Monday, July 25, 2011

Gold ETFs or Physical Gold or Gold Funds?: The Gold Investor's Quandary

In my last article, I made a case for investment in Gold. The thing about gold is that there is no true way to determine its exact value. You can determine the value of bonds by their coupon rate & nature of the issuer and also stocks by looking at the underlying company and its earnings & management. Gold on the other hand responds to investor sentiment and demand. As mentioned in my last article, the huge deficits in Japan, USA and some Euro-zone countries have created an environment, where gold seems to be the safe haven investors seek in these turbbulent times. This article seeks to address the quandary investors face in relation to how to invest in Gold and of the different instruments available in the market, which one would be the best.


There are three common methods for Gold investment –


1. Buy Gold ETFs (Exchange Traded Funds)
2. Buy Physical Gold in terms of gold bars and coins
3. Invest in Gold funds

Gold ETFs:


Gold ETFs (Exchange Traded Funds) are open-ended funds which track prices of gold. They are listed and traded on a stock exchange; hence, they can be bought and sold like stocks on a real-time basis. These funds are passively managed and they mirror domestic gold prices. By enabling investors to invest in gold without holding it in physical form, Gold ETFs offer a rather unique investment opportunity to investors. You need to have a demat account if you want to buy a Gold ETF.

Pros:

Gold ETFs are convenient since there is no physical delivery of gold involved. Since the SEBI mandates that the purity of underlying gold be 99.5% and above, the investors do not have to worry about the quality of the gold. Gold ETFs offer convenience in terms of transparent pricing and selling of the ETF units. And most importantly you do not have the hassle of storing physical gold (no locker charges or mental tension if stored at home). ETFs are tax efficient - ETFs sold after a year of purchase are not taxable.

Cons:

ETFs need to remain liquid and so they cannot invest everything into gold and so you are actually not investing in 100% gold. ETFs maintain certain amount of cash as part of their assets along with physical gold. Gold ETFs may have an annual expense of 1% charges depending on the fund house which issued the ETF.

Physical Gold:

Physical Gold can be purchased from a bank or a trusted jeweler in the form of gold bars or coins.


Pros:


In September 2008, shareholders in ETF securities were left high and dry - unable to trade popular commodity securities, due to concerns over the future of their backer, insurance giant AIG. Overnight, banks and brokerages stopped making markets in the Exchange Traded Commodities (ETCs) backed by the troubled insurer. In the event of your ETF fund house going bust, you would be left holding illiquid units whilst its value keeps falling.
Physical gold can be converted into cash by taking it to any jeweler. Banks however will not buy the gold bars they sold to you. Physical gold is the safest form of investing in gold.

Cons:

Banks and jewelers charge a premium when they sell you gold (premium could be anywhere between 2-10%). And if you sell your gold in less than 3 years, you would be taxed. Again, your local goldsmith may not give you the correct value or the spot price of gold.

Gold Funds:

A gold fund comes in two variants – they either invest in gold or they are a fund of funds wherein they buy various ETFs.


Pros:


By investing a fixed sum of money every month, you get the benefit of rupee cost averaging. Gold funds provide you this benefit, where you can invest a fixed sum of money in units of gold fund sailing through the highs and lows of gold. Currently, there are around a dozen gold ETFs listed on the stock exchanges. But barring the gold ETF of Benchmark Fund, known as Gold BeES, and the gold ETF of Reliance, their traded volumes on the stock exchanges are not significant. This raises an issue of liquidity of the investment. In case you invest in gold through gold funds, you can surrender the units to the mutual fund at any time and based on the payment cycle, you will get your money. This ensures that you are able to get your money back whenever you want.

Cons:

Gold funds charge you a 1.5% annual fee which is higher than the amount charged by ETFs.

Conclusion:


Gold funds are typically attractive for those who want to take the benefit of rupee cost averaging principle through a systematic investment plan. However, if you are looking to opt for short term trade based on Gold pricing you should opt for ETFS. Gold ETFs provide an opportunity to benefit from sudden price movements of gold as the prices of gold ETF reflect the value of the underlying gold on a real time basis. If you are a long term investor and would hold your investment for more than 3 years, go with physical gold. As the saying goes, one size cannot fit all. You have to decide what fits you and what your needs are.

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