Financial advisors who believe their clients are participating in the huge run in gold stocks by simply owning a diversified Canadian equity mutual fund may have to think again.

Many active fund managers who use fundamental, bottom-up analysis to spot undervalued companies have difficulty determining the outlook for the gold price, which is capricious and largely influenced by investor emotion. Consequently, many fund managers have little gold exposure in their portfolios.

Advisors wanting to serve clients a slice of gold exposure as a hedge against inflation, political upheaval and weakening paper currencies may want to consider investing in sector mutual funds or exchange-traded funds that specialize in securities tied to the precious metal.

Gold bullion has been in a long-term uptrend since bottoming in April 2001 at US$256 an ounce. It has been trading recently in the US$1,200-an-ounce range and many pundits believe it is on its way to loftier heights. In the quarter ended June 30, seven of the top 10 S&P/TSX stocks were gold-producing companies. The S&P/TSX global gold index rose by 21% in the second quarter of 2010, the highest quarterly increase since 2002.

According to Kathleen Wylie, senior research analyst with Rus-sell Investments Canada Ltd. in Toronto, only five of the 101 institutional managers investing in Canadian large-cap equities who provide data to Russell were overweighted in gold stocks. Without a significant holding in gold stocks, it’s a formidable challenge for portfolio managers to outperform the index, she says. At 13% of the S&P/TSX composite total returns index, the gold group is now the third-largest weighting after financials and energy stocks. (For more on investing in gold, turn to page 26.)

“Most institutional funds are severely underweighted in gold stocks,” Wylie says. “For value managers or bottom-up stock-pickers who rely on fundamental analysis and seek to buy companies at a discount to intrinsic value, it’s hard to determine what gold companies are worth. Gold stocks shoot up when there are fears about inflation or political instability. The bullion price is subject to emotion and speculation, and difficult to predict.”

Likewise, on the retail side, investment funds specializing in gold are racing ahead of broadly diversified equity funds that may be underexposed to gold. According to Morningstar Canada, the average precious metals equity fund showed a 38.6% increase in return for the year ended July 31, far ahead of the 9.1% return shown for the average Canadian equity fund. During the past three years, which include the gut-wrenching 2008 market sell-off, precious metals funds showed an average annul return of 2.4%, beating the annual 5.1% loss suffered by Canadian equity funds.

If the gold price continues to rise, many active fund managers will be in even more of a quandary, Wylie says, as their fundamental investment yardsticks prevent them from participating in what could be an irrational trend. IE