Certainly there have been a lot of jittery investors dumping their American greenbacks and flooding into the ultimate currency lately. That influx has prompted gold to roar back to life after its 2008 slide, and it recently topped US$1,200 an ounce. Now, as Europe plunges deeper into debt, some respected analysts are saying it could reach US$3,000.

So should you buy in and ride the wave? It’s hard to say. There are many good reasons why gold could continue its ascent for a while longer. On the other hand, gold is volatile right now and when it does fall, it tends to fall fast. To help you decide, I’ll take you through the cases for and against sprinkling a bit of bullion in your portfolio. Then I’ll take a look at some interesting mutual funds in the precious metals sector (see table on page 2).

The case for gold largely revolves around three current trends in the global economy. The first is the “flight to safety” that tends to occur during uncertain times. Right now, the world is looking for an alternative reserve currency to the faltering American dollar, and thanks to the European debt crisis, it doesn’t look like it will be the Euro. The resulting migration from U.S. dollars to gold has helped push up the price.

The second trend is the slow build of economic forces pushing us towards inflation. The current budget deficits reported by many struggling European countries (not to mention that reported by the U.S.), don’t look sustainable. Yet the drastic cuts required to balance budgets will be extremely unpopular. So what’s the alternative? Some say inflation. By tolerating some moderate inflation (say 4% to 5%), and eroding the value of money by as much every year, Western governments could reduce their debt burdens. This may take another year or two to start happening, but it’s a real possibility. If it does, gold could soar, as it is widely seen as a hedge against the risk of surging inflation.

Thirdly, it’s worth noting that central banks, which were dumping gold in the late 1990s and the early 2000s, are now buying again, mainly in a bid to diversify their foreign reserve holdings. The serious troubles in Europe make me feel that this could continue for some time. If it does, gold still has room to appreciate further.

Before you start burying gold bars in the backyard, though, it’s worth taking a moment to consider the risks. For starters, remember that buying into any investment that’s trading at such a high valuation is dangerous. Dot-com stocks looked just as fantastic in 1999 before the bust, and U.S. real estate was a sure bet in 2006.

Gold is a risky investment because when it loses investors’ interest, there is nothing to support it. Industrial demand for the metal is limited, so its fundamentals are purely based on investors’ appetite. People who invested in gold in the 1980s lost two-thirds of their capital. Those who stayed invested had to wait 30 years to break even. That’s why I don’t recommend that you hold precious metals funds in the core of your portfolio. Instead restrict them to a speculative portion of no more than 10%.

If you do decide to increase your exposure to gold, the first question you will face is whether you should buy pure gold (be it in the form of coins, bars or exchange-traded funds with real gold holdings), or a precious metals equity mutual fund.

When you compare pure gold to a gold equity index fund, you find that there’s not much difference. If at the end of 2001 you invested $10,000 in pure gold, your investment would be worth $27,390 today. That compares to $25,900 if you had invested the same amount in a precious metals equity index fund. Pure gold would have outperformed the index fund by more, but gold prices are denominated in U.S. dollars. Because the U.S. dollar has been falling against the loonie, when you adjust your returns for currency, the returns are pretty similar.

But I think an actively managed precious metals equity fund can do better than either pure gold or the index. As “The gold standard” table underneath shows, several funds in the category have outperformed the S&P/ TSX Global Gold index by a significant margin, and with average returns of 20% per year on a 10-year basis. Such spectacular returns are usually achieved through exposure to junior gold miners. Investing in juniors by yourself is risky, but by investing with a smart fund manager who keeps a diversified portfolio, you can reap handsome short-term benefits while minimizing the risk.

Dynamic Precious Metals is a good example of an actively managed precious metals fund that has achieved above-average results on consistent basis. I attribute this performance to a solid stock selection with an emphasis on small cap issues. This fund was particularly adept at maintaining a liquid portfolio during the 2008-09 plunge in gold prices, which enabled it to contain its losses well below the average category loss.

