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Trading Gold Funds© Sound Mind Investing | September 2009
This article is a follow-up to A Road Map for Investing in Gold As promised in that article, I'm now going to provide the details of the Upgrading research I conducted in an attempt to identify a profitable methodology for investing in gold funds. Frankly, the results were disappointing. Yes, the rates of return from Upgrading were higher than those from holding gold bullion or investing in the average gold fund (see table below).  But I was hoping for a reduction in volatilty, and especially for an improvement in the three-month "worst case" scenario. I got neither. I doubt that many investors have the stomach for staying the course with this strategy during the down periods. Having offered that warning, here are the details. THE TIME FRAMEI began the research with results from 1991 because 18 years seemed a sufficient period of time to establish the basic effectiveness of an Upgrading system. Also, the research is labor intensive and I needed to make it manageable in order to have time to test various inputs. Had I gone back further, my conclusions might have been different, but I doubt it. THE FUNDS IN THE UNIVERSEInitially I included all 14 of the no-load gold funds that have been in existence since 1990 (a year of data was needed to calculate the momentum score for each fund as they entered 1991). The results were quite erratic, largely due to a few funds that were much more volatile — on both the up- and down sides — than the group as a whole. These funds would rocket to the top, and then drop precipitously in the face of any weakness. Thus, their stay near the top was short lived. I removed the four worst offenders, and started over with the 10 remaining funds. Both groups are shown in the table.  You'll note that three of the funds in the test group have added loads at some point in the test period, and are now available as "C" shares with an automatic 1% redemption fee. (All 14 funds are now included in the SMI Portfolio Tracker tool. THE MOMENTUM FORMULAThe standard momentum formula is to rank funds according to the sum of their 3-month, 6-month, and 12-month returns. That is the formula I used in the testing and is behind the numbers that appear in the table. I also tested the outcome using the same approach we use in our Sector Rotation strategy. It differs in two ways from our normal Upgrading approach. First, the formula includes the 1-month returns as well as the other three periods. Second, there is no delay in executing the fund changes, that is, we publish the month-end data on the first business day of the new month so changes can be made more promptly. The outcome, unfortunately, was inferior — slightly lower returns with 33% more turnover. THE SELL SIGNALIn our normal Upgrading strategy, we typically sell a fund when it falls out of the quartile (top 25%) of its peer group. However, with a small universe of 10 funds, that was impractical. I settled on a "top 40%" standard to reduce turnover (which was already quite high). A fund, once purchased, would be held until its momentum ranking no longer placed it in the top four in the group, that is, if it fell to fifth place or lower. It would then be replaced with the fund ranked highest at that time. THE RESULTSHere are the month-by-month results [Excel file] from applying the momentum formula to the 10-fund universe. It assumes a one-month delay in being able to act on the data. (For example, the end-of-December data is obtained from Morningstar in mid-January, An approach to investing in gold via mutual funds that some may prefer over Upgrading is to select one or two of the better performing ones and simply hold them. Over the 18-year period, two funds appeared in the Upgrading portfolio more than any others — the USAA and Vanguard funds. What would the results have been if you had owned either of them rather than Upgrading? They're shown in the table at right. Some years Upgrading was better, some years one or the other of the funds was better. The USAA fund had better long-term returns with similar volatility, so it seems like a reasonable choice. Or, perhaps holding both the USAA and Vanguard funds would be more comfortable for some. (Taking a buy-and-hold approach such as this is certainly a lot less work!) WHERE DO YOU GO FROM HERE?Thomas Edison once said, "I have not failed. I've just found 10,000 ways that won't work." I didn't spend time finding 10,000 ways that Upgrading doesn't work particularly well with gold funds, but I found a few. To improve the results and lower the risk, it seems that a timing filter is needed that would eliminate owning the funds during unfavorable environments. Perhaps that will be the subject of future research. In general, for those wishing to add a gold component to their portfolios, I'm advocating an accumulation strategy which involves directly owning gold bullion. For those planning to add a small amount (say under $10,000), I recommend buying gold coins and taking possession. For those investing more than $10,000, there are two safe options. If you're not intimidated by the prospect of wiring money overseas, I recommend a savings account at GoldMoney.com. Their website is user friendly, and your transactions costs will be lowest with this approach. Alternately, gold coins are also an option, again being sure to take possession of your coins. I have no specific recommendations when it comes to the indirect ownership strategies such as with mutual funds other than be aware of the risks. All I can say is that owning these is not for the faint of heart. When it comes to the gold funds, it's a wild ride any way you look at it.
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, specifically the section dealing with gold-mining companies. (If you haven't read that article as yet, please do so before proceeding.)
the momentum rankings are published in SMI in late January, the change is made on January 31 in time for February. So we buy at the end of January based on the end-of-December rankings — a one month delay.)
