There has been much ink spilled over whether there is a need to hold gold in one's portfolio. Gold can be seen as the ultimate hedge. The precious metal becomes a good investment when the government's deficit spending results in rampant inflation, and general pessimism shakes strength out of the dollar. Stock market bulls can use gold as inflation protection. Bears can turn to the precious metal to protect their capital against market downswings. When the overall picture looks dicey, gold shines, as evidenced by its meteoric rise this past year. With general uncertainty heading toward the future, gold as a portfolio hedge may make sense for investors. The real question is how to add that 5% weighting?
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Miners, Bullion and ETFs

Just as there are many thoughts on whether investors should even choose gold, there are just as many ways to go about adding it to a portfolio. Certainly, buying and storing physical gold bars or coins is an option. Although historically, this has been very expensive with investors typically paying more than the spot price when they buy and receiving less than spot when they sell. The more modern way is to buy gold bullion-backed exchange traded funds (ETFs) such as the SPDR Gold Shares (NYSE: GLD) or the ETFS Physical Swiss Gold Shares (NYSE: SGOL). These funds represent one-tenth of an ounce of gold, which is stored in various vaults. The third option for investors is to choose gold miners. By investing in an ETF like the Market Vectors Gold Miners (NYSE: GDX) or individual miners like Freeport-McMoRan (NYSE: FCX), portfolios gain leverage. Gold-mining stocks are typically more volatile than the physical metal. This increased volatility can mean higher profits in up markets.

Finding That Secret Way

A fourth way to participate in the gold market is pretty unknown to investors. Royalty override firms can provide the "back door" into the gold realm. These firms function in one of two ways: either by owning land and allowing other miners to drill for a share of whatever the miner finds, or by providing capital to struggling miners for rights to gold. As a result, royalty override firms provide portfolios with lower risks than miners - virtually zero environmental exposure and none of the headaches associated with operating and labor costs. The firms just sit back and collect the royalty interests on their properties.

Two Picks

In 2009, Royal Gold (Nasdaq: RGLD) received royalty revenue from 23 producing properties. In addition, the company owns royalty interests on 10 development-stage properties and over 80 exploration-stage holdings. Recent royalty deals include agreements with Gold Corp's (NYSE: GG) Penasquio mine and producer Barrick (NYSE: ABX). While there is a chance that these exploration holdings could turn up bust, the odds are still in Royal's favor. The real ace up Royal's sleeve is in its acquisition of International Royalty (NYSE: ROY). Royal Gold gains other commodity exposure through ROY's royalties in coal via Arch Coal's (NYSE: ACI) Skyline mine. The company produced nearly $29 million in free cash flow in the recent quarter and has no long-term debt. The company pays a 1% dividend.

Following a similar strategy with regard to "poor man's gold", i.e. silver, Silver Wheaton (NYSE: SLW) is poised to grow as much as Royal Gold. The company currently has stakes in three of the planet's five largest silver deposits. With royalties on 875 million ounces in proven reserves and another 366 million in exploratory reserves, Silver Wheaton is expected to report earnings of 73 cents per share in 2010 and 90 cents per share in 2011. This is up from 38 cents a share in 2009. The company also enjoys zero income tax on its trading activities as it is domiciled in the Cayman Islands. The company currently does not pay a dividend; however, management has hinted that it will begin one later this year. (For a look at companies with high dividends, check out America's Top Dividend-Paying Stocks.)

Bottom Line

Even at its current prices, gold remains a valuable hedge against uncertainty. There are many ways to play the precious metal, including several popular ETFs. However, investors may want to look at the royalty override firms of Royal Gold and Silver Wheaton for play on the metal. Investors gain access to cash flows sponsored by the mining activity without many of the risks and costs associated with the actual mining.

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