RBC Global Precious Metals is another good choice. This fund has delivered excellent returns on a 10-year basis, and again, the portfolio manager was good at containing losses during the 2008 fall, this time by maintaining a high cash balance and holding some gold futures.

Still, I must emphasize that if you choose any of the listed funds, be prepared for a drop if the market turns. Losses posted during the 2008 slide ranged from 25% to 55%, and as a rule, precious metals equity funds are twice as volatile as regular equity funds. In short, if you’re an active and bold investor who wants to buy into the gold rush, you need to remain alert to market trends and be ready to exit when you reach your target price. On the other hand, if you’re a buy-and-hold investor looking to add a new asset class, gold may not be an ideal choice.

The gold standard
Precious metals funds have returned 20% a year over the past 10 years

Suzane Abboud, CIM, is president of FundScope Ltd., a mutual fund research company located in Toronto.

Let’s start with the issue of safety. Dividend funds aren’t as safe as most people assume because they’re tightly tied to the ups and downs of the financial sector. Dividend funds bet a big chunk of their money on this single sector of the economy because most of the Canadian companies that pay healthy dividends happen to be either banks or insurance companies. As a result, most Canadian dividend funds have half or more of their assets riding on the stocks of a relative handful of financial-industry firms. If the financial sector hits a bump, dividend funds feel the pain, immediately and intensely.

Quite a few dividend funds combine this financial sector obsession with a willingness to venture far outside the small universe of dividend-paying stocks to complete their portfolios. In other words, they stash stocks with low or no dividends into what is supposed to be a dividend fund. To understand why, join me on a brief trip into the mind of a typical dividend fund manager.

“My fund is supposed to pay dividends, but my options are limited,” he or she thinks. “If I want to stick to steady dividend payers, my predominant choices are banks, insurance and utility companies, most of which pay dividends in the 2% to 3% range. But my fund charges annual expenses of more than 2%, so if I buy stocks in those companies, I’ll have hardly anything left to distribute to investors.

“If I can’t deliver the promised dividends, how can I keep my clients happy? I guess my best bet is to invest for capital gains instead. If I can make some capital gains, I can distribute those gains at yearend to compensate for the low dividend income. Right now, for instance, since commodity prices are soaring, I might as well ride the trend and allocate some 20% or 25% of my fund to energy and mining stocks. True, these stocks don’t pay much in the way of dividends, and they’re rather risky, but they hold the potential for some nice capital gains.”

You can probably see where all of this is going. The typical Canadian dividend fund winds up holding a bunch of dividend- paying financial stocks and a lot of other stocks that don’t pay dividends or pay very small ones. Once you pay the hefty 2%-plus management expense ratios (MERs) imposed by most dividend funds, not a lot of actual dividend income is left over to go into your pocket. Most investors in these funds end up with less than 1% a year in income that can be attributed to dividends. Investors in some funds get even less, because the high management expenses eat up all the scanty dividends.

It surprises people to learn that dividend funds aren’t actually great dispensers of dividend income, but it’s true. Most of these funds are really equity funds in disguise. The typical Canadian dividend fund and the typical Canadian equity fund display roughly similar volatility. Each generates much the same amount in terms of dividend income. “If it walks like a duck and quacks like a duck, you can be reasonably sure it’s a duck,” goes the old saying. So if you’re investing in a dividend fund because you think it’s somehow safer than an equity fund, you might want to think again. You probably own what is really an equity fund despite its dividend label.

At the very least, you should examine how you’re getting paid. Fund companies know that most investors don’t look too closely at how their income is generated. Thus, to offset the low dividends they receive, many dividend funds distribute a regular payout to their investors. But if this payout is larger than the fund’s net dividend income—and it usually is—a good chunk of the money that winds up in your wallet is really not dividend income.

In good years, the extra money may come from capital gains, but in years where there are no capital gains to distribute, your fund company may simply return part of your initial investment to you, to make you feel that you are getting regular income. If you hold a dividend fund, ask your adviser whether its distributions include return of capital. If so, your dividend fund is really just taking your money and paying it back to you — after extracting its fees, of course.

