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Precious Metals For Late Cycle Diversification

CEFA was joined by Axel Merk, President and Chief Investment Officer of Merk Investments.

The following Q&A recaps a discussion about how precious metals can provide diversification for a traditional stock/bond portfolio. As part of CEFA's CEF Insights podcast series, the podcast audio can be heard here.

Axel Merk

CEFA: Welcome to CEF Insights, your source for closed-end fund information and education brought to you by the Closed-End Fund Association. My name is Diane Merritt. Today we are joined by Axel Merk, President and Chief Investment Officer of Merk Investments. We're so glad you could be with us.

Axel: Great to be with you.

CEFA: Can you discuss the key characteristics of companies in the precious metals and minerals sector, as well as the benefits and risks they present to investors. How do these benefits and risks differ from investing directly in the actual precious metals?

Axel: Yes. Investing in the precious metals sector has unique opportunities and risks. First of all the reason people invest in this sector because they're fascinated by it, but as a serious institutional investor, a key reason to invest in it is diversification. Precious metals in general have had a near zero correlation to equities, and most notably they have performed well in every stock market, bear market since the early 1970s, with a key exception of the early 80s, where real interest rates were pushed very high. Now, precious metals are known to be reasonably volatile and the precious metals companies, mining companies take this to another level.

Now the plus side of that is that with a fairly small component, you can get quite a bit of a boost to a portfolio. Now that comes with wonderful risks and wonderful opportunities. To just name a few, when you invest in the mining company itself, the general gist of it is that the fixed cost of mining is reasonably constant. That's a bit of a simplification, but if you assume that the price of the precious metals goes higher, you have more leverage in it, because a 10 percent move in the price of the metal can have a multiplier effect on the earnings because they get all the marginal revenue is profit.

Now all that said that it is a very diverse space. You have some senior mining companies that have fairly predictable cash flows all the way down to exploration companies that are literally trying to strike gold. The risk profiles are very, very different depending on where you are. But taken together they provide on the one hand a speculative opportunity, but more precisely they provide an opportunity to add diversification to a portfolio.

CEFA: Passive investment strategies in various asset classes have gained a lot of traction in recent years. Merk Investments is an active investment manager. In the precious metals sector, what advantages do you see for an active manager with respect to managing risk and adding to performance?

Axel: Yes, so first of all, much of what we do is active. We do also do passive work. We actually have a passive physical gold ETF in the market where investors can take delivery. But ASA is an active fund and we do a lot of active work. We do a lot of fundamental work, especially when it comes to the mining companies. To just give you an idea, the system overall isn't that huge, and there has been amazing consolidation in that sector, which has led to the passive folks, most notably the indices, to be what I would call top heavy.

The benchmark for ASA is the FTSE Gold Miners Index, has the top two names have 38% of the index. The top 10 holdings have 78% of the index. In GDX the most commonly known passive index, I don't have the exact number, it's a little over 60% I believe that the top 10 holdings are. It's a very top heavy index--or both of these indices are very top heavy--and that obviously increases the risk that if anything doesn't go right in these companies, there is an issue. 

Also, I mentioned earlier that mining companies come in various flavors. These indices tend to focus on the large companies and when you do that, you're getting less of a diversification because they tend to be moving more with the general flows.  On the smaller companies, there's obviously also an index for the smaller companies but it's being passively managed. You have to be very careful on the small companies that you choose companies that have sustainable cash flows, that have access to financing and the index just can't differentiate that. 

There is significant potential for the active manager to add value and manage that process properly. To just kind of to tell you, you asked earlier about the risks. The risks in the sector are, all the equity risks and then some, right? You can have management make mistakes. Well, in the gold space the life of the mine is not infinite, and so there you have... That's a risk you have to manage. You have to, I mentioned access to cash flow, well mining is expensive. Ultimately of course the goal is that the gold you get out of the ground for example, pays for it, but you have to get there and survive to get there. There are many, many risks in that. 

Also, you have the risk of the large companies are more subject to that than the smaller ones is that, they do whatever investors want them to do. What I mean with that is that, when you have a surge in the price of gold, which we've had in the past at times, then they might be trying to just maximize getting the ounces out of the ground or making unreasonable acquisitions. There are all kinds of unique paths in these industries where I believe active management can add great value.

