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Even Gold Funds Begin to Lose Their Luster

Not only are gold funds the top-performing fund category over the past year, but with returns of 56.9%, they have far outpaced the second-best-performing category, real estate funds, which have returned 14.8% for the 12 months ended June 30, according to Lipper of New York.

But the gold rush may be over.

As in previous bear markets, gold funds have been one of the most popular investments. Their positive returns have attracted assets and have served as somewhat of a panacea for the few fund companies that offer them. Gold funds are up 19.6% year-to-date through July, whereas domestic stock funds are down 19.4%. So far this year, gold funds have taken in more than $1.6 billion in net inflows compared to $1.1 billion for all of 2001, according to Lipper.

But because their performance began faltering over the past two months, many investors have begun to dump them. Gold funds lost 12.7% of their value in June and declined another 20.8% in July, a heart-pounding decline for investors who bought high. As a result, after receiving net inflows of $400 million in May, gold funds had net outflows of $110 million in June.

Investors quickly flock to gold funds when markets become volatile because the vehicles thrive during rough times and their performance does not correlate with the equity markets, analysts said.

Instead, the value of gold is driven by inflation as well as political and economic volatility, analysts said. Gold gains value during turbulent years mostly because of psychological factors, said Whitney Dow, an analyst at Financial Research Corp. in Boston. Generally speaking, cultures have valued gold for thousands of years, so investors figure that if markets plummet or global politics spin out of control, gold will retain some value.

"It's hard currency," Dow said. "During either inflationary times or times of political unrest, some investors turn to hard assets like gold. It's a commodity that has some sort of implied universal value. It's like stuffing cash under your mattress."

Indeed, The Vanguard Group, of Valley Forge, Pa., closed its Precious Metals Fund to new investors in late June after investors rushed into the fund. The portfolio, which holds mostly gold-related stocks, had posted astounding returns of more than 50% during the first six months of this year and garnered more than $628 million in new assets during that time, a spokesman said.

But the fund's board worried that the rush of assets would render the fund too unwieldy to invest in the scant 28 stocks that its portfolio holds. Most gold funds invest in only a handful of stocks. Strategic Insight, a research firm in New York, does not expect the fund will reopen to new investors until the end of the year.

All That Glitters . . .

While gold funds can provide one of the few opportunities for investors to make money and for fund companies to attract assets during a down market, they can be troublesome for investment firms to run, analysts said. For one, fund companies have trouble making a profit from gold funds because many only accumulate assets of between $25 million and $100 million, Dow said.

That has prompted some firms to cut their losses and merge or liquidate the products. For example, Morgan Stanley merged its Precious Metals fund into its Morgan Stanley Natural Resources Fund two years ago, Dow said. Today, that fund has a scant $1 million in assets under management and has posted disappointing returns of negative 13% in 2001 and negative 12.3% year-to-date through Aug. 8, according to Morningstar of Chicago.

While assets may flow into the products quickly and at staggering volumes, they diminish with equal speed when gold loses value, analysts said.

"People who have invested in these funds for a long time have been burned," said Christopher Davis, a Morningstar analyst. "They know that when these funds start going down, they're going down in a hurry."

The reason gold funds have been losing assets is because these investments are "generally short-term money," Dow said. "There's a lot of money that's chasing past performance or prospects, and those assets don't stay around too long."

But if gold funds thrive during periods of economic and political volatility, why would they decline in value now, when the U.S. is at war and the stock market is still in turmoil? The answer, Davis said, is that gold prices are correcting after investors became overly exuberant.

"Although we've had a lot of market instability and the war on terrorism has continued, those things are nothing new," he said. "A lot of gold investors realize they bid up the price too high too fast, and a lot of the valuations of the gold mining companies became pretty stretched."

In addition, he said other investors have found some semblance of financial safety in real estate or even cash and are shying away from gold funds.