmes' view, gold rose in the 1970s because people were afraid of inflation, which averaged 9.2% from 1973 through 1982. Even though inflation is nowhere near that level now, the fear trade still exists.

"We're in the middle of an extended period of negative real interest rates that will likely last through the year," he says. "Deficit spending is also a concern. Gold investors worry that currencies might be devalued, as governments in developed nations pay for social welfare programs."

Such anxieties are well-told tales, but a new chapter has recently been added to the gold story: the love trade. "The love trade is unique to gold," Holmes says. "People buy gold out of love, especially in the emerging markets." He explains that it's customary in most emerging markets, particularly Asian countries, to give gold as a gift to friends and relatives for birthdays, weddings and to celebrate religious holidays.

For example, Holmes says that China becoming a global presence has added enormously to the demand for gold. In India, the world's largest gold market, jewelry consumption rebounded in 2010, according to the World Gold Council. "I don't believe the drivers pushing up the price of gold will evaporate," Holmes adds.



Believing that gold prices will go higher might not be the only reason to buy a precious metals fund. Diversification can also be a selling point. These funds definitely deserve a position in your portfolio if you want an investment that is not correlated to other asset classes, says Dan Denbow, co-manager of the USAA Precious Metals & Minerals Fund. "A precious metals fund often will act differently than other holdings."

As mentioned, precious metals funds had a great year in 2010, which was merely a good year for other funds. They also gained 20% and 64% in 2001 and 2002, while the S&P 500 suffered terrible losses. Conversely, precious metals funds had many down years in the 1990s, when the S&P 500 gained over 18% a year; it lost more than 8% again in 2004, while the blue-chip benchmark had a double-digit gain.

Thus precious metals funds can be a volatile asset class, just as gold prices can swing widely. "At today's levels, a $175 correction in gold prices is a non-event," Holmes says. "People stop buying when they think the price is too high. But when the price drops a bit, the buyers come back in. Those corrections are buying opportunities for investors."

Investors also might own a precious metals fund as a defensive position, Denbow contends. "Many investors are afraid of currency debasement, because of government debt," he says.

To make up deficits, governments can raise taxes, cut spending or create inflation. Many investors believe that inflation will be the result. Tom Anderson, global head of ETF strategy and research at State Street Global Advisors in Boston, says that gold-oriented funds can also hedge possible market weakness caused by geopolitical concerns such as sovereign debt problems in Europe.

In short, proponents of precious metals funds offer many reasons for buying them, even after a lengthy period of superior returns: non-correlation, bad news hedging and opportunities for superior returns. "What has happened in the past isn't as important as your current and your future outlook," Denbow says. "Investors should not try to time the market." As is the case with any volatile asset class, a dollar cost averaging or rebalancing approach may be the best way to build a position in these funds.



That said, not everyone is convinced that clients need precious metals funds. "Gold is great for jewelry but bad for your portfolio," says Mark Matson, CEO of Matson Money, an investment advisory firm in Mason, Ohio. He adds that if clients have a globally diversified portfolio, they already own companies that mine gold. "There is no need to load up on more of it," he says. "You already may have more of it than you think."

Matson compares the performance results of various asset classes from 1926 through 2010. The annualized return from gold has been 4.92%, less than the 5.3% from five-year Treasuries and only half the 9.9% from U.S. large-cap stocks, he says. Yet the standard deviation of gold returns has been 19.42, versus 19.19 for U.S. large-caps. Over the long term, then, gold is as volatile as stocks but has a lower historic return than five-year government bonds, which have much less volatility.

On the other hand, Holmes believes that gold's volatility can be a plus for portfolios, if administered in small doses. "Over long time periods, you can see the benefits of using gold for diversification," he says. "We feel that a 10% portfolio weighting in precious metals is appropriate."

That allocation might be evenly divided between gold bullion and unhedged gold mining stocks, Holmes says. "You would rebalance whenever your allocation gets out of line," he says. "That way, you're capturing volatility, not chasing it." That is, an investor would buy gold when holdings drop below 10% of a portfolio and sell gold when it tops the 10% goal.

Financial planners who agree with Holmes have some golden exposure in their clients' portfolios. Lloyd Stegent, president of Stegent Equity Advisors in Houston, recommends gold as a form of "wealth insurance" because of its negative correlation to stock, bonds and fiat currencies. His core allocation to gold and silver is 5% to 10%, depending on the client.