Does that mean that dividend funds are bad investments? Not at all. Some manage decent returns by picking stocks well. But so do some equity funds. My point is that adding a dividend fund to your portfolio doesn’t do as much as you think to diversify your investments or ensure you a steady stream of income.

There are better strategies. In fact, if you buy the right products, a well-diversified, dividend-paying portfolio can still be an excellent investment.

I like dividend-paying stocks for three reasons. First, they have a record of strong performance. The Dogs of the Dow strategy consists of investing in the Dow Jones Industrial Average stocks that have the highest dividend yields. This strategy has rewarded U.S. investors with superior returns over the long term.

A second reason to like dividend-paying stocks is their ability to cushion you from harm if the market tumbles. Sure, if the market falls 10%, it still hurts. But if you’re receiving a 3% dividend, you can console yourself with the thought that three years of those dividends will largely make up for your loss.

My final reason for liking dividend-paying companies is that they tend to be disciplined firms. Dividend-paying firms know that making a bad acquisition or fumbling a new product will jeopardize their dividend and antagonize investors for years. So these firms are less likely to take silly risks.

To buy a good selection of dividend-paying companies, you can choose from far better products than the expensive, low-paying and highly concentrated offerings of most Canadian fund companies. In my column in the October issue (Shooting for the stars) I suggested several cheap exchange-traded funds (ETFs). These are essentially mutual funds that trade like stocks. Chief among their virtues are low, low management expense ratios — most charge you only 0.4% and 0.6% a year, or less than a quarter of what an equivalent mutual fund would charge.

Any of the dividend ETFs that I mentioned in my October column would be a decent buy for income-seeking investors. Most deliver dividend income that exceeds 3% a year. In particular, Claymore Canadian Dividend & Income Achievers (TSX:CDZ), iShares Canadian Dividend Index (TSX:XDV) and iShares Dow Jones Select Dividend Index (NYSE: DVY) deserve a close look.

Another interesting choice is iShares Dow Jones EPAC Select Dividend Index (NYSE: IDV). This ETF tracks the top yielding 100 companies in Europe, Asia, Australia and Canada, which means you get the benefits of global diversification and are shielded from further deterioration in the U.S. dollar. The fund has a superb dividend yield of around 5% and charges a management expense ratio of only 0.5%. Those advantages more than compensate for its 40% concentration on financial stocks.

The only disadvantage is that the fund has been around for only a year. But I like its strategy for selecting its holdings. Among other things, it requires companies to have at least three years of uninterrupted dividend payments. I am reasonably confident that, over the long term, this strategy will provide superior results.

One good reason to pay attention to these upstart economies is their sheer size. The four biggest of the emerging nations are Brazil, Russia, India and China, which are often referred to collectively as the BRIC countries. Just like a true brick, the BRIC countries pack a wallop. China and India are the world’s two most populous nations; Russia and Brazil also rank in the top 10, with populations many times that of Canada.

The BRIC countries are just the beginning of what’s available outside the developed world. The emerging markets category ranges from Poland to South Korea to Mexico to South Africa. Taken together, emerging markets now represent about a quarter of the global economy. Since 2001, their economic growth rate has been triple the growth rate of developed economies. Stock markets in these emerging market economies have churned out 21%-a-year gains over the past three years.

Strangely, though, Canadians don’t seem much impressed by this sizzling growth. Emerging market equities represent less than 1% of the money held in Canadian mutual funds. I fear that Canadians are simply not recognizing the new realities of the marketplace.

The most common objection I hear to investing in emerging markets is that these markets are too volatile. To some degree, I can sympathize with the complaint. Last summer, emerging market equities lost 25% of their value in less than two months. They subsequently regained all their losses, but their temporary plunge was scary.

