Why It Still Makes Sense to Invest in Gold Mutual Funds Despite the Change in Tax Rule

April 20, 2023 Mutual Fund

As you may be aware, with the passage of the Finance Bill 2023, the taxation of debt mutual funds (that invest less than 35% of their assets or portfolio allocation in direct Indian equities) changed with effect from April 1, 2023.

The new tax rule also became applicable to gold mutual funds — Gold ETFs and Gold Saving Funds — plus Fund of Funds (FoFs) and International Funds as they are essentially classified as non-equity mutual fund schemes for taxation purposes.

As per the new tax rule, the indexation benefit that helped reduce the tax impact (by taking into account the cost of the inflation index) in the case of Long Term Capital Gains of these schemes is now no longer available.

But does that mean you should no longer invest in gold mutual funds?

Certainly not. Gold mutual funds, viz. Gold ETFs and Gold Saving Funds are still smart ways to invest in gold.

Compared to holding gold in physical form (bars, coins, jewellery, etc.) — where you worry about storage, security, holding cost, and resale value — Gold ETFs and Gold Saving Funds are convenient, cost-effective, transparent, liquid, flexible, and a hassle-free way to own gold in your portfolio.

Speaking about Gold ETFs, they are backed by 0.995 finesse gold, can be safely held in a demat form, and is better aligned to the price of physical gold. They generate returns broadly in line with the domestic price of gold.

Similarly, Gold Saving Funds invest in underlying Gold ETFs, which benchmark the performance against the prices of physical gold. Gold Saving Funds strive to produce parallel returns that closely resemble the underlying Gold ETF. To invest in a Gold Savings Fund, you are not required to have a Demat account. The units of Gold Saving Funds can be purchased through a mutual fund distributor or directly from the fund house.

Some may say these are “paper units”. Surely they are, but your money is invested (by the fund manager) in actual/real gold, and thus when the price of physical gold rises, it influences the performance of gold mutual funds.

At present, there are compelling factors that make a case for investing in gold strategically…

• Elevated Inflation — Retail inflation is still above the target range of most central banks, although it has moderated a bit. Highly uncertain crude oil, climate changes bringing unseasonal rains and hailstorms, geopolitical tensions, and imported inflation are some factors inflicting risk to the inflation trajectory.

  Graph 1: Gold historically rallies in periods of high inflation

  (Source: World Gold Council)  

  According to the World Gold Council study, in years when inflation was between 2%-5%, gold's price increased by 8% per year on average. This number increased significantly with even higher inflation levels. And over the long term, gold has not only preserved capital but also helped it grow. Since 1971, gold has outpaced the U.S. and world consumer price indices. For this reason, gold is said to be a hedge against inflation.

  The WGC observes that going forward, the interplay between inflation and central-bank intervention will be key in determining the outlook for 2023 and gold's performance. Also, if the greenback weakens, it could provide support for the precious yellow metal.

• Global Economic Uncertainty — Economic consensus projects weaker global growth akin to a short, possibly localised recession. Notably, mild recession or economic slowdown and weaker corporate earnings have historically been positive for gold.

  Graph 2: Performance of gold during recessions

  (Source: World Gold Council)  

  Graph 2 above shows that recessions have usually been favourable for gold. In five out of the seven last recessions, gold has delivered positive returns reveals the WGC study.

  Graph 3: Gold performs well even in the recovery periods following a systemic selloff

  (Source: World Gold Council)  

  Besides, during the recovery phase as well the WGC study highlights that gold has rewarded investors decently well.

• Simmering Geopolitical Tensions — It's been more than a year since Russia invaded Ukraine, and there are no signs of it ending soon despite the diplomatic interventions of many global political leaders. North Korea's tactical nuclear exercises are sparking fear. China-Taiwan relations aren't good, and there are fresh tensions between the two. China is also intimidating India with its build-up at the Line of Actual Control. In the Middle East and North African (MENA) region as well, there are conflicts.

• Stock Market Volatility — Against the backdrop of the above and guided by domestic factors, stock market volatility is likely to intensify, particularly if it upsets the path to economic growth and corporate earnings.

  Graph 4: Gold has been less volatile than many equity indices, alternatives, and commodities

  (Source: World Gold Council)  

  The WGC study reveals that because of gold's scale, liquidity, and diversity of the various sources of demand, gold has been less volatile than equities, alternatives, and other commodities. Also, usually, gold has a negative correlation to equities and other risky assets.

[Read: 5 Reasons Why You Need to Own Gold in Your Portfolio in 2023]

Considering the aforementioned factors, among many others, several central banks are adding gold as a risk mitigation measure and part of their reserve management. As per the latest data published by WGC, India added 3 tonnes(t) of gold in February 2023 and is holding a sizeable 790t of gold reserves.

As an investor, you should not be discouraged to invest in gold the smart way — through Gold ETFs and/or Gold Saving Funds — just because the tax rule is unfavourable when in reality there are convincing reasons to strategically own gold.

Graph 5: Gold is an effective portfolio diversifier

*Data as of April 17, 2023.
(Source: ACE MF; PersonalFN Research)  

Consider allocating 10%-15% of your entire investment portfolio to gold and hold it with a long-term view (of over 5 to 10 years) by assuming moderately high risk. The long-term uptrend exhibited by gold as an asset class cannot be ignored and highlights the importance of owning it in your portfolio. Graph 5 above vindicates that gold would be an effective portfolio diversifier.

So, if you are considering buying gold on the auspicious muhurat of Akshaya Tritiya, go ahead! Be a thoughtful investor.

Happy Investing!

This article first appeared on PersonalFN here