Exchange-traded funds continued to attract assets in 2012 while money has been exiting  equity mutual funds. Still a majority of assets continue to be invested in actively managed products: As of the end of 2011, of the nearly $13 trillion invested in funds, index and exchange-traded funds comprise only about 8 percent, according to the Investment Company Institute.

As active investment managers who have experienced bull and bear markets, the financial industry’s deregulation and re-regulation, and the shifting needs of baby boomers, we are pleased that actively managed mutual funds continue to be the choice for a significant portion of portfolios.

The ETF industry has matured from its adolescent days, yet it continues to morph in puzzling ways that produce mediocre results. In my blog, I’ve discussed some eye-openers to help investors understand the risks of ETFs before putting their money in a product that might end up with unexpected outcomes.

Take the relatively new iShares MSCI Global Metals & Miners ETF (PICK), which began trading at the beginning of February 2012. The ETF is based on the MSCI ACWI Select Metals & Mining Producers Ex Gold & Silver Investable Market Index, which is a non-diversified basket of companies located in developed and emerging markets that are involved in producing or extracting metals or minerals. Its 10 largest holdings make up 50 percent of the index, which makes it a more concentrated, potentially more volatile, portfolio.

By comparison, as of November 30, 2012, the top 20 holdings in the Global Resources Fund (PSPFX) make up 43 percent of the overall portfolio.

In theory, one chooses a natural resources investment to gain access to the companies that stand to benefit from the world’s growing needs of natural resources. In addition, commodities offer portfolio diversification, as they have historically had a lower correlation to the overall market.

However, in a faceoff, PSPFX would steal the puck from PICK, as the Global Resources Fund has outperformed the ETF by nearly 13 percentage points since PICK’s inception in January 2012.

PSPFX also added significantly more return with less risk compared to the ETF over the same timeframe. The Global Resources Fund experienced an annualized standard deviation of 15.95 percent compared to the PICK ETF, which had an annualized standard deviation of 24.34 percent, according to Morningstar Direct.

You can also compare two gold equity investment vehicles. Although gold miners have had a challenging year, the Gold and Precious Metals Fund outperformed the Market Vectors Gold Miners ETF (GDX) by 400 basis points.

As I often remind investors during presentations, there is no free lunch on the commodities table—every investment comes at a cost or a risk. When it comes to emerging markets and commodities, there are inefficiencies that we believe give active managers an edge. In emerging markets, the capital markets are not as sophisticated as in developed markets and the information can be less uniform and straightforward. Managers who have an explicit and tacit knowledge of the country and its way of doing businesses are likely able to flush out the best opportunities. We believe it is worth paying a bit more in management fees to get the expertise needed for these specialized markets.

The Eastern European area is a good example of a nuanced market. While the presidential reelection of Vladimir Putin in Russia caused markets to stress over how he would lead the country, Turkish stocks have experienced substantial growth. U.S. Global Investors’ Eastern European Fund (EUROX) benefitted from its ability to invest in the entire area: Russian stocks make up only about 37 percent of the fund while Turkey comprises 17 percent of the fund. See the fund’s regional breakdown here.

We believe this is why we have significantly outperformed the Market Vectors Russia ETF year-to-date as of December 13, 2012:

Indexers often argue that active managers have periods of underperformance. Fellow Canadian Wayne Gretzky has been called the greatest hockey player ever, holding or sharing more than 60 records that he collected during his 20 seasons of playing in the National Hockey League. He holds the NHL record for the most hat tricks—achieving three goals in a single game more than 50 times—and when he retired, Gretzky was inducted into the Hockey Hall of Fame.

However, under asset management’s rigid standards for active managers, the “Great One” might be considered a loser, as his team won the Stanley Cup “only” four times.

From time to time, active managers underperform; yet, they have the opportunity to add alpha. ETFs, on the other hand, are built to only match the benchmark and are never expected to beat it.

While ETFs offer instant execution, liquidity and lower fees, certain passive investments may not get you where you want to go over the long-term. The “hat trick” equivalent that Global Resources, Gold and Precious Metals, and Eastern European Funds has been able to achieve this year against their respective ETF peers is more diversification, better historical performance and less volatility.