Stegent also has an additional 10% allocation to these precious metals right now because "global bankers are printing money to buy government debt, which is know as quantitative easing," and because "real Treasury bill rates are currently negative." He adds that historically gold has risen in price when Treasury rates were negative.



Yang says that some advisors believe a 5% portfolio weighting is appropriate for a precious metals fund. Planners who would agree with this 5% or even Stegent's bigger 10% strategy have many options from which to choose. There are more than 20 mutual funds in the precious metals category, for instance.

Some mutual funds are more gold-centric than others, while some are more diverse, Yang says, explaining the diverse funds might hold natural resources stocks or companies with other precious metals. In 2010, the diverse funds may have outperformed those that concentrate on gold because companies with positions in silver (up 80% in price last year) and palladium (up 97%) might have gained more than companies focusing on gold (up 28%).

Yang says there's also a difference in the type of company a fund will hold. Some hold large-cap mining companies, while others hold "junior miners." To figure out which kind of a fund it is, compare average market caps in annual or quarterly reports. "Generally, funds with smaller mining companies tend to be more volatile," she adds.

Planners who expect the price of gold to rise may prefer mutual funds holding mining stocks. Especially now that gold producers have removed their hedges, relatively small moves in gold prices may generate larger increases in profit margins and stock prices. As noted, the price of gold rose by about 28% last year, yet precious metals funds returned nearly 42%, on average, and some entries, such as Oppenheimer Gold & Special Minerals, returned almost 55%.

On the other hand, the reverse can be true: Funds that hold mining stocks can suffer large losses on small drops in the price of gold, which eat into profit margins. Yang adds that mining companies can have other exposures, such as country risk, if a fund owns mines in places where problems arise.



For a pure gold play, ETFs may be a good choice, Yang says, adding that some ETFs hold bullion. SPDR Gold Shares, an ETF widely known by its GLD ticker, has accumulated over $50 billion in assets since inception in late 2004. "This ETF's sole asset is a grantor trust that holds physical gold bullion," State Street's Anderson says. "It has no cash, no futures and no stocks."

Other ETFs also hold gold bullion; some hold silver. Such funds may be less volatile than mutual funds holding mining stocks, on the upside and on the downside. Last year, for example, GLD's 29.3% return was far behind the 41.7% gain of precious metals mutual funds. However, in 2008, when precious metals mutual funds lost an average of 30%, GLD gained nearly 5%. For the five years through 2010, GLD reports annualized gains of 21.9%, versus the 19.2% returns of Morningstar's precious metals category of mutual funds.

Yang notes that still other ETFs use futures to invest in precious metals. For example, PowerShares DB Precious Metals ETF is structured to have 80% exposure to gold and 20% to silver.

"Some financial advisors and investors like the idea of getting two precious metals with one fund," says Bryon Lake, senior product manager at Invesco PowerShares. Again, futures-based ETFs may provide more of a direct play on the prices of precious metals with less correlation to the broad stock market, compared with mutual funds. Compared with bullion-based ETFs, futures-based ETFs have a different tax treatment; Lake suggests advisors check with a tax professional to evaluate possible client outcomes.

Invesco PowerShares also offers two inverse gold exchange-traded notes (ETNs) through its expanded marketing partnership with Deutsche Bank, Lake says. They are designed to gain value when the price of gold drops and generally lose value when gold rises. "Long-term gold bulls may use these ETNs as short-term hedges, so they don't have to take gains and owe tax when they think gold will back off," he says.



Stegent's first choice for his core 5% to 10% allocation is the Central Fund of Canada, a closed-end fund that has gold and silver bullion stored in Canada. This fund, along with the Sprott Physical Gold Trust and the Sprott Physical Silver Trust (two other closed-end funds), guarantees that the metals are owned by the trust, not loaned out and are fully insured against loss, he says.

For his additional 10% allocation, Stegent mainly uses ETFs Physical Swiss Gold Shares and ETF Physical Swiss Silver Shares. In addition to the bullion allocation, he may allocate a few percentage points to one or more of the following, depending on client risk tolerance: Market Vectors Gold Miners ETF, Junior Gold Miners ETF, Global X Silver Miners ETF, First Eagle Gold Fund and Tocqueville Gold Fund.

Planners who want to sprinkle a bit of gold dust onto their clients' portfolios have many alternatives from which to choose. Today's ominous headlines may make clients receptive to holding an alternative asset with a centuries-old pedigree. However, planners with long-held positions in precious metals may find these funds have topped their allocation range, so taking profits for clients would be a prudent move. right now.