Some investors have had a golden touch this year. The fact that they touched gold, in fact, made them stand-out investors. Gold attained new nominal (meaning, unadjusted for inflation) highs this fall, making bullion one of the best investment assets of the year. By mid-September, gold had notched a better-than-16 percent return. Compare that to the 1.4 percent loss in large-cap stocks reflected by the S&P 500 and the 4.2 percent capital appreciation in the Barclays Capital Aggregate Bond Index. Gold, therefore, has proved to be a real portfolio hero.

Bullion’s not without its detractors, though. As gold rises, so, too, does the volume of the on-going debate between mining stock aficionados and bullion fans. Investors and advisors are often left to wonder what makes the better investment.

Mining stock advocates point to the leverage obtainable through equities. Mining stocks magnify gold’s moves because of the enormous influence the metal’s market price has on a company’s earnings. Once bullion prices advance beyond production costs, price changes go straight to a producer's bottom line.

At the same time, those enamored of bullion point to the purity of a metals investment. There’s no equity market influence or management risk conveyed through direct investment in metal.

The answer to the “better investment” question really depends upon how you define “better.” Looking at bullion and mining stocks as stand-alone investments is one thing. The utility of metal or mining stocks as portfolio components is another.

Next, you have to consider what kind of mining shares you’re considering. There are established producers and there are pre-production companies—outfits that engage in the exploration and development of mining stakes. There should be no surprise in discovering that the “juniors” are riskier than established producers.

To take the measure of mining shares’ risks and rewards, we need to isolate their unvarnished performance from the effects of portfolio management. We need to look at the passive performance of the miners obtainable through index-based investments.

One such investment is the Market Vectors Gold Miners ETF (NYSE Arca: GDX), a portfolio of 30 global mining companies which tracks the NYSE Arca Gold Miners Index. The names populating the index are some of the world’s biggest and best-known gold producers such as Barrick Gold Corp. (NYSE: ABX) and Newmont Mining Corp. (NYSE: NEM). Nearly 90 percent of GDX constituents carry a market capitalization of $5 billion or more.

A younger sibling of the GDX fund is the Market Vectors Junior Gold Miners ETF (NYSE Arca: GDXJ); it is comprised of 60 issues—largely exploration companies with an average $850 million in market capitalization. Taking a stake in the GDX portfolio is akin to buying blue-chip stocks, while the GDXJ portfolio exhibits the risk and reward characteristics of a venture capital investment.

To effectively compare these highly liquid, stock-based products against bullion, we need to find an equally transparent and liquid proxy for gold. That would have to be the SPDR Gold Shares Trust (NYSE Arca: GLD), the world’s largest bullion-backed portfolio. The correlation of GLD’s price to that of bullion is better than 99 percent. (GLD’s year-to-date correlations to the miners’ ETF and other assets are exhibited in Table 1.)

Top line performance—that is, year-to-date returns—have clearly been the junior miners’ strong suit this year. Prices for smaller-cap mining issues rose at nearly twice the pace of bullion in 2010. GDX’s return, at 19.8 percent, was closer to the metal’s, but its risk (the standard deviation of its daily returns) was just a shade under that of the juniors.

Overall, exploration and development companies have been twice as risky as bullion in 2010. The annualized volatility of the juniors was 38.1 percent versus GLD’s 16.6 percent but, because of the close correlation of the miners to bullion, there isn’t any diversification benefit derived from the extra risk. In short, miners don’t provide any “zag” beyond gold’s “zig.”

This becomes readily evident when gold investments are overlaid on a portfolio made up of equal parts large-cap stocks represented by the SPDR Trust (NYSE Arca: SPY) and broad-based fixed-income securities tracked by the iShares Barclays Capital Aggregate Bond Index Fund (NYSE: AGG). Table 2 shows the performance of constantly rebalanced portfolios using each of the three exchange-traded gold products.

The outcomes shown in Table 2 may seem counterintuitive at first glance. Despite the greater stand-alone returns obtained by mining share funds this year, the bullion-backed GLD trust provided the best diversification benefit when used as a portfolio component. The benefit derives from GLD’s more negative correlation to stocks -- which lost ground this year -- and the trust’s nearly flat correlation to bonds -- which appreciated in 2010.

Of course, it’s not likely that an advisor would recommend such a large exposure to gold. Neither is it likely that portfolios would be constantly rebalanced. A more common allocation to gold would be 5 to10 percent. Monthly rebalancing, too, is more than adequate for most portfolios.

When the gold exposure is reduced to 10 percent and the portfolio rebalancing frequency dialed down to monthly, composite returns become nearly identical, no matter what gold investment is selected. The essential difference between the gold products lies in their volatilities. The relatively low volatility of bullion prices this year produced a better risk-adjusted return, as shown in Table 3’s Sharpe ratios.

The takeaway from all this is that mining shares, as a class, is clearly more volatile than bullion. Sometimes, their higher risk yields compensatory rewards and sometimes not. Despite the stellar returns of junior miners in 2010, gold stocks haven’t paid off as well as bullion for portfolio builders.