A Gilt Edge To Your Portfolio

I am 37 years old and have been investing in Indian equities for the past eight years. I have built up a reasonably diversified portfolio of debt and equity in equal amounts, but now I want to explore more investment avenues. I would like to accumulate gold as it is considered a safe asset. Please advise me on the best way to invest in gold.

Somnath Panigrahi

Spot Gold Prices In USD (Oz.)

Your decision to invest in gold will help you diversify your portfolio. Gold has a low correlation with most equities, and can act as a hedge against inflation. Additionally, you will also benefit from a fall in the dollar. As you can see in the chart, gold prices have appreciated considerably in the last 40 years. The chart is from the World Gold Council website and shows the London Gold PM Fix in USD. However, note that it illustrates some significant fluctuations in the price of gold. Hence, you should not assume that investments in gold are risk-free.

Gold prices are influenced and driven by many variables including economic growth, dollar value, jewellery demand, central bank reserves, mine production as well as the demand from India and China (the world’s largest consumers of gold). Most importantly, the prices are driven by the ‘fear factor’ – gold prices have spiked during periods of economic uncertainty such as the OPEC crisis in the 1970s and the sub-prime crisis in 2008. There is no predictability with regard to the prices of the metal. Also, unlike other asset classes like debt or equities, gold does not yield any interest or dividends and is only driven by demand, supply and speculation. Thus, you should not have a large percentage of your portfolio invested in gold.

Traditionally, physical gold was the favoured (possibly the only) way to invest in the yellow metal. Today, there is a bewildering range of avenues to choose from. These are shown in the following table:

Table: I

Currently in India, the only way to invest in gold-mining companies is to invest in international Fund of Funds (FoFs) such as AIG World Gold Fund and DSP Blackrock World Gold Fund. All FoFs are treated as debt funds for tax purposes, as are ETFs. Therefore, investors can save on taxes by investing in FoFs or ETFs rather than in physical gold. Mutual funds are exempt from wealth tax, while physical gold is not.

The performance of gold mining stocks is linked to the price of gold. A rise in gold prices should usually drive up these stocks. In practice, however, the shares of these companies are influenced by gold reserves, mine capacities and the costs involved in mining gold. Gold-mining stocks are effectively sector-focussed equities and may not always move in tandem with gold. Recently, there has been a spike in mining costs, which has resulted in downgrades of several gold mining companies. This has dragged down the gold-mining stocks.

YTD, the AIG World Gold Fund and DSP Blackrock World Gold Fund have generated negative returns of one per cent and five per cent respectively. The Sensex significantly outperformed these funds, as it generated a positive return of nearly 13 per cent. During the same period, MCX spot gold increased by 15 per cent and gold prices on the London bullion market (LBMA Gold PM Fix) increased by six per cent. The difference between the returns of MCX gold and London gold is because of the depreciation of the rupee against the dollar.

The following table indicates that gold ETFs have outperformed gold-mining funds in the long-run. Thus, you would be better off investing in ETFs rather than in gold-mining funds.

Table II

Gold ETFs aim to closely track the returns of physical gold. These funds are better investment avenues than physical gold. If you invest in physical gold, you need to arrange for secure storage such as a bank locker. These problems can be eliminated by investing in ETFs. In addition, investments in ETFs can be made in very small amounts (the minimum investment is usually 1 unit). Another advantage is that ETFs hold high quality gold. In contrast, when you are buying physical gold, you usually need to investigate the purity. The prices of gold ETFs are also more transparent than those of physical gold as the ETFs are traded on exchanges and the NAVs are publicly available.

Inspite of their numerous advantages, gold ETFs do have some drawbacks. A major limitation is tracking error, which may lead to a difference in returns between the ETF and physical gold. Also, ETFs do not offer an SIP option and may be subject to liquidity problems.

Gold FoFs invest in gold ETFs. They have all the advantages and disadvantages of the underlying ETFs, with the added advantage of making investments through the SIP route. Also note that gold FoFs may be more cost-effective for investors without a demat account. However, they do have some major drawbacks. Gold FoFs usually have exit loads unlike ETFs. They also have higher tracking errors than ETFs. Therefore, the returns of gold FoFs are usually slightly lower than the returns of the underlying ETFs. Since you are a seasoned equity investor with a demat account, you would gain more from investing in an ETF rather than in an FoF.

In India, the best way to invest in gold is through an ETF. However, despite the recent stellar performance of ETFs, the Sensex has outperformed gold over the last 20 years. Between January 1991 and September 2012, the Sensex has generated an absolute return of 1645.38 per cent while gold (London Gold PM Fix – USD) has generated returns of 334.24 per cent.

You should have the bulk of your portfolio invested in equities and debt. For diversification purposes, you could have a maximum of five per cent of your overall portfolio invested in gold. You should also consider your investment horizon and risk profile while investing in gold.

Notes:

1) YTD considered as 4th September, 2012.
2) All quantitative data from Accord Fintech unless otherwise stated.