CEFA: Axel, your firm has recently taken on the management of traditional closed-end fund, ASA Gold and Precious Metals, symbol ASA. The fund was previously internally managed, and now Merk Investments has been hired as an external manager for the fund. What does this change mean to investors and how do you see this impacting the corporate governance of the fund?

Axel: Yes so, ASA is the oldest I believe closed-end funds that's trading on New York Stock Exchange. Founded in 1958. It's been through various iterations and for quite some years now it was, quote unquote, “Internally managed.” In the internal management model, everything, all the expenses go directly to the net asset value. That means every stamp that you buy if there is such a thing people buy anymore, all the salaries of the management and so forth. That has some advantages and disadvantages as well.

But because this segment in the market has been out of favor and performance has been negative in that space for some time, and because of the overall share count being reduced over the years, the fund has shrunk in size. That then creates a cost structure that the board considered to be unsustainable in the long run. They had a search as to what can they do. One of the things that has been decided is to move to an outside manager.  We're the new outside manager, you have an arm's length agreement on basis points what the management fee is. That puts the overall fund on a more sustainable model. That's the background. 

Now on top of that, as we have come in we've worked with the board to put in place what we call our best practices. I'm not suggesting that in the past there were bad practices, but there are things you can do in an outsourced model, where you outsource as many pieces as you can from fund accounting and administration, where you have more cross checks and whatnot, which we believe will be in the benefit of shareholders in the medium term at a cost point that is competitive. Then quite relevant to investors are two things, the investment philosophy and at the other end of the spectrum, the discount in the market. 

On the investment philosophy side, the fund had been managed very conservatively. If you look at it, it was less volatile than the overall sector the market has--the performance hasn't been all that great. We obviously don't have a crystal ball, but what we are doing is, we are making the fund a tad more assertive. We are moving down the ladder so to speak, and not investing in the royalty companies quite as much, not investing in the biggest names quite as much. Moving more towards select development companies, where we believe they have access to cash as they're growing. Companies that we believe will react more favorably if and when the price of gold moves higher. At the same time we tried to impose, and are imposing, the risk management we have inside of our firm. We do have extensive experience managing restless investment vehicles, so we can deal with the various things. 

Then the other thing I mentioned is the discount in the market. Well many closed-end funds, ASA in particular, has had a very significant discount in market. One thing that's different for us from our predecessors is that, a lot of what we do has a public face. If anybody Googles my name they'll see us in many, many places. It's just in our genes to be communicating more with the public. We try to get the word out. We recently had the webinar on ASA that's available on our website for example. We're going into things that are deeper. We're very open to talking to any shareholder and potential shareholder, who has an interest. 

In communicating we believe that we can get more attention onto ASA because we believe that this kind of the market is an opportunity. Working actively on communicating what our ideas are, executing on those ideas and then at the same time introducing best practices on the management, all these things we believe may help to reduce the discount. Obviously we can't promise that, but we're working on that. At the same time we believe that the changes we're making in the portfolio, may help ASA to be a performer that makes it worthwhile for investors, to obviously then pay the expense ratio of the fund.

CEFA: How does your investment philosophy differ from the way ASA has previously been managed?

Axel: I alluded to that a little bit with regard to the kind of more assertive management. Overall, obviously the overall mandate the objective of the fund has not changed. The objective of the fund is to invest in gold and precious metals companies, to conduct fundamental research including site visits. We have our portfolio manager Peter Maletis, has come to us from Franklin Templeton where he worked for almost 10 years on their precious metals fund. He has traveled to over 40 countries around the world, and knows the management of almost all the mining companies out there quite well; knows all the broker trends very well and is willing, and has shown to be able in the short life of the fund has had so far under our leadership, has been able to make this fund a tad more assertive.
Anybody who kind of looks at the past performance will see hopefully, that it is going to be more assertive. What I mean with that is that metrics like the beta we of course we can't say what it will do, but by moving down that ladder a little bit on the size of the firm and being more diverse in that sense, we do believe it will give investors more what we think that many investors are looking for. They are looking for a reduction of discount, or they're looking obviously to make money.

