Gold Funds v/s Gold ETFs

I had written to you about 4 years ago to know about gold funds. My understanding was that gold funds track gold prices, which you had concurred with. Based on this understanding, I made some investments in AIG World Growth Fund (now known as Pinebridge World Gold Standard Plan) between September 2009 and February 2010 through a weekly SIP at an average cost of Rs 11.63 per unit. The NAV of the fund has been recorded at Rs 15.70, Rs 14.73, Rs 11.54 and Rs 9.20 in April ‘11, August ‘12, March ‘13 and November ‘13 respectively. This NAV trend is not in consonance with the price of gold. I would like to know where my understanding has gone wrong. I also need your advice with regard to holding or redeeming my investment in the fund.

– Mukesh Tandon, Lucknow

In my answer four years ago, I had explained the difference between gold mining funds and gold ETFs. Here is an extract:

“The primary difference between ETFs and gold funds is the nature of the investments itself. Gold funds invest in shares of companies whose business is mining gold (or other precious metals). The logic is that if the value of the underlying metal increases, the share price of the mining company should go up in greater proportion since the company owns a whole inventory of metal in their mines! The value of their entire inventory would have gone up whether mined or not. The converse can also happen. Whereas the ETF strictly invests in the metal to the extent it has issued units to investors. At any time, the value of its holding will be similar to the value of the units outstanding.

The beta or sensitivity of gold funds is almost twice that of a gold ETF. Hence, one can assume that the risk of value falling is also twice that of a gold ETF. In my opinion, a gold ETF is a valid alternative to buying gold as an investment and a gold fund is like any sector equity fund – it is an ETF with added risk!”

Gold ETFs simply track the price of physical gold, while funds such as Pinebridge World Gold Fund invest in shares of gold mining companies. Generally, the shares of these companies rise and fall sharply synchronous with the increase and decline in gold prices.

The fund you have invested in has suffered in the last four years. On December 2, it was trading at a NAV of Rs 8.09 – below the post-NFO NAV. In the past few years, there has been a spike in mining costs, which has hurt the share prices of gold miners. Even when gold prices were rising, these companies failed to benefit. The pain was magnified when the metal started falling this year. On an absolute basis, the fund has generated a negative return of nearly 40 per cent over the past few years, though gold prices have risen over a four year-period and gold ETFs have generated positive returns of over 40 per cent. The bleak returns can be attributed to the recent decline in gold prices.

Your have been relatively lucky as your effective loss (in absolute terms) has been only about -30.4 per cent. You managed to restrict losses by investing through SIPs. The rupee depreciation has also helped Indian investors, as it has partially offset the decline in gold prices.

Unless, you have a very long time horizon, you may want to completely exit Pinebridge World Gold Fund. Even if the rupee continues to depreciate, the fund will still take time to recoup its losses and add value to your portfolio.

There are several headwinds to gold prices in the near-term. In the past, gold has acted as a hedge against inflation and the dollar. However, it is now losing its value as a hedge, as inflation rates are modest in most developed countries.

Gold prices have also been adversely affected after the US Fed announced that it may start tapering its QE program. Since this announcement, the dollar has appreciated and may rise even further when QE is actually reduced. Historically, there has been a negative correlation between gold and the dollar. The strengthening dollar and positive economic indicators in the US have reduced the demand for gold.

More importantly, gold prices are driven by the ‘fear factor’ – spiking during periods of economic uncertainty such as the 1970s OPEC crisis and the 2008 sub-prime crisis. A combination of stable global economic conditions and less ‘easy money’ may limit the upside in gold prices, as the yellow metal has effectively functioned as a crisis hedge over the last few years.

Prices of the metal may also be adversely affected by lower demand from India – one of the world’s largest consumers. This is especially in light of the efforts made by the Indian government and the RBI over the past few months to curb the demand for gold.

Hence, unless you want to accumulate physical gold, invest only a very small proportion of your overall portfolio (five per cent) in gold funds for diversification and as a hedge against rupee depreciation.

Redeem your investment in Pinebridge World Gold Fund and participate in the yellow metal through ETFs, as they closely track the returns of physical gold. Even then, do not assume that investments in gold are risk-free, as gold prices are unpredictable. Unlike other asset classes like debt or equities, gold does not yield interest or dividends and is only driven by demand, supply and speculation. As the outlook for gold prices is currently uncertain, build up your investments in ETFs gradually. Try to benefit from rupee cost averaging by investing a fixed amount each month in gold ETFs.