Gold ETFs are similar to mutual funds that are traded on stock exchanges, i.e., one can buy and sell units from the stock exchanges. Just as an equity mutual fund, where a pool of money is gathered from investors by an asset management company (AMC) to invest in shares, so is the case here, but with pure gold as the underlying.
The AMC allots units to the investors that can be then traded on the exchanges. The price of the ETF correlates with the underlying physical gold, adding the flexibility of equity investment to the age-old simple gold investment.
In basic terms, buying gold ETFs means purchasing gold in the electronic format.
How Gold ETFs Work
Every unit of a Gold ETF represents one gram of gold and is of 99.5% purity. This physical gold is stored in vaults of custodian banks and works as the underlying from which the units derive value.
This can be understood with this example: suppose the AMC decides to allot the value of 1 gram of gold to each unit, in that case the price of each unit will be approximately the same as the price of 1 gram of gold. There are various investment funds that enable consumers to trade in Gold ETFs. Some of them include Nippon India Gold ETF, Axis Gold ETF, Kotak Gold ETF among others.
Benefits of Investing in Gold ETFs
- No price variation: Gold ETFs are bought and sold at the same rate, which is not the case in case of physical gold. The physical gold market operates at different prices in different geographical locations. Also, the buying and selling rates are different in order to cover the liquidation and other costs that are incurred in the trading of physical gold.
- Purity: When you deal in Gold ETFs, the purity is assured as the sector is organized and 99.5% purity is the standard, whereas the physical gold market lacks the transparency to generate trust in the purity.
- Liquidity: The convenience of selling the product which is listed and traded on recognized stock exchanges can never be matched to transacting in physical gold.
- No fear of theft: Gold being stored in a demat form rescues the investor from the worries that physical gold brings with it. It also helps investors save on locker charges, which are otherwise incurred to keep the physical gold safe.
- No entry and exit load: The investment in Gold ETFs does not charge any entry or exit load as it is traded on the stock exchange.
- No indirect taxation cost: Physical gold attracts indirect taxes such as GST at the rate of 3% on the purchase and sale value. This cost is saved in the ETF transactions as ETFs are securities and securities are specifically excluded from GST.
Risks of Investing in Gold ETFs
- Fluctuation risk: Gold as an investment option has a history of showing exponential growth only when the economy lacks stability. The glitter of the metal is inversely proportional to the economic scenarios. For example, gold hit an all-time high when the world was hit by Covid-19 and now trades at almost 20% less than the highs, when the economy is stabilizing.
- Time limit to trading: Trading on the stock exchanges is restricted to five working days 9:15 am and 3:30 pm, making it difficult to trade in the metal in the exact manner as physical gold, which is available throughout the year at stores selling often between 9am to 9 pm.
- Expense ratio: These are the fees charged by the AMC and are added to the purchase cost to ensure smooth functioning of the fund. The expense ratio includes fees for record retention, payments covering the salaries of the employees and other general allocated expenses. Costs like these are not incurred with physical gold and direct equity investments.
- Lack of options for physical delivery: Investments, with quantities above 1 kg of gold are eligible for physical delivery, which reduces the acceptability of the product among general masses who compare it with the physical form where the quantities traded can be as low as 1 gram.
- Limited volumes of trade: The product being new and not very well known does not see high liquidity on the stock exchanges, reducing the gains earned. This can be understood by the demand and supply logic: if the seller is in need of funds, they will eventually be okay to sell at a lower price in order to fulfill their need. This happens because the buyers want to buy at a lower cost, effectively reducing the profit earned.
- Sentimental value: Gold demand historically, is driven by sentimental value, which gold ETFs fail to justify, and that reduces the acceptability of the product by the general masses.
- Taxation: Gold ETFs are taxed on sale leading to capital gains tax, which is an added liability to the investment. This is not the case when we redeem the other digital gold option i.e. Sovereign gold bonds (redemption on maturity is tax free for SGBs).
Ways to Invest in Gold ETFs
There are two methods of investing in Gold ETFs; one is the direct route and the second is the passive route of investing.
Direct route: Buying units of gold ETFs requires opening a demat account through a stock broker. Post which, just as we purchase shares, units of gold ETFs can be purchased via the stock exchanges directly.
Indirect route: In case one doesn’t want to invest in gold ETFs via the demat option, they can invest into gold funds that indirectly invest in gold ETFs. For example, the HDFC Gold fund that invests in HDFC Gold ETFs. These are called fund of funds. This option is usually preferred by investors for whom mutual fund investment through their app is convenient or better understood.
Gold ETFs Compared With Other Investment Products
Gold ETFs Vs. physical gold
- Comparing gold ETFs with physical gold is not completely justified as physical gold also serves the jewelry demand in addition to the investment demand.
- Physical gold investment has different buying and selling rates, which is not the case with Gold ETFs. But the traditional usage benefits of the commodity has historically outrun the benefits of the digital product.
- The comparison of the investment proportion gives the consideration points of indirect taxes, difference in buying and selling rates and also safety and liquidity.
- A detailed understanding of the return requirements and purpose of investment is required before investing in any of the two options.
Gold ETFs Vs. SGBs
- Sovereign gold bonds (SGB) is a product sold by the Reserve Bank of India (RBI). The sale takes place in a series of close-ended opportunities being presented throughout the year. The product offers 2.5% interest on the actual investment value in addition to the gold value increment of the commodity. In simple terms, SGBs help investors putting their idle gold to earn for them.
- As opposed to gold ETFs, the trade volumes of this product is low, which hurts the interests of the investors.
- Both products serve as alternate options to the traditional investment method in the yellow metal. SGBs are RBI-backed, adding to trust in the product. Whereas gold ETFs possess higher trading volume compared to SGBs.
- Investing in any of the two products needs a careful consideration of the average holding period the investor would want to opt.
- Other digital options such as Paytm Gold, provide the physical delivery option which small gold ETFs investments lack.
Gold ETFs Vs. equity investment
- Long-term equity investments in quality stocks have provided good returns to investors and liquidity and fair pricing of equity investments has been able to attract investors. This is similar to gold ETFs, which provide the same comfort of liquidity and fair pricing to the investor. Thus, the two options work as complements rather than being comparatives.
- If you were to choose one of the two, considerations of risk, overall stability in the period of investment, the economic growth prospects in the specific investment sector and the geography should be thoroughly thought over.
Gold ETFs Vs. debt investment
- Debt investments provide an investor the comfort of promised returns, unless the economic health of the investment is deteriorating. The debt market accordingly ranks the bonds to specify the quality of the underlying asset class.
- The bond prices that had seen a sudden sharp fall in the recent pandemic period have now started stabilizing, reducing the bond yields. Thus, just as equities, bonds respond to bad economic scenarios in a negative manner, giving gold the opportunity to hedge the position.
Investors comfortable with the idea of digital options should understand the liquidity, risk and investment period requirements and analyze the pros and cons before investing in gold ETFs.
The key point is to have a diversified portfolio and to achieve the same via investing in gold can prove to be a good choice if done with in-depth research and understanding.