On Wednesday, I was handed an investment report entitled "Zombies." T
he report by Harris Associates L.P. focused on interest rates, but it could well have focused on precious metal funds instead. Investors holding those funds will feel like their portfolios were afflicted by the same plight causing havoc in AMC's hit show "The Walking Dead."
As I discuss in the July issue of our Quarterly Low-Load Mutual Fund Update, the second quarter was a disastrous one for precious metals funds. The average quarterly loss for the funds tracked was 34.6%. Since the start of 2013, these funds have lost, on average 45.9%. Precious metals ETFs haven't fared any better, down 47.7% for the six-month period ended June 30, 2013.
The natural reaction to seeing these numbers is to run, or the financial equivalent of running. (Just don't scream; zombies are attracted by noise. And thanks to advances in entertainment technology, zombies move a lot faster in the decades since "Night of the Living Dead" was released in 1968.) Yet, unlike a fictional apocalypse, running is not always the best option when a fund incurs a significant drop in value.
The majority of a fund's performance is determined by its objective. As such, your decision to invest in a fund specializing in a certain sector, industry, style or geographic area should also be determined in large part on how the fund's objective fits within your overall portfolio strategy.
A manager required by his fund's objective to invest in a particular asset class, a geographic area or a sector or industry has no control over the factors that directly influence a significant portion of the returns he realizes. When gold prices fall, there is little a precious metals fund manager can do to protect the portfolio from losing value. The same fund manager also does not deserve credit for delivering good returns simply because precious metals prices have risen.
This is why it is important to compare a fund's performance against its peers. Asset classes, geographic markets, investing styles, sectors or industries all move in cycles. What was leading the market a few years ago may lag now or lag in the future. This diversity in returns is what makes portfolio diversification work; over the long term, the shifting market preferences can lead to less volatility for one's portfolio.
There, of course, is another component to keep in mind when deciding what to do with a precious metals fund: the reason an investment was purchased. Commodity-related investments, such as precious metals funds, should only be purchased for two specific reasons: the expectation of short-term price appreciation or long-term portfolio diversification. These are separate reasons and should never overlap. It is very difficult to consistently realize positive returns through short-term trades; it is impossible to avoid losing money when a trade starts getting treated as an investment after the price drops. Speculation and investing are two different things. Never treat a fund (or a stock) bought for the purpose of realizing a short-term profit as a long-term investment because the price didn't move the way you thought it would.
Most importantly, be sure you understand the historical volatility before making a long-term investment. Precious metals funds, for example, are subject to big price swings. Their ability to add long-term diversification comes at the emotional cost of dealing with some quarterly statements that reek of a zombie-like stench. It's not a characteristic every investor has the risk tolerance to put up with, but commodity-related investments can have a role for those willing to put up with roller-coaster returns.
Disclosure: I am long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author of this commentary owns shares of SPDR Gold (NYSEARCA:GLD)