The golden way to invest

Gold exchange traded funds make the purchase of gold as easy as stocks. But that does not mean it is a better investment.

Traditionally, gold has been purchased in the form of jewellery. But apart from serving as a beauty aid, gold has several other advantages.

One, from time immemorial, through different economic eras, it has proved to be a great store of value and a good hedge against price rise.

But keeping gold in a physical form has its problems. Investors have to incur the cost of safe-keeping and then there is the fear of theft. What if you could invest in gold without any of these hassles?

Last year's Budget enabled one to do just that. Finance Minister P Chidambaram announced that the capital market regulator would soon permit mutual funds to launch gold-based exchange traded funds (ETFs).

In January this year, the Securities and Exchange Board of India announced the guidelines for launching gold ETFs.

Following the final guidelines, two asset management companies-UTI Mutual and Benchmark Mutual-have filed their respective offer documents for the proposed product. Soon, gold shares are going to be a reality for Indian investors.

So, should you buy gold ETFs, as opposed to stocks or bonds or even gold jewellery? To answer this, we need to understand what exactly this creature called ETF is. And can gold provide better returns than other asset classes.

ETFs-what?

ETFs are passively managed funds tracking a benchmark index and reflect the performance of the chosen index. An ETF is like a hybrid financial instrument, a cross between an index fund and a stock. A equity-based ETF would invest in a basket of stocks that reflects the composition of an index, say Nifty or Sensex.

These funds are freely traded on the stock exchange and derive value from the underlying asset, i.e., stocks.

Similarly, gold ETFs invest in physical gold and derive their value from the underlying asset. In other words, the price of gold ETFs will be directly linked to the price of gold itself and hence the returns from a gold ETF will more or less equal to returns from gold bars or coins.

The two gold ETFs -- Gold Benchmark Exchange Traded Scheme and UTI Gold Exchange Traded Fund -- to be launched soon will be listed on the National Stock Exchange. Investors can buy or sell units of these schemes, like any other stock listed on the exchange, through their brokers.

Both funds will be passively managed open ended schemes. These funds will invest up to 90 per cent of total assets (if not 100 per cent) in physical gold. They may hold up to 10 per cent of their total assets in money market instruments and other debt securities.

Steam left in the yellow metal?

But, with the gold prices hitting the roof, is it wise to invest in gold? The international price of gold has appreciated 46 per cent from $427.6 to $623.7 over the past one year.

Globally, the proponents of gold base their optimism on the long-term weakness in the dollar owing to the large US trade deficit and the favourable demand-supply dynamics for the metal.

Yet, assigning a price to gold isn't as easy as stocks because there is nothing like an earnings per share which can provide a benchmark on what should be the fair value.

In terms of returns, gold may hardly be able to match the performance of stocks.

With the economy expected to grow at eight per cent per annum in real terms, and a nominal growth rate of 13 per cent or so assuming an inflation of five per cent, market analysts expect corporate earnings to grow at 15 per cent over the next few years.

Currently, stocks are close to fair valuations trading at price-earnings ratio of 15 times which means a return of 15 per cent on an annualised basis. Government bonds currently offer around 8 per cent, pre-tax.

Maintaining that gold can't be compared to stocks, gold analyst Bhargav Vaidya says that even from these levels the precious metal should deliver around five per cent returns.

Gold, for real returns

Gold is not to be bought with high return expectations, but for the virtues it offers. Firstly, gold acts as a good portfolio diversifier. This is due to its historically low-to-negative correlation with stocks and bonds.

Sanjiv Shah, executive director, Benchmark Mutual Fund says, "The economic forces that determine the price of gold are different from the forces that determine the prices of most financial assets. The price of gold depends upon various factors, including the supply and demand for gold, foreign exchange rates, the rate of inflation and the political situation around the world."

Adding to this Sameer Kamdar, national head (mutual funds), Mata Securities,   says, "Rising interest rates are putting pressure on equities, debt and currency. So, there will be a flight to safety and people will shift to gold."

Secondly, gold has proved to be a good hedge against inflation. Gold is less volatile than stocks yet over long periods of time, the metal has consistently delivered returns in excess of inflation.

Shah says, "Gold is not an investment for today or tomorrow but for the long-term." Adds Vaidya, "Gold should be bought purely because it is a store of value."

And then there are reasons why gold funds make more sense than investing directly in gold. Kamdar says, "India is the biggest consumer and there is no organised market for gold which, retail investors can access. A fund will enable investors to buy gold effortlessly."

The only issue, he adds, is that traditionally people are used to buying gold in a physical form. So, it will take some time for them to accept the new concept.

However, as Shah points out, in India, out of the total savings of 29 per cent, about 16 per cent are in physical assets like gold and real estate. People can consider deploying a small portion of this into paper gold, as it is a more efficient way to save.

Plus, another key benefit of gold ETFs is that it is affordable even for very small savers. "Investors can buy gold in small quantities and they will not have to worry about its safety and insurance cost," says Shah.

The minimum number of units that can be bought or sold is 1. Each unit of gold ETF is approximately equal to the price of one gram of gold. The going price per gram of gold is around Rs 1,000.

Then again, gold as an asset class attracts wealth tax. But gold units are not treated as assets as defined under the Wealth Tax Act and therefore would not be liable to wealth tax. "Since it is a non-equity oriented fund the tax treatment will be like a debt instrument," says Shah.