Outlook on Natural Resources
Learn what our investment team believes will drive gold and natural resources in the new year by joining our Outlook 2013 webcast. Sign up today and email us with your questions, so we make sure we cover what’s on your mind.

Click here for more information about the performance, investment objectives, and expenses of the funds and ETFs discussed in this commentary.

Gazing into their crystal balls last week, Wall Street firms interpreted differing futures for gold next year. Morgan Stanley awarded gold the “best commodity for 2013” while Goldman Sachs called the end of the metal’s hot streak. After seeing 11 consecutive years of positive performance from gold, one needs to be wary of research analysts’ price forecasts, as they have consistently underestimated the shifting dynamics driving the precious metal higher.

Take a look at analysts’ annual predictions of gold prices, which is “a telling picture,” CEO Nick Holland of Gold Fields told the crowd at a mining conference last summer. From 2006 through 2011, Bloomberg’s contributing analysts have forecasted that future gold prices would be lower. “The analysts who keep telling us the gold price is going down have been wrong seven years out of seven. That’s a remarkable track record!” says Holland.

It is worth keeping gold’s DNA of volatility in mind as the day-to-day price of gold naturally fluctuates, of course. Based on 10 years of data as of September 30, 2012, over any 20 days, there is a 7 percent chance of a 10 percent change in the gold price. Swings have historically been more frequent for gold equities, moving 10 percent up or down about 30 percent of the time over the same time frame.

The upside to gold stocks is that investors historically have received a 2-to-1 leverage by owning gold equities instead of the commodity. U.S. Global’s Portfolio Manager Brian Hicks reminded The Gold Report readers of this fact during an extensive conversation that he and Portfolio Manager Ralph Aldis had with Brian Sylvester.

Read the interview now.

We believe that effective management can help miners gain more leverage over the metal for their shareholders. Picture the gold price as a pulley with gold company executives applying force on one side of a rope. The more disciplined and successful the management, the bigger the potential boost in gold equity returns.

The muscle that gold miners can use to increase their “multiplier effect” for shareholders is three-fold: grow production volume, expand margins or optimize capital, explained Holland. “You want to keep showing that you can increase the return on the mine and that you can increase the cash flow available for shareholders at a particular gold price.”

In recent years, gold mining companies have been facing the dilemma of trying to grow their production profile while also depleting their current resource base. As I explained to Mineweb in a recent podcast, no miner wants to show investors that their production profile is in decline, so there has been a huge push to grow gold production.

However, this “growth for growth’s sake” mind frame has resulted in a congested intersection of projects in the pipeline. Take a look at the chart that National Bank Financial (NBF) put together showing an “unprecedented wave” of projects that mining companies are planning over the next decade. Each dot represents either a gold and precious metals project or a base metals and iron ore project. The bigger the dot, the larger the estimated cost of the project.

The 2006 through 2010 construction history benchmarks the engineering and construction industry’s capacity to build new mines. Relative to the size and number of new projects in the pipeline, the current pool of expertise to build these projects is quite limited.

NBF’s mining analysts indicate that about 30 projects can be completed in a two-year time frame.
The critical shortage of technically skilled people has been driving up the cost of projects and resources. “Mines that used to cost $2 billion only a few years ago, now cost $5 billion,” and the beneficiaries of these projects have not been shareholders, but contractors, employees, consultants, governments and equipment suppliers, says Stifel Nicolaus’ George Topping, a well-respected analyst with years of experience in capital markets.

In his research, “Don’t Build It And They Will Come,” he analyzed the projects that four senior miners, Barrick, Goldcorp, Kinross and Newmont, have in the pipeline, looking at the capital expenditures, cash costs and internal rates of return to determine whether he thought the projects should be continued or deferred.

Of the 14 he looked at, only five projects were worth pursuing, in his view. Instead of spending the money on these projects, “senior producers would be able to pay higher dividends, say yielding 5 percent at current prices,” according to Stifel. A monthly or quarterly dividend program shows that gold miners have a pulse and are taking disciplined action in paying back some of their capital.

The Fairytale Land of Cash Costs
The other factor that has been hurting gold miners is the outdated use of a cash costs measure which doesn’t reflect the true costs of mining. In the Mineweb podcast, Ralph and I discussed these “cash cost fairytales,” with Ralph pointing out that only governments believe gold miners have seen a windfall profit from the rising price of gold. He says,

“You’ve got to thank your cash cost marketing for basically taxing 50 percent of your gains away in the form of taxes when the government has risked no capital on the project and not borne any of the risks during the construction of the project.”

