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10 Things You Must Know About Investing in Gold Funds

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10 Things You Must Know About Investing in Gold Funds
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Gold has been a popular investment option for us Indians since times immemorial as this yellow metal has historically been associated with wealth and prosperity. It is this love for the yellow metal that has led India to become one of the largest importers of gold in the world as we produce very little of this precious metal ourselves. Traditional investment in gold has been made in the physical format mainly in the form of jewellery, gold bullion and gold coins however, due to the problems related to storage and security of the metal, a new method of investing in gold has emerged and gained popularity in recent times. These investment options are known as gold ETFs and gold mutual funds. The following are 10 key things you need to know before you invest in gold funds.

1. There are multiple gold funds on offer

The fascination of gold investments for Indians extends much farther than just the jewellery store. So much so that almost every fund house in India has its own gold ETF as well as mutual funds that invest specifically in these gold ETFs. These gold investments are market linked thus affected by global and domestic market prices of the yellow metal, but can be held in a dematerialised (DEMAT) format such that each gold fund unit is equal to 1 gram of gold so you don’t need to worry about storage or security of your investment unlike physical gold.   

2. You can invest in Gold at commodities exchanges

Apart from gold funds, you do have the option of investing in gold spot contracts and futures through the commodities market. In these trades, gold is not traded as units but as spot and futures contracts. This method of investing in gold is a lot more complicated as compared to gold funds and more suitable for expert investors who are adept at futures trading. In India, gold is traded in 3 commodities exchanges – NCDEX (National Commodity and Derivatives Exchange), MCX (Multi Commodity Exchange of India) and National Multi Commodity Exchange of India (NMCE). All of these support electronic trades and feature pan-India presence.

3. Gold funds are traded in multiple exchanges

As mentioned in the earlier sections, gold can be traded in commodities exchanges however this is not the same as buying and selling gold mutual fund units. In case of gold funds, the investments are made in gold bullion or gold ETF and these funds may be traded in either the BSE-Sensex or the Nifty stock exchange. Gold mutual funds invest primarily in gold ETFs, hence they are often considered to be in the category of funds-of-funds mutual funds. Additionally some publications have gold mutual funds listed under the debt fund category.

4. Value of gold fund varies according to market demand/supply

Gold funds are directly linked to the market value of gold hence susceptible to the volatility of global as well as gold prices in India. Usually during times of economic turmoil, gold prices surge as more investors look for safe investment bets and investors at large have historically considered gold as a safe haven. When larger numbers of investors buy gold whether in physical or digital format, there is a contraction in available supply of the metal which pushes up the gold prices. When global and domestic gold prices rise, so do the value of gold funds and gold ETFs.

5. Sovereign gold bond is not a gold fund

The sovereign gold bond issued by the Government of India in recent years is in fact not a gold fund! For starters, it is not traded in stock markets and it cannot be liquidated in stock markets like traditional gold funds. The government guarantees a fixed annual rate of return (interest) on your investment in the bond and at the end of the tenure you will receive a value commensurate with the market value of gold at the time of redemption. Unlike market-linked gold funds, sovereign gold bonds are backed by the government and hence feature lower risk but the projected returns are also lower.   

6. Gold Funds are best for Diversification

The main reason for investing in gold funds is related to the issue of portfolio diversification, which is described best by the old proverb “don’t put all your eggs in one basket”. If you make all your investments in a single product, you might find that your investments have lost a large portion of the value overnight when there the markets take a turn or you might find that your ROI is very low. Hence instead of going all in and investing solely in equities or debt funds, you can choose to invest in gold funds as well to balance your risk with the expected returns. This way, when equities take a nose dive, gold funds and debt investments would ensure that a large portion of the portfolio value will be maintained in spite of the volatility in markets.   

7. Use gold funds only as a hedge investment

We Indians are fascinated by gold and it is only natural that even digital gold investments are perceived as a safe bets during uncertain times just like the physical metal. There is however a catch, gold prices when compared with the rate of inflation often provide returns that are at par with traditional deposits like bank tax saver fixed deposits but feature a much higher risk and no tax deduction benefits. Additionally, gold prices are also subject to volatility through an inverse correlation with equities. So though gold funds are ideal as an investment during times of economic uncertainty, when stock markets witness a bull run, gold funds are less attractive as compared to equities. This is because gold prices fall when equities perform well as gold investments do not provide capital appreciation at par with equity investments. This is the key reason why the savvy investors do not make gold funds the mainstay of the investment portfolio instead use it as a supplementary investment option.

8. Gold funds  are subject to capital gains

Gold funds similar to debt mutual funds are subject to Capital Gains taxation rules as per the applicable criteria. This tax is applied to the value by which your capital i.e. initial investment has increased (appreciated). The capital gains tax feature 2 options – short term capital gains and long term capital gains. In case of short term capital gains received through liquidation of your gold fund investment within 1 year of the initial investment, gold fund profits are taxed as per your current tax bracket. On the other hand, in case of long term capital gains, the tax rate is 10% with indexation and 20% without indexation. On the other hand, physical gold is taxable as per wealth tax rules, which do not apply to gold ETF and gold mutual fund units.   

9. Limit your exposure to Gold funds

Though gold funds are often suggested as a supplementary option to traditional mutual fund investment in case of those interested in hedging their investment bets, the exposure to gold funds is best kept limited. In fact some investment experts suggest that avoiding this class of products in favour of options such as company fixed deposits or debt funds would be a better idea. The main argument against gold fund investments stems from the fact that though the price of gold has seemingly held its own against inflation, the returns on gold funds are quite low when one factors in the capital gains tax that have to be paid on these investments. Moreover, gold funds are subject to market risk like any other ETF (exchange traded fund) or mutual fund, hence old favourites like PPF and bank tax saver deposits might actually be a better investment option during periods of market turmoil.

10. The inflation vs. gold argument

It has long been believed by investors that gold prices reflect increases and decreases of inflation and hence the price of gold will adjust to preserve the value of your investment. In actuality, the relationship is governed by multiple factors including inflation hence the correlation is not as proportionate as many investors would believe. So though gold funds tend to hold their own in case of inflationary pressure, the relationship is actually a lot more complex and unpredictable. Thus gold ETFs and funds perform well below the level set by equity investments when it comes to returns offered at the time of redemption. Add to that the fact they fall in the purview of capital gains taxation rules and most experts would agree that gold funds barely provide returns worth considering if you have a capital appreciation goal.

All said and done, gold funds (both ETFs and mutual funds) are here to stay and they will continue to be part of many investor portfolios simply because gold-related products give the impression of being safe haven investments. This is especially true when unexpected situations such as demonetisation produce volatility in stock markets or investor outlook is poor due to low GDP growth or employment figures. Add to that the fact that whenever gold prices surge, gold funds rally and you would realise that gold funds will continue to fascinate investors for a long time into the future.   

Edition: February 2017

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