The unfortunate reality is that you can expect more of the same. Emerging markets involve risk. Brazil and Mexico suffer from social imbalances and inefficient tax systems. Russia is moving back towards autocracy. India has to deal with inflation and a growing current account deficit. China is still a communist country where the rule of law is unpredictable.

But the problems don’t outweigh the potential. The key to investing in emerging markets is protecting yourself so you enjoy a high chance of profit and a low chance of losing your shirt. Here are four tips to help you on your way:

Think about the big picture

It’s reasonable to dedicate 15% to 20% of your portfolio to emerging markets. Don’t invest more unless you are a gambler.

No matter how much or how little you invest, make sure you diversify your holdings to ensure that a downturn in one region or country can’t sink your portfolio. In particular, you should avoid mutual funds that specialize in a single emerging market country or a small region. The risk is simply too high. A well-diversified emerging markets portfolio would have the bulk of its assets in the Asia-Pacific region (outside of Japan) with smaller portions invested in Latin America, Eastern Europe and Russia, and South Africa.

To hedge your bets, look at what else is in your portfolio. Emerging market funds usually move in ways that are out of step with Japanese equities, Canadian financial services or even Canadian balanced funds. If you mix your emerging markets investments with one or two funds from those other categories, you reduce your overall risk, since any downturn in one area is likely to be counterbalanced by gains in the other.

Go global

Choosing your own emerging market mutual fund can be tricky, since the funds available in Canada tend to be expensive and often go on hot or cold streaks that have little to do with management skill. As an alternative, consider investing in a global equity fund that has an emerging market component. The Trimark Global Endeavour Fund, the Chou Asia Fund and the Mawer World Investment Fund are all good examples.

Cut costs

If you decide to go all the way with a pure emerging equity fund, buy an exchange-traded fund (ETF) such as the MSCI Emerging Markets Index Fund, which trades on the American Stock Exchange (AMEX: EEM). This ETF gives you instant exposure to emerging markets around the world at much lower cost than an equivalent mutual fund.

It’s not just stocks

Consider emerging market bonds. A diversified portfolio of emerging market bonds is now yielding 2.5 percentage points more than a portfolio of Canadian bonds (or two percentage points more than U.S. bonds). With Canadian 10-year bonds currently offering a paltry 4% yield, this extra return is a welcome bonus for income-hungry investors.

The additional return isn’t without risk, of course. As Argentina demonstrated two years ago, governments in emerging countries sometimes default on their bonds. Still, if you keep a diversified mix of bonds, the risk premium should more than compensate you for any losses caused by default.

Before investing, you should be aware of a couple of specific pitfalls. The first is currency risk. You may take a hit if the currency the bond is issued in loses value against the Canadian dollar. This is true of any foreign investment and the best defence is a well-diversified portfolio that is split up among many different currencies.

You should also be aware that emerging market bonds fluctuate depending on how investors perceive their relative risk. The current two percentage point spread between emerging market bonds and U.S. government bonds is low by historical standards, suggesting to some observers that emerging market bonds are overvalued. Remember, though, that these are bonds, not stocks. If you (or your portfolio manager) hold on to your investment, you can enjoy the extra yield from these bonds and get back your principal upon maturity. The key is to invest only money that you will not need in the next few years.

To find a good emerging market bond fund, you will have to go outside of Canada and look at some of the ETFs available on the U.S. stock exchanges. You can examine the selection at a website called ETFconnect.com. Look for emerging market funds under the “Fixed Income” category. The site shows you the current annual interest payments and the degree of risk the fund is taking on. Risk is measured by the average credit rating of the portfolio. The holdings of emerging market bond funds typically range from relatively low risk BB+ bonds (one notch lower than investment grade) to high-risk C issues. You should look for a mix of high yield with relatively low risk. Right now, I think the Western Asset Emerging Markets Income Fund II, Inc. (NYSE: EDF) is appealing. It offers an 8% current income distribution level and has a BB+ average portfolio rating.

So where should you go looking for investment opportunities instead? In my opinion, small capitalization stocks — typically those of young companies or small firms — are the most tempting alternatives out there.

