Don't Fall for Fool's Gold

Are there any gold index funds or ETFs that represent a basket of gold shares?

QUESTION: Are there any gold index funds or exchange-traded funds that represent a basket of gold shares?

ANSWER: Sorry. It appears you've stumbled upon an untapped corner of the investing world. But while there aren't any gold-focused index funds or exchange-traded funds currently available, you do have at least 38 precious-metals mutual funds to choose from, according to fund-tracker Morningstar. Only a few of them, like American Century Global Gold (BGEIX), are purely dedicated to gold. But these days, the average precious-metals fund holds at least 70% of its portfolio in gold, so you do have a sizable pool to choose from.

But if you ask us (OK, you didn't, but we're going to answer the question anyway), you'd probably be better off limiting your gold exposure to your jewelry box rather than your portfolio -- even though the returns of this group have certainly been dazzling as of late. The average precious-metals fund is up about 58% over the past 12 months, according to Morningstar, compared with the Standard and Poor's 500's dull return of 0.14% over the same period. That said, if you look at the returns over the long term, you'll see that gold hasn't always retained its luster. Over the past five years, precious-metals funds have actually lost 6% on an annualized basis while the S&P 500 is up 9%.

Historically, gold has always been a popular investment during times of economic distress or political uncertainty. "It's a place where investors retreat for perceived safety when there are upsetting developments in the world, whether that be hyperinflation, wars, international upsets or economic hard times," says Don Cassidy, senior analyst at Lipper. For example, back in the late 1970s and early 1980s, when inflation was soaring in the double digits, gold peaked at $850 an ounce. And after the events of Sept. 11, there was also a minirush to gold, says Christopher Davis, an analyst at Morningstar. Most recently, retail demand for gold in Japan has propped up gold prices and boosted fund performance.

But despite its perception as a safe haven, you shouldn't view gold as a financial Rock of Gibraltar. Precious-metals funds are one of the most volatile categories around in terms of risk, says Morningstar's Davis. "They tend to go up two out of 10 years and are down the rest of the time," says Cassidy. After peaking at $850 an ounce in 1980, gold prices these days are around $300. Moreover, parking your money in gold means missing out on the greater gains in the stock market. "Long-term investors haven't been rewarded for all the volatility (in gold)," says Davis.

Fact is, with inflation holding steady and an economic recovery underway, it's hard to make a case that there will be a further rise in gold prices. But if you're still hell-bent on investing in this sector, you should proceed carefully. First off, you should keep an eye on expenses. Precious-metals funds have higher expenses because of their international exposure and their tiny asset bases, says Davis. Right now, the category average is 2.09%, compared with 1.38% for the average mutual fund. If you aren't one to pay a lot for your funds, consider Vanguard Precious Metals (VGPMX), which has a low expense ratio of 0.65% and respectable long-term performance. Its five-year annualized returns rank in the top 4% of its category. Even then, the overall exposure in your portfolio should be limited to a small 5% or 10%. Otherwise, you just might find that you were simply chasing fool's gold.