As gold prices strengthened this year, many investors turned to the undervalued gold miners segment to capture the strong returns.

However, gold exchange traded fund investors should keep in mind that gold mining stocks are no substitute for the hard asset.

“Year-to-date gold mining stocks have surged, with the Philadelphia Stock Exchange Gold & Silver Index up over 110% as of September 23rd, setting off a new ‘gold rush’ in the eyes of investors,” Maxwell Gold, Director of Investment Strategy for ETF Securities, said in a note. “From their perspective holding gold mining equities is the same as (if not better than) an investment in gold itself. This, however, is a misconception and overlooks many deficiencies in holding gold miners as a proxy for gold within portfolio allocations.”

When gaining exposure to gold, investors should consider gold miners as a distinct category set aside from physical gold allocations within a diversified investment portfolio to maximize gold bullion’s investment and risk management characteristics.

Since gold miners depend on industry competition and specific management factors beyond the price of physical gold, producer stock prices may be affected by additional factors outside of the precious metal. Specifically, miner valuations are dependent on profitability, operational costs, financial health and other specific risks. Moreover, miners may also engage in activities that limit shareholder participation in gold, such as gold hedging, cost cutting measures, high debt financing, mergers and acquisitions, and dividend cuts.

These company specific factors that may weigh on mining stocks are especially noticeable during broad market sell-offs when we see a clear divergence between equities and traditional hedges like gold bullion. Gold explained that gold miners underperform gold on average during periods of large stock market drawdowns.

Physical gold has shown an average return of 7% during market drawdowns of more than 10% in the S&P 500 since 1987. In contrast, the Philadelphia Stock Exchange Gold & Silver Index on average posted a total return of -7.2%, offering limited downside protection against an average -21.1% drop in US equities.

“It appears that gold miners have not acted as effective risk hedges in most periods compared to gold over three decades,” Gold. “During these market periods, gold miners have behaved more in line with equities and lacking gold’s historic downside protection qualities.”

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