Research indicates that an “all-in cost” is much more indicative of the true cost of mining, as it takes into consideration operating costs, sustaining capital, construction capital discovery costs, and overhead tax along with acceptable profit. For example, CIBC’s research calculates that a sustainable number for mining an ounce of gold would be $1,700.

Listen to the Mineweb podcast.

These factors highlight the importance of active management, as gold companies that are successful at executing what they’ve articulated to the public should be more effective at leveraging the price of gold.

In addition, as Brian explains to The Gold Report, “The precious metals market is surprisingly inefficient,” meaning that active managers such as U.S. Global can take advantage of dislocations in the market. We believe this is how the 4-star* rated Gold and Precious Metals Fund (USERX) has been able to outperform its benchmark, the FTSE Gold Mines Index, over the 1-, 5- and 10-year timeframe as of September 30, 2012.

• Listen to the podcast with Mineweb to hear Ralph and me discuss how mining management is becoming more disciplined.
• See companies we are bullish on by reading The Gold Report interview.
• See U.S. Global’s Special Gold Report on more factors driving miners.

Expense ratios as stated in the most recent prospectus. The expense ratio after waivers is a voluntary limit on total fund operating expenses (exclusive of any acquired fund fees and expenses, performance fees, taxes, brokerage commissions and interest) that U.S. Global Investors, Inc. can modify or terminate at any time. Performance data quoted above is historical. Past performance is no guarantee of future results. Results reflect the reinvestment of dividends and other earnings. Current performance may be higher or lower than the performance data quoted. The principal value and investment return of an investment will fluctuate so that your shares, when redeemed, may be worth more or less than their original cost. Performance does not include the effect of any direct fees described in the fund’s prospectus (e.g., short-term trading fees of 0.50%) which, if applicable, would lower your total returns. Performance quoted for periods of one year or less is cumulative and not annualized. Obtain performance data current to the most recent month-end at www.usfunds.com or 1-800-US-FUNDS.

*Morningstar Overall Rating™ among 70 equity precious metals funds as of 9/30/12.

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Gold, precious metals, and precious minerals funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The prices of gold, precious metals, and precious minerals are subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 5% to 10% of your portfolio in these sectors.

Morningstar Ratings are based on risk-adjusted return. The Overall Morningstar Rating for a fund is derived from a weighted-average of the performance figures associated with its three-, five- and ten-year (if applicable) Morningstar Rating metrics. Past performance does not guarantee future results. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund’s monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.)

Holdings in the Gold and Precious Metals Fund as a percentage of net assets as of 9/30/12: Barrick Gold 4.33%; Goldcorp 2.68%; Kinross Gold 2.48%; Newmont Mining 5.92%

The Eagle Ford shale formation lies south of our headquarters in San Antonio, Texas, giving the U.S. Global investment team a firsthand, tacit perspective on the oil and gas industry’s growing natural resources phenomenon. We’ve witnessed how the oil activity is boosting the local economy with solid-paying jobs, a healthy housing market and strong consumer sentiment, as oil giants such as Schlumberger and Halliburton take a bigger stake in the area.

After seven long decades of importing oil, the U.S. seems only a few years away from reversing the flow, largely from shale technology not only in Texas but several areas around the country. In 2005, the U.S. reported net imports of 13.5 million barrels per day, or almost two-thirds of its oil needs, according to Raymond James. By the end of 2012, net imports are projected to fall to 8.6 million barrels per day, which is about half of the country’s current consumption.

By 2020, the estimated gap between supply and demand narrows considerably.

Production has been growing at such a steady pace in recent years that Credit Suisse says the U.S. should see the largest growth of crude oil than any other oil producing country by 2015. An anticipated growth capacity of nearly 4 million barrels per day in the U.S. is three times more than Iraq, and almost four times more than Brazil, Canada and Russia.

2012 might be the year that the world fully realizes the significant contribution North America has made to the overall global oil supply, especially after the International Energy Agency (IEA) claimed that the U.S. would surpass Saudi Arabia as the largest oil producer around 2020.

