Gold is on fire, but the smartest way to get in is via gold ETFs
By: Tavaga Research
Gold brings a glint to our eyes. The rare metal’s allure is universal. We have dyed it in different colors to suit our sartorial needs, molded it in biscuits and blocks to stash away, and held on to it dearly for its inherent value.
But unknown to many, we do not need to deal with physical gold to unlock its worth. Paper gold such as gold ETFs (exchange-traded funds) is a veritable means of buying into gold’s timeless appeal. Gold ETFs are not far removed from the pricing of actual gold and don’t have the drawbacks of physical gold.
The quicker we familiarise ourselves with paper gold and gold ETFs the better because there is a gold rally afoot, creating an opportunity to diversify our portfolio.
Harried investors, amid global economic uncertainty, have been moving their money from equities to the yellow metal, considered a safe haven (evident during the Lehman Brothers’ bankruptcy and multiple other instances of increased volatility in the past).
Spot gold prices in India rose by nearly 22.22 percent in rupee terms since January 1, 2020, for 10 grams of 24-carat gold (99.9 percent purity).
In dollar terms, the price of gold went up over an all-time high of over $1,800 an ounce in July, rising by 18.76 percent year-to-date (since January 1, 2020).
This would then be a good time to consider gold’s role, especially if we lacked the non-interest asset in our investment instruments. The need of the hour is stability, and gold would infuse it in our portfolios, no matter how the money market fares.
Not Physical Gold
The high prices have seen gold jewellery demand soften for now. But there is no need to regret not being able to buy more gold ornaments. The traditional ways we are most familiar with for investing in gold are becoming redundant with options such as gold ETFs coming to the fore.
It helps that gold’s value steadily increases, even if it can’t beat inflation. The average gold jewellery buyer is spellbound by its role as a symbol of wealth and social security in our multicultural society, both urban and rural.
If we look beyond the cultural symbolism of physical gold, it will dawn on us how wasteful it is as an investment. As elaborated here, gold ornaments see us paying anywhere between 5 and 25 percent extra as making charges and there is the price paid for impurities.
Gold bars and coins, which are 99 percent pure, turn out to be difficult to liquidate as well, as banks, which sell them, don’t always buy them back.
Besides the loss of value, physical gold brings with it the need for safe storage, with the onerous task falling on us. Even paid bank lockers don’t guarantee its safety.
Paper gold, on the other hand, bets on the price of gold to give us returns, such as gold ETFs, without the concomitant problems.
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11 facts about gold ETFs
So, what are gold ETFs, really? These are exchange-traded funds, introduced in 2007 in India, which have gold as the underlying asset. The price of standard gold bullion, which is 24 carat and 99.9 percent pure, is tracked by these funds. We can consider them to be dematerialized form of physical gold.
As new units are bought by the end customers such as retail investors, the fund manager buys physical gold, and stores and insures it with a custodian bank. Authorized participants are tasked with the purchase and sale of physical gold to moderate the cost of the ETF units.
As of May 2019, Sebi has allowed ETFs to invest in exchange-traded commodity derivatives (ETCDs), a financial instrument, provided they have gold as the underlying commodity. The effect of combining ETCDs and physical gold on the volatility of an ETF is yet to be determined as it is still early days.
Expect us to have more on this soon. Meanwhile, we sum up 11 key features that make gold ETFs a worthy addition to our portfolios:-
- Based on physical gold – The money we invest in buying units of gold ETF goes towards buying standard gold bullion of 99.9 percent purity of 24 carats.
- No entry cost – There are no entry fees to buying into gold ETFs. We can start with as little as one unit, which would be 1 gram of gold (can be 0.5 grams for some ETFs). There is no exit load, as well. This lets us include gold in our portfolio in small denominations if we want to test the waters.
- Easy to trade in – Gold ETFs are traded on the stock exchanges with the underlying asset being gold. Hence, the ease of trading applies to these units as well. The prerequisite would be an online trading and demat account to trade-in. The transaction fees comprising brokerage and government duty are low compared to other options.
- Easy to liquidate – Gold ETFs can be bought and sold like stocks, at market price, during the trading hours of 9.15-15.30 hrs. There is no lock-in period.
- Performance linked to spot gold price – These passive funds are traded on the stock exchange (NSE and BSE in India), with gold as an underlying asset. Hence, the funds track the benchmark or domestic spot price of physical gold (easily cross-checked), affording retail investors like us a transparent view. We are exposed to the real-time price of gold on the exchange.
- Price close to exchange gold price – Loss of value is minimal as the gold ETF unit price is one of the closest to gold prices. There is less erosion in value compared to dealing with solid gold, as there are no markups like making charges or wastage.
