Gold ETFs: An Effective Portfolio Diversifier

August 31, 2023 Mutual Fund

The precious yellow metal, gold, has played a pivotal role in socioeconomic development all around the world. It is a strategic long-term asset class that even central banks consider important for their reserve management. Gold is a liquid asset, carries no credit risk, considered to be a reserve currency, and its historical performance reveals that it is a store of value. This scarce commodity, in this day and age, commands diverse utility: besides jewellery, it is used in manufacturing electronic appliances, electrical switch gears, aerospace technology, dental treatments, as a medicine, and more!

Over the years, financialization has also led to the investment demand for gold owing to its appeal of being an effective portfolio diversifier due to its negative correlation with equities. Other than gold bars and coins, there are Gold Exchange Traded Funds (as well as Gold Saving Funds and the Sovereign Gold Bond Scheme) available for investment today.

Let’s understand why owing Gold ETFs is a smart way of owning gold and how it can be a portfolio diversifier.

Gold Exchange Traded Funds or Gold ETFs

A Gold ETF is a passively managed mutual fund scheme that aims to track the domestic price of physical gold by making direct investments in gold.

It offers investors an innovative and cost-efficient way to invest in gold without having the hassle of physically holding it. On purchase of a Gold ETF, units are allotted to you, the investor.

The units purchased are backed by 0.995 finesse of physical gold. The physical gold is held in vaults by an appointed custodian for the Gold ETF by the mutual fund house on your, the investors’ behalf. Besides, this gold with the custodian is insured and valued periodically, as per the guidelines stipulated by the Securities and Exchange Board of India (SEBI).

Thus, the investor can own gold without having to worry about making charges (as in the case when purchasing gold in a physical form), storage hassles, risk of misplacing, theft, etc.

The investment objective of a gold ETF is to generate returns broadly in line with the domestic price of gold and gold-related instruments subject to a tracking error.

Tracking Error (TE) is the variance between returns of the underlying benchmark (gold in this case) and the Net Asset Value (NAV) of the Gold ETF.

By and large, when gold appreciates and the NAV goes up, you, the investor benefit. Gold ETF benchmarks its performance against the domestic price of gold, the Tier 1 benchmark index.

How to purchase Gold ETF units?

You need a demat and trading account. The purchase order can be placed through your broker – just like the way you buy shares on the recognised stock exchange.

When you buy a gold ETF unit/s, these will be reflected in your demat account (usually on a T+2 basis). Note that investments in Gold ETFs cannot be made through the Systematic Investment Plan (SIP) route.

Why it makes sense to add Gold ETF units to your investment portfolio

Not all asset classes move in the same direction at all times. There have been years when equities have disappointed investors and gold has fared better, proving to be a hedge.

Graph1: Performance of Equity, Debt, and Gold in the respective calendar years

Data as of July 31, 2023
(Source: ACE MF) 

The graph above vindicates how gold proved to be a portfolio diversifier in 2019 (when the outbreak of COVID-19 occurred), 2020, and then 2022 (when the Russia-Ukraine war) started. At the start of 2023 when we witnessed the collapse of banks in the U.S. and Switzerland viz. Credit Suisse, Silicon Valley Bank, Signature Bank, Silvergate Bank and First Republic Bank owing to asset-liability mismatches, and there was a buzz about banking crisis and possible recession; gold did well.

In seven months through the calendar year 2023 (as of July 31, 2023), the precious yellow metal, gold, has delivered a +8.70% absolute return.

While Indian equities are in an exuberant phase (markets are at an all-time high) and debt instruments are yielding better returns (in a rising interest rate scenario), gold has displayed resilience. This is because smart investors are realising the importance of holding adequate gold in the portfolio amidst times when the risk emanates from the following factors:

• Elevated inflation
• El Nino conditions pushing food prices up
• The burgeoning debt-to-GDP ratio of many major economies
• Bonds yield showing an inversion in the last couple of months
• Chances of global economic slowdown (if not a recession) later in the year
• Simmering geopolitical tensions

Moreover, central banks signalling that policy rates may increase further is not deterring smart investors, as they recognise gold’s trait of being a store of value, a safe haven amidst uncertainties, a hedge, and an effective portfolio diversifier.

Even central banks evaluating risks looming are adding to their gold reserves. The World Gold Council’s 2023 Central Bank Gold Reserves Survey reveals central banks have a positive view towards gold. Seven in ten central banks surveyed believe that gold reserves will increase in the next 12 months. This is a 10-point increase from last year.

Graph 2: Factors weighing central banks’ gold holding decision

(Source: 2023 Central Bank Gold Reserves Survey) 

The historical position of gold, its performance during times of crisis, its hedge against inflation, a geopolitical diversifier, carrying no default risk, and being very liquid, have been viewed as some of the highly relevant factors.

It is important to make a strategic allocation to gold — by holding around 20% of the entire investment portfolio in gold ETFs with a long-term horizon.

Graph 3: Gold has fared well over the long term

Data as of July 31, 2023
(Source: MCX) 

The long-term secular uptrend gold has exhibited cannot be ignored. In the last decade, gold has clocked a CAGR of nearly +7.7% as of July 31, 2023, and since India’s independence, clocked a CAGR of nearly +9.0% (as of July 31, 2023).

What about the liquidity of Gold ETF units?

They are highly liquid and the sell transaction gets executed at the prevailing NAV (which is closely tracked against the domestic price of gold).

To sell the gold ETF units, you need to place the order with the broker who will then execute it on the stock exchange, and if the trade is executed successfully, the proceeds from it shall be received on a T+2 basis into your bank account, and the gold ETF units move out from your demat account.

Is it possible to convert Gold ETF units into physical gold?

Yes, that’s possible but only for a certain quantity, which is usually 1 kg.

In this case, the fund house will carry out KYC (Know Your Customer) checks to validate that the delivery reaches the same person as the actual investor.

Subsequently, the fund house will issue a ‘delivery order’ to the custodian and investor.

While taking the delivery of your physical gold, you are required to produce the KYC documents plus the delivery order issued.

To take physical delivery of gold after conversion, keep in mind you are required to pay in cash for the accrued expenses, transportation costs, and GST (Goods and Services Tax) levied by the fund house.

This entire process of converting the Gold ETF units and taking physical delivery of gold generally takes around 2 to 3 working days.

What about the tax implications?

With effect from April 1, 2023, the taxation of Gold Mutual Funds has changed. The indexation benefit is no longer available. The capital gains made on the sale of Gold ETF units are now taxed at the marginal rate of taxation, i.e. as per your income-tax slab (just as in the case of a debt mutual fund scheme).

Final words…

Gold ETF provides you, investors, with an excellent way to diversify your investment portfolio and adopt prudent asset allocation. Be a thoughtful investor.

Happy Investing!

This article first appeared on PersonalFN here