By: Tavaga Research
We associate the auspicious occasion of Dhanteras with wealth, and we associate wealth with gold. With several instruments in the market constituting gold as their underlying, an individual is likely to reach a question. Should you buy physical gold, Sovereign Gold Bonds (SGBs), or Gold ETFs? Nowadays, digital gold is also an offering that may or may not serve as an ideal alternative.
As paperless gold is getting streamlined across investment portfolios, the traditional ways to accumulate gold are becoming redundant.
While it’s true that we attach a cultural value to physical gold, it makes for a wasteful investment. Making charges alone affects the overall gains from the investment in physical gold. Additionally, the price we pay for physical gold may be partially allocated toward impurities.
Also, physical gold demands safe storage and for safe storage, we approach banks for lockers on rent. Even the lockers don’t provide a guarantee of safety in case of an eventuality.
Undoubtedly, gold provides stability to an investment portfolio. The ongoing global pandemic has proven to be the best example of how gold is a worthy investment.
Typically, portfolio managers advise an exposure of 5 to 15 percent to the yellow metal. Gold limits the downside risk of the portfolio in a situation when equities are not performing well.
The real question is which instrument: Gold ETFs, SGBs, or digital gold?
Gold ETFs have been trending this year after receiving a net inflow of more than Rs 6,300 crores. The benefits offered by Gold ETFs are unparalleled when it comes to comparison with physical gold.
Gold ETFs employ a form of investing that is better known as passive management. Gold ETFs are passively-managed in that the fund’s objective is to mimic the real price of the gold by allowing for minimum deviations.
However, the truth of the matter is that a slight deviation is inevitable. Although ETFs attract a lower expense ratio, they still contribute to tracking error. Tracking error is the difference between the ETF returns and physical gold returns.
Tracking errors stems from the need for the fund to maintain a cash balance to cater to redemption requests. The bright side is that even with the tracking error, Gold ETFs’ features outweigh the potential costs of making charges.
While Gold ETFs’ characteristics are equity-like, capital markets offer another bond-like instrument with gold as their underlying: Sovereign Gold Bonds (SGBs). SGBs are interest-paying instruments issued by the RBI on behalf of the Central Government; with such backing, SGBs have negligible credit risk.
SGBs are also traded on the secondary market which is why the lock-in period of 5 years does not pose an inconvenience.
The price of SGBs is calculated by averaging the price of 999 purity gold in its last three trading sessions. The prices are fair estimates for the prevailing price of gold but are not exact estimates.
ETFs, strive to give a real-time performance. What ETFs lack due to tracking error, SGBs lack due to pricing methodology. Nevertheless, the difference can be ignored for the sake of the bigger picture.
Due to the thinly traded fixed-income market, liquidity offered by Gold ETFs is slightly higher. SGBs also consist of a maximum investment limit that allows each investor to not invest in more than 4 kgs of gold.
Taxation treatment is different for SGBs as well. The 2.5 percent interest on SGBs is fully taxable. However, there is no capital gains tax on returns generated through the appreciation of gold prices.
The catch with both Gold ETFs and Gold SGBs is that at redemption or maturity, the proceeds of the sale are in the form of cash. Therefore, physical gold is involved only in the background. An investor in either of the instruments does not get to see the physical gold for real.
Digital gold or E-gold is accumulating the yellow metal in tangible form. The highlighting feature of digital gold is that purchase and payment of gold is carried out online. Therefore, an individual does not have to approach a seller or a dealer. Mobile wallets also offer the option to purchase digital gold.
An investor can buy gold for any denominations, even for as low as Re 1. Gold purchased digitally is stored in 100 percent insured vaults and can be exchanged for real gold or exchanged for jewelry at the end of the holding period.
On the contrary, all the drawbacks that apply to physical gold also apply to digital gold. Except for an easy purchase option, digital gold offers nothing more. Digital gold is also subject to a limit on the investment period, say five years, after which the investors have to accept delivery or redeem the units.
Moreover, a GST of 3% is levied on the purchase of digital gold. However, the biggest risk of participating in a digital gold transaction is that there are no regulators for the product. Gold ETFs are regulated by SEBI and SGBs are regulated by RBI.
Investors who missed the recent rally in gold still have a good opportunity to accumulate the Gold ETFs at regular intervals through the SIP route as the future of yellow metal still looks bright due to the festivities in India, the upcoming stimuli by many developed nations, debasement of the currency, and the ongoing uncertainty surrounding the outcome of US Presidential Election 2020.
Team Tavaga wishes you and your family a very Happy Diwali!
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