I’m not the first person to make the case for small caps, of course. Since 2001, small caps have delivered an average annual return that is north of 15% in Canada and 13.5% in the U.S. But while the prices for these stocks have soared, I believe there is still some value left, especially if you’re thinking in terms of a multi-year investment and if you know where to look.

I base my case upon history. Small caps have almost always delivered better returns over the long term than large cap stocks or bonds — and right now large cap stocks and bonds are so expensive that their returns are likely to be dismal for the foreseeable future.

James O’Shaughnessy, the well-known U.S. investment researcher and money manager, presents the evidence for smallcap stocks in his new book Predicting the Markets of Tomorrow. Using historical data, he concludes that the average real return (i.e., what you make after inflation) from an index such as the S&P 500 that focuses on large companies is just over 7%. But here’s the catch: if the actual return from these large cap stocks exceeds 7% for a sustained period, it tends to be lower in subsequent periods, thus reverting towards the historical 7% average.

O’Shaughnessy argues that since returns from the S&P 500 far exceeded the 7% historical average during the Internet bubble, we are now in a correction phase that will drag down returns to the range of 3% to 5% over the next several years. Once you factor in the 2%-plus cost of management on a typical mutual fund, you’re left with a dismal return that won’t do much to make your retirement dreams come true.

For bonds, the picture is even worse. With bond yields currently around 4% a year, you make next to nothing in real terms after you subtract inflation of 2% to 3% a year and investment costs.

The case for small cap stocks, fortunately, is much better. Smaller companies have more room to grow than big firms. They’re more nimble as well, so they can move faster than their bigger rivals to capitalize on opportunities.

History demonstrates the payoff from those advantages. Since 1925, small caps have outperformed large caps by two to three percentage points a year with only brief periods of underperformance. After crunching all the numbers, O’Shaughnessy expects small caps to return in the range of 7.6% to 9.6% a year over the next 20 years.

If he’s right, the implications are enormous. Investors who stick to traditional large caps, bonds and cash assets will need to work much harder for retirement. Those who venture more aggressively into the small cap world can reap significant long-term benefits, provided they choose their investments wisely.

The first step in choosing wisely is assessing just how much of a bargain you’re getting. Where the buys on the next page summarizes the current situation and, at first glance, it seems to contradict much of O’Shaughnessy’s advice. As you can see, large cap stocks look like a better deal at the moment than small caps. You pay a lower price-to-earnings ratio (P/E) to buy large caps. You also enjoy lower management expenses and trading costs — yet the bigger stocks are less risky than their smaller counterparts when you measure their beta, or how much they move up or down in relation to the market.

Fortunately, you see a more attractive picture if you look only at the value component of the small cap universe. These stocks are slightly cheaper and slightly less risky than the overall small cap universe. My conclusion? If you’re going to make a bet on small cap stocks, concentrate on the relatively cheap, relatively undervalued end of the category.

I am not — repeat, not — inviting you to put all your money in small cap value stocks and ignore everything else. Diversification remains the best long-term strategy. However, a moderate bias towards the small-cap value sector can let you benefit from the long-term potential of this category, while alleviating concerns about current valuations.

In Small game hunters below, I have compiled a list of funds that specialize in the small cap area and that have a decent long-term record and a value bias. My list is not based on any rigorous quantitative approach. I have simply selected a handful of small cap funds that I like, because I am familiar with their history and style. So much the better if some of those funds have sagged for the past year or so: I know they will come back, because they always have in the past.

Where the buys are

Small cap stocks are now more expensive than large cap stocks. But bargain hunters can still find a deal if they focus on small cap value stocks.

Source: data compiled from information available in the public domain on ishares.com for the benchmark index funds of each style.
Source of estimated trading costs for each style is Harry S. Marmer’s book Perspectives on Institutional Investment Management.

Small game hunters

A few of my favorite small cap funds. All my chosen funds favor value picks.