- Advantageous passive investing – Gold ETFs carry the perks of passive funds such as being cost-efficient with low management fees and transparency of returns as the price movement mimics that on the exchange; with less value eroded by wastage and high fees, gold ETFs are more value for money for us
- SIP or lump sum – Gold ETFs, like other ETFs, let us invest either with a SIP-like (systematic investment plan) arrangement or a lump sum amount. Of course, for retail investors, the SIP route is advised, as explained here.
- No storage hassle, no fear of theft – Gold ETF units issued to us are linked to our credentials (KYC or Know Your Customer details), so unless we fall victim to identity theft, the paper gold would be safe in its dematerialized form. The bullion bought against ETF units is stored and insured with the custodian, without end investors having to worry.
- Fewer taxes than physical gold – Unlike physical gold, we won’t be paying GST on purchasing a unit of gold ETF. If our holdings exceed Rs 30 lakh, we won’t be charged wealth tax, that physical gold attracts.
- Loan collateral – Gold ETFs can be used as a bank loan collateral security, should the need arise. We can put it to work even if we are not selling it off.
Choosing a gold ETF
We would need to look at these data points before picking a gold ETF from the country’s leading funds:-
Net Asset Value (NAV) – It denotes the ETF’s unit price and should be compared with the spot gold prices to find the extent of digression. Nav is calculated by dividing the assets in the fund’s portfolio, except the liabilities, by the outstanding shares/units of the fund.
Returns – The profit made by an ETF portfolio would be its returns or income
Performance deviation – There would still be a difference between the returns on spot gold prices in rupees and gold ETFs, and it affects profitability. The smaller the deviation, the more value for us. The deviation is due to the fund’s cash holdings and expenses (leads to tracking error) and the cost of managing the ETF (called the expense ratio). Management cost for running the fund is low compared to actively managed funds such as mutual funds, but can still amount to 0.35-0.8 percent a year.
Here are some of the gold ETFs in India:-
- Axis Gold ETF
- Birla Sun Life Gold ETF
- Canara Robeco Gold ETF
- HDFC Gold Exchange Traded Fund
- ICICI Prudential Gold Exchange Traded Fund
- IDBI Gold ETF
- Kotak Gold Exchange Traded Fund
- Quantum Gold Fund (an ETF)
- Reliance Gold Exchange Traded Fund
- Religare Gold Exchange Traded Fund
- SBI Gold Exchange Traded Scheme
- UTI GOLD Exchange Traded Fund
Steps to invest in gold ETFs
Step 1 – Open an online trading and demat account with a broker, by supplying the requisite identity documents; choose the broker for its low brokerage (or no brokerage with brokers such as Upstox, a discount brokerage), ease of transaction and research support
Step 2 – Log in to the demat account and load money to enable trading
Step 3 – Choose the gold ETF
Step 4– Decide on the number of units to be bought and order, or refer to this blog on setting up a SIP-like arrangement
Step 5 – Demat account will be debited for ETF trade and brokerage, if applicable
Step 6 – Units of gold ETF will be credited to the demat account on the day of trade
Non-fund charges for gold ETFs
Besides the fund’s expense ratio, albeit low, we also pay for brokerage every time we trade in gold ETFs, just as with stock trading. The brokerage can be avoided if we opt for a discount broker such as Upstox. A demat account, which is mandatory for gold or other ETFs, also calls for an annual maintenance charge.
Taxation on gold ETFs
Gold ETFs don’t require us to pay GST when buying them. Neither do they incur wealth tax if our holdings exceed Rs 30 lakh, however, solid gold attracts.
The taxation on gold ETFs kicks in when we sell our units for a profit, in the form of capital gains tax. If we sell within three years of buying the units, we would be liable for short term capital gains tax according to our tax slab. For profiting off holdings held for over three years, we would have to pay long term capital gains tax of 20 percent, after indexation benefits (ie. accounting for inflation on the purchase price).
Risks in gold ETFs
The risk with gold ETFs, which otherwise is also a strength, is the link with domestic spot gold prices. Being ETFs, these instruments are not geared to outperform actual gold prices but move in line with them as they track the index. It would also mean, gold ETFs won’t stray too far away from gold prices (apart from the tracking error margin) and would be sheltered from any whimsical calls of a fund manager.
We would need to remember gold prices in India are affected by international market trends as well. So, market-rate fluctuations of gold would have an impact on the gold ETF NAV too.
The Gold Rally of 2019 and 2020
Stock markets and currency markets have taken a pounding across the world.
Stock indices fall in 2020
With money markets wavering, gold’s glitter has become brighter for investors. Its sturdy existence has inspired more confidence than a volatile economy.
Ask the central banks of the world, many of which have mopped up 374 tonnes of gold in all, in the first half of 2019, the highest since 2000, according to the World Gold Council.
