Investing: Gold mining funds are hot but risky

Finding gold is one of the most thrilling experiences you can have. Seeing a glint of gold in the bottom of a pan while standing in a muddy streambed is great. Finding a gold coin on the sidewalk is even better. And finding gold in your mutual fund statement – that's the best.

Well, it is when your gold fund is up for the quarter. And gold funds have been up big. Funds that invest in the yellow metal itself gained an average 5.1% in the first quarter, vs. 1.5% for the average stock mutual fund. But funds that invested in gold mining stocks rocketed to a 12.2% gain, according to Lipper, which tracks the funds.

Should you invest in gold mining funds? If you have a relatively short-term outlook and you think gold will rise, then it's a reasonable bet. But don't be fooled: Gold mining stocks haven't been a great long-term investment, and barring a long-term rise in the price of gold, they won't be in the future, either.

Until the advent of exchange-traded funds that hold the physical metal, such as SPDR Gold Shares (GLD) or iShares Gold Trust (IAU), most gold funds were actually gold mining funds – that is, they invested mainly in shares of gold miners, such as Barrick Gold (ABX), Goldcorp (GG) and Newmont Mining (NEM).

Investing in gold mining shares has some advantages over investing in the actual metal, the primary one being that stock certificates are cheaper and easier to store, at least on an institutional level. ("Farnsworth! Take 50 gold bars out of the vault and sell them!")

The other advantage of gold mining stocks is that investors can get a larger rise out of them when gold prices rise than they could by investing in the actual metal. Consider Goldcorp, which can produce gold at $950 to $1,000 an ounce. We'll use $1,000 in this example. When gold sells for $1,200 an ounce, Goldcorp makes $200 profit per ounce.

Now let's say that gold rises to $1,400 an ounce. Barring a major rise in costs, Goldcorp's profit would rise to $400 an ounce, a 100% gain. This is the kind of thing that makes Wall Street's heart go pitty-pat.

What are the disadvantages of gold mining stocks? Let's put the process in reverse. Just as a gold mining company's earnings get a shot of adrenaline when gold prices rise, they get stuffed into a sack and dumped down a mine shaft when gold prices fall. When the metal peaked at nearly $1,900 an ounce in 2011, it fell by about a third. Gold mining stocks, however, fell by 50% to 75%. "You get leverage on the way down, but also on the way up," says Arne Espe, vice president of mutual fund portfolios at USAA Investments.

Junior gold mining companies, which are smaller, got the biggest pop last quarter, primarily because their stocks got hammered last year. "They own the rights to the gold in the ground, but often don't have the money to develop it," says Espe. Attracting that money is much easier when the price of gold is rising, not falling. Market Vectors Junior Gold Miners ETF (GDXJ) fell 61% last year. It's up 16.7% so far this year.

Gold miners have other problems. It's expensive and difficult to open a gold mine. Many companies use a process called heap leaching to extract small amounts of gold from large amounts of ore. It involves using copious amounts of cyanide, which rarely goes over well with the neighbors, one reason why it's hard to open a new mine just about anywhere.

And, naturally, when gold looks to be in a long-term uptrend, gold mining companies like to open new mines, which reduces their earnings. When gold prices fall, they tend to shutter their less profitable mines – which can sometimes mean that production falls just when prices start to pick up again, proving that those who run gold mining companies are human, too.

The final disadvantage: If you want to own gold because you feel that soon the world will be enveloped in hyperinflation, the currency will collapse and you'll be sitting pretty because you own gold, a gold mining fund won't help you much. You probably won't be able to trade your shares for food or guns or land. You'll need to buy the metal itself and keep the happy thought that civilization will descend into the dark ages.

Who should buy gold? You could make a reasonable assumption that gold has taken a big hit since 2011 and is somewhat undervalued. If you're the kind of investor who is interested in making an intermediate-term, high-risk bet with a portion of your money that you can afford to lose, gold miners are mildly interesting. Espe thinks gold hit a bottom around $1,200 per ounce and thinks it will go higher, especially consider the amount of money created worldwide since gold's earlier peak in 1981.

At least for the past 20 years, gold mining stocks have been a spotty long-term investment. The average gold mining fund has gained 84% the past 20 years, vs. 517% for the Standard and Poor's 500 stock index. The story has been the same the past decade, with gold mining stocks rising 43%, vs. 104% for the S&P 500.

But success in investing depends on where you start measuring. If we start from the bottom of the gold market – in August 1999, when gold hit $255 an ounce – gold mining funds have gained 279%, vs. 86.5% for the S&P 500. If indeed gold hit a long-term low at $1,200, then the funds could be a decent bet.

But that's what it is: a bet. If you decide to make it, keep your bet small and hope that it won't pan out. When gold soars, bad things are happening elsewhere: war, catastrophe, economic hard times. No one really wants that.