The U.S. output expected by 2020 amounts to more than 10 percent of what the IEA says will be the world’s daily oil requirement of 96 million barrels per day by 2020. This compares to a consumption of 87.4 million barrels per day today. And, when you factor in the expected decline of about 10.5 million barrels per day from the mature fields around the world, North America’s success in this area is significant to global supply.

In addition, new discoveries of oil have led to disappointing results. There was high hope that a small group of countries—Brazil, Russia, Iraq and Kazakhstan, or the BRIKs—would “redraw the world’s oil map by boosting their production over the next two decades,” says the Financial Times. However, the newspaper reported that Kashagan field in Kazakhstan, “the biggest oil discovery in nearly four decades,” will finally begin pumping next year after several delays. Its anticipated flow is about 150,000 barrels per day, then rising to 350,000 barrels a day, but those figures are way below the maximum pumping target of 1.5 million barrels a day.

Yet century-old legislation may be the biggest obstacle to the U.S. becoming a card carrying member of OPEC. Around the time when Henry Ford was selling his Model T to millions of Americans, the government passed the Minerals Leasing Act of 1920, dictating that all U.S. crude exports must get approval from the government before proceeding. At the time, the country had net imports of about 300,000 barrels of oil a day.

Since the 1940s, the U.S. hasn’t had to worry about what to do with excess barrels of oil. With the rising use of oil, the country increasingly consumed more of the commodity than it produced. However, over the years, certain types of exports have been allowed, including exports to Canada (not including the crude from the Trans-Alaska Pipeline System, which has other restrictions), exports from Alaska’s Cook Inlet, re-exports of foreign origin crude, and exports made under international agreements, says Raymond James.

But other exports are only permitted on a case-by-case basis as they are more dependent on what the government believes is in the nation’s best interest. Beyond what’s written in the rule books, “there are political overtones to anything that entails presidential discretion,” says Raymond James. The firm compares potential oil exports in the future to the experience of natural gas exports today, noting that “utility and manufacturing trade groups are actively lobbying against U.S. liquefied natural gas export permits because, of course, any such exports would incrementally raise domestic gas prices.”

In the spirit of economic nationalism, Raymond James believes that “as applications for crude export permits become more common, we would anticipate opposition to emerge, which means that the newly reelected Obama administration will probably suffer political backlash if it signs off on increasing exports of U.S. crude.”

The backlash that would result is likely because there is a common misperception between exporting crude and the price of a gallon of gasoline at the pumps, which is based on the Brent price of oil. “The irony here is that U.S. consumers pay a global price for gasoline, and exporting U.S. ‘land-locked’ light sweet crude would actually help push down the global price of gasoline,” according to Raymond James.

“Keeping the ‘land-locked’ crude in the U.S. does nothing to help domestic consumers, but as we all know, politics and reality can be very different things,” says the research firm.

If Washington prevents oil from leaving the country, the likely outcome is that barrels will begin stacking up in the Gulf Coast area. With the significant growth from areas such as the Bakken, Eagle Ford and the Niobrara Formation in Nebraska, Bank of America Merrill Lynch estimates that by 2017, refiners will likely be “saturated with light oil.”

How do investors benefit in the near term? Look to U.S. oil refiners, especially those with mid-continent exposure such as HollyFrontier (HFC) and Phillips 66 (PSX), which stand to benefit from these rising trends in production. Refiners have two distinct advantages that help them bring in more profits. One is the fact that the price of WTI oil has been trading at a discount to Brent. In 2012, the spread between WTI and Brent averaged about $17 per barrel. Domestic refiners have access to less expensive crude and benefit from the price differentiation as its refined product is priced closer to Brent. The other big advantage for U.S. refiners is record low prices for natural gas, a commodity used in large quantities by refineries.

The Global Resources Fund (PSPFX) gives investors front seat access to this growth. In its diversified portfolio, there are multiple ways to benefit from the rising supply of oil in the U.S. See the funds’ latest list of top 10 companies here.

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. Because the Global Resources Fund concentrates its investments in a specific industry, the fund may be subject to greater risks and fluctuations than a portfolio representing a broader range of industries.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Holdings in the Global Resources Fund as a percentage of net assets as of 9/30/12: HollyFrontier 1.86%; Phillips 66 0.00%; Schlumberger 0.00%; Halliburton 0.00%