RBI, India’s central bank, was among them, with its gold reserves increasing by $2.2 billion to $25.16 billion in August 2019. Beefing up gold reserves is traditionally done to reduce reliance on the US dollar as a reserve asset by central banks.
The clairvoyance of the central banks has heralded the current international gold rush, triggered by a perfect storm building up — US-China trade tensions, with the potential to become a full-fledged trade war, the slowdown in China and India’s economies, interest rate cuts by central banks of all sizes, and currency devaluations.
When the US Federal Reserve (US’ central bank) slashed interest rates for the first time in a decade, the end of July 2019, US President Donald Trump declared a 10 percent tariff on $300-billion worth of Chinese imports. Not one to take it on the chin, China let its currency (the renminbi) go above 7 yuan on the dollar, an unpleasant surprise as it was an 11-year low, and stalled the purchasing of US farm goods.
Such economic nationalism is not isolated and can be seen in movements like Brexit, America First, and widespread anti-immigration discourse. It bodes ill for open trade relations, turning the focus on the need to hedge investments from fickle economic pressures. Gold shines on as a safe haven, in this light.
The confidence in the dollar, powering global markets throughout, could also get chipped away as the US prints more money to repay its ever-rising national debt. Gold can hold its own as a payment method in case of currency devaluation.
Following the US-China financial sparring, three central banks (of India, New Zealand, and Thailand) cut interest rates by more than expected, to spur their economies. It dragged down bond yields worldwide, making gold, which does not work on yielding interest, seem attractive in contrast.
In July 2019, the IMF (International Monetary Fund), the global lending agency, revised its growth forecast for 2019 to 3.2 percent, a downward revision of 0.1 percent, in the light of an imminent trade war.
India has been buffeted by the global deflationary headwinds too. To compound its woes, the country’s economy is in the middle of sluggish industrial production and job generation, spreading further gloom.
But rising prices also stymie buyers of gold jewellery and bars. That is where gold ETFs come in, which let us get in at the minimum gold price possible at a given time, without a premium attached to it. Observers say the drop in demand for physical gold will be offset by demand from central banks for hedging and by gold ETF buyers, helping maintain the rally.
A case in point being the rise in holdings in the world’s largest gold-backed ETF, SPDR Gold Trust, by 7.3 percent in 2019.
Gold ETFs in India have yet to come into their own, and before the current rally, had been seeing net outflow in assets under management (AUMs). But at the end of May 2020, the holdings stood their ground at ₹10,102 crores, belying the trend of the preceding months.
Indian investors have secured better returns from gold over the years than their global counterparts.
Gold has clocked compound annualized returns of 13 percent over the last 20 years (from Rs 4,300 per 10 gm to present day) and 13.17 percent in the last five years (from Rs 26,343.5 per 10 gm), faring better in India due to a weak rupee (against the US dollar).
The World Gold Council says since 2000, investment demand for gold has increased by 15 percent on average every year, worldwide.
|Timeless and malleable|
Gold remains a timeless metal for adornment and investment. The noble element is non-corrosive and malleable, and the investing world has found its own ways of making the most of it through paper gold.
Gold is considered safer in choppy weather because it protects against currency fluctuations, finding favor with central banks.
It helps that gold’s price is governed by global macroeconomics, so it acts as a foil to Indian market instruments.
Even though gold mining has picked up, boosting supply, growing demand has balanced out gold prices, not letting the increased supply dent it.
Gold in our portfolio
Gold ETFs can bolster our portfolio with the relative price stability afforded by the rare metal. Gold is a strategic asset and not just a tactical one.
Allocating 5-10 percent of our investments in gold ETFs could be a safety net against unexpected slumps in equity indices. If we are living through a particularly tough slump in the money markets, we can increase our gold ETF holdings for a couple of years to ride it out. Those above forties could also amp up their gold investment to 15 percent for greater security.
Other forms of paper gold
A gold FoF invests in gold ETFs but does not need a demat account. A few financial institutions including brokerages offer e-gold in partnership with MMTC. SGBs are issued by the Central government, every few months, with the earlier ones sold on the secondary market.
SGB’s redemption is not taxed and it earns us 2.5 percent interest a year. However, they are less liquid than gold ETFs because of their maturity period of eight years and a lock-in period of five years.
E-gold has been known to give slightly higher returns than gold ETFs and don’t have management fees but incurs a wealth tax for holdings above Rs 30 lakh, unlike gold ETFs.
The economic ups and downs since the global downturn in 2008 have proved that even gold can get volatile. Investors, worldwide, turn to gold if large economies suffer a setback but drop it when recovery is in sight. However, investing 10 percent of our money in paper gold such as gold ETFs is considered a smart move in the current times.
If we choose a gold ETF, it can act as a hedge as we approach retirement or in troubled times.