As relatively small as the gold market is — and as confused as supposed “experts” are over the signals that the moves in gold prices send — the yellow metal holds a huge fascination for many investors. So with gold having fallen 35% from its 2011 high, you might be wondering if now is the time to leg into a fund like Vanguard Precious Metals and Mining Fund (VGPMX) to get exposure to the area.

Its managers, Graham French and Matthew Vaight of U.K.-based M&G Investment Management are fairly astute skeptics in the field who are executing a logical strategy. Nonetheless, the fund’s focus on this volatile corner of the markets should give investors pause.

A Sound Strategy in a Limited Market

You might be aware that gold prices saw their largest one-day drop since the early 1980s in April, plunging 9% in a single day, from $1,535 to $1,395 per ounce. One investment pundit claimed the metal was signaling a potential market decline, while another said it signaled a coming economic boom.

So, it was with more than a little interest that I read French and Vaight’s comments in their latest letter to shareholders, which was released in late March.

I get the strong sense that these are rational managers. French and Vaight search for companies with “trustworthy management [and] low-cost, high-quality assets in structurally compelling industries … with manageable geopolitical risk.” In other words, they consider much more than just the price of gold or other commodities when selecting companies. (Remember, Precious Metals and Mining is not a gold fund per se, though its broader mandate doesn’t mean it isn’t heavily focused on gold.)

The managers also demonstrate intellectual flexibility and a willingness to admit when they are wrong, writing, “We exited our position [in NovaGold Resources (NG)] after losing confidence in management’s ability to operate the business effectively.”

A sound strategy run by intellectually honest managers is usually what I am looking for when buying and recommending a mutual fund. In my eyes, French and Vaight might have a sound strategy … however, in a niche market, the performance of the sector is going to overwhelm the strategy applied.

Give Those Double-Digit Returns a Double-Take

I was surprised to see Vanguard Chairman Bill McNabb write that “the fund’s performance is a credit to M&G.” With double-digit returns over the past decade, I want to agree with McNabb — but I can’t.

To start with, the managers didn’t generate double-digit returns over the past decade in a vacuum. They actually underperformed their benchmark during the past decade by only 1%-plus a year. That suggests that the fund rode on the coattails of a hot asset class.

But Vanguard really lets investors down in the most recent annual report when they go to pains — boxing out an entire section — to make the case that “it isn’t a ‘gold’ fund.” The rationale is that the “fund has no exposure to the actual metal, and while it may hold the stocks of gold-mining companies, it has a broader mandate and invests in an array of equities related to precious metals, base metals, minerals and mining.”

Click to Enlarge This is true. The fund does not hold gold bullion and is not limited to gold-mining companies. The description suggests you are getting a diversified fund and all of the benefits that come with it. Yet there is no discussion of the risks involved in investing in a very small corner of the market.

Although Vanguard would prefer I not do this, let’s compare an investment in Precious Metals & Mining with an equal investment in physical gold.

The graph at right starts at the end of 1999, near the low for gold prices and the 2000 stock market high. For the first seven years or so, the fund far outpaced the metal before falling off a cliff. But in the six months from May 2008 through Nov. 2008, the fund lost a shocking 69%, while the metal only fell 14%. And though the fund did rebound strongly off that bottom, since it topped (but did not reach a new high) in April 2011, the fund has declined 51%. While stock markets are continuing to make new highs, Precious Metals & Mining still needs a gain of 125% to fully recover.

Is Gold Really a Good Investment?

Click to Enlarge If you haven’t noticed, I’ve never been a fan of gold or this fund, as I believe the risks far outweigh the rewards. Yes, gold has had a terrific run over the past decade, but it has not always been a great investment — or store of value. In this second chart showing the long-term price of gold, you can see that after peaking in the early 1980s, gold lost about 60% of its value over the next 20 years, and more than 80% after adjusting for inflation — something that gold has been heralded as protecting investors from.

And is gold really a safe haven?

Think about some of the major events over the past several months alone, such as massive quantitative easing across the globe, the near-collapse of Cyprus and the implications that would have had on the eurozone and elevated geopolitical tensions between the U.S., its allies and North Korea. Any one of these is a classic argument for why you would want to own gold, and yet the metal is off 20% and Precious Metals & Mining is off 24% since the beginning of the year, while the Vanguard 500 Index Fund (VFINX) is up 17.9%.

Bottom Line: Take a Pass on Gold

When it comes to growing money or protecting against inflation, I believe you and I are much better off investing alongside outstanding managers who are buying stocks of companies that produce goods and services which are part of the real economy rather than buying into an industry where half of the output is used to make jewelry (a consumer discretionary purchase if there ever was one), another 40% is simply used for investment, and just 10% is used for industrial purposes.

While French and Vaight are decent managers, the market they invest in worries me. Investors here need to be prepared for a very bumpy ride. For me, 5% would be a big position, and probably one I would never take. I don’t see it helping too much on the way up, but it sure could hurt on the way down.

Editor Dan Wiener and Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.