Now, anybody that buys ASA I believe is either going to buy it because they like the discount story that they think that we can help reduce the discount, or they like that the space may do well and through ASA they may get these at a discount. With our management`, you get fresh blood, you get a management team that's motivated, you have the breadth also of the rest of what we do at Merk. We do a lot of work on interest rates, inflation, all aspects that are quite related to the price of the metals. While we of course don't have a crystal ball as I mentioned already, we do believe that that additional input can help shape the direction ASA is heading in.
CEFA: The U.S. economy is continuing on its 10 year expansion, but in many areas of the world, growth is quite slow. At what stage do you see us in the economic cycle?

Axel: I'm not telling you anything you don't know. The economy is in advanced stage of an expansion. What I believe is a little different from what many people are thinking, I actually think that inflationary pressures are increasing. The Federal Reserve is highly complacent about the lack of inflation and partly because inflation has been so low for such a long time.

But if you look at how many people have been moving from the sidelines into the job market, at some point we can't pull them in anymore. It may well be that the economy is going to slow, just as those wage pressures are then jumping over and create other inflationary concerns. Also, the current inflation numbers and the Federal Reserve itself has said as much, have been depressed, mostly because of statistical measures. Those sort of headwinds to inflation are going to turn into tailwinds and we wouldn't be surprised if again we're going to be very near the end of the economic expansion and yet inflationary pressure is going to increase.

Historically at the end of the economic cycle is favorable to gold and gold mining companies. Now all that said, the price of gold hasn't moved all that much. Not long ago I was quoted in saying that we may even see another interest rate hike later this year and the market obviously has gone to completely the opposite direction of that. But to me I always am concerned what may the market be underpricing and the concern about inflation is something that the market may be under pricing, in my view.

CEFA: How does this impact the way you structure your portfolio?

Axel: It is cautiously optimistic on the price of gold. We don't expect that the price of gold is going to blow out tomorrow. By the way when we structure our portfolio, we want to make sure that companies are sustainable at the current price level. We're not going to buy companies, and then saying, “Hey we think the price of gold is going to go up 20% and then this company is going to be profitable and is going to make a killing.” That's not how we operate. 

We're looking for good management that can execute based on their operating model and to the extent that they may need more capital if you look at the smaller companies, that they have strong partners. The sort of strong partners over the years have changed. In the past, they could look to investment funds, but many investment funds don't have that sort of capital anymore because they have shrunk in size. Then they need to have other avenues.
CEFA: Well infrastructure is interesting as the global requirements for infrastructure investment is significant, but government budgets are already stretched. How do you see these needs being addressed by governments and the private sector?
Axel:  Well, you're right, Diane. The needs are significant. Governments can play a role. They can provide attractive regulatory structures that will incent new investments and they can also help by privatizing assets. And we've seen a number of infrastructure assets privatized around the world in recent years. For example, you've seen the Spanish airport network, the Mexican electricity grid, Charles de Gaulle, the French airport is being put up for privatization this year; Asian wireless tower assets, the Australian railroad network. So a lot of big marquee assets have been privatized. So there's still a lot of potential for further privatization. For example in the U.S., the U.S. is actually the only advanced developed economy that hasn't undergone widespread privatization of transportation infrastructure, roads, ports and airports.

In terms of the private sector, it's important to understand that we don't need the government to privatize assets for us to have investment opportunities. The private sector is meeting the demands and putting capital where it's needed, in fact, there's been hundreds of billions of dollars of capital invested in midstream energy and telecom infrastructure in North America.
Now that said, because we are positive on the price of gold in the medium term, that is one of the key reasons why we are working on making this fund more assertive. Obviously I can't say what we'll do specifically tomorrow, but what I'm communicating to you is things we have communicated elsewhere, including our recent webinar.
CEFA:  How are listed companies positioned to take advantage of these developments and are there fundamentals attractive?
Axel:  The fundamentals are very attractive, and they are very well positioned to make these investments. The first thing to look at would be their ability to make these investments from a balance sheet perspective, and the balance sheets generally for infrastructure companies are very strong. So they are well positioned to make these investments, and to the extent that they need to come to back to the markets to raise equity capital, there is high demand on the part of investors for these types of assets. So the capital markets will be there to the extent that companies need to come back and access them.
CEFA:  Are valuations in the precious metals space at attractive levels?
Axel:  Well they're suddenly much more attractive than they have been in the past. A value investor is always faced with the choice that something that's good value might become even better value down the road. But if we look at a number of different metrics, yes I do believe they're attractively valued, be that at anything... For example Canadian investors that historically are good at... Quite healthy investors in that space, are significantly under invested, based on research we see in our own analysis as well. 

If you look at other metrics as how companies are valued based on cash flow. If you take like a present value model, those valuations also suggest that the valuation is low. Now, part of that is that many of the senior mining companies, the large mining companies have not invested a lot of money. That means the life of the mines has become shorter. That means they may be forced or at least encouraged new acquisition. Obviously we've seen some acquisitions before.

That is, by the way, one of the reasons why we've moved down the tier a little bit because while there have been some acquisitions that are without a premium, some more recent ones, are with a significant premium, and so we may be holding some of the funds that some of the companies that might be acquired. Obviously we don't know that, but we think we're being positioned there. They might be benefiting from that. The other metrics some other current metrics you can use, based on various metrics, they are not expensive.

Obviously the price of gold has a big impact on that. Going back to your original question about this space as a whole, because there's leverage in the price of gold, well to the extent that people believe the price of gold may be moving higher and then many companies in this space should have a positive performance. Now obviously the opposite is also true. The risk is that the price of gold goes down and then it is all the more important that one chooses companies that have a sound operating model.
CEFA:  Where do you see the best opportunities among precious metals companies?
Axel:  Well I don't want to be too company specific, but I would encourage anybody to kind of get up to speed on what we do, and the sort of companies that we invest in. We're limited as to what we can communicate. Our quarterly filings and so forth is probably the best source to go to. Now I would discourage anybody to buy a precious metals company just because you see in some finding that we've bought it. Mostly because you're not going to be around when we decide to sell it. 

I think personally I have some findings to that extent. I bought shares in ASA itself and as my kind of vote of confidence that where I see the opportunity. Obviously there are other choices investors have. The uniqueness about the space is that, you can choose the risk profile that you're looking for. In a closed-end fund like ASA, you got the opportunity of maybe having a discount that closes, plus the active management, plus the type of companies we choose. In an ETF, and obviously they have their own set of risks, but you know what you're getting, but what you're getting may be because of the deficiency of the index, not ideal.

Then of course you can go out and buy individual companies. But in this space it is very, very risky to go after individual companies. Simply because the individual company risk are all that significant. That's why holding a portfolio of mining companies is something that investors might want to look at.
CEFA:  How do you believe an allocation to equities of companies in the precious metals sector is best positioned in an investor's diversified portfolio?
Axel:  Yes, so obviously we can't give specific investment advice. As I indicated in the introduction, the mining companies tend to be more volatile than a regular equity portfolio. People can keep that in mind. If you look at the traditional 60-40 portfolio, equities versus fixed income, how do you create diversification? A mining portfolio allows investors to get something that historically has performed well during many bear markets. 

By the way not all companies have done well in bear markets. In the financial crisis, some small companies didn't have access to credit, and so they are mining, those mining companies have challenges as well. But you can get with a fairly small addition quite a bit of additional diversification. Now clearly if somebody is very pessimistic about markets, this is an aggressive way if one wants to see it to get diversification. There is always cash as well available.

I cannot give a specific recommendation on whether you should have 5% in the portfolio, 10% or more. It really depends on the investor. The one advice I do give people is that, you should not have more of anything in your portfolio than you can sleep with at night. I'm not referring to the gold pot that you could put under your pillow.
CEFA:   Axel, we appreciate that you have taken time to join us today.
Axel:  My pleasure.
CEFA:  And we want to thank you for tuning into another CEF Insights podcast. For more educational content please visit our website at

Audio recorded 05/30/19.


Closed-end funds trade on exchanges at prices that may be more or less than their NAVs. There is no guarantee that an investor can sell shares at a price greater than or equal to the purchase price, or that a CEF's discount will narrow or be eliminated. CEFs often use leverage, which increases a fund's risk or volatility. The actual amount of distributions may vary with fund performance and market conditions. Past performance is no guarantee for future results.



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