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What are Gold Exchange Traded Funds and How Do They Work?

    IndianMoney.com Research Team | Wednesday, May 01,2013, 03:03 PM
 

There is an infamous saying "There’s Something About Gold That Brings Out The Avarice Among Men" We have all read of the Californian Gold rush where people from all corners of the globe rushed to grab their gold. Most returned empty handed. We have also read of the gold hauls of SS Central America and SS Port Nicholson and millions of dollars spent on searching and recovering golden treasure from the depths of the ocean. Who has not heard of the legendary "El Dorado" a mythical city of gold or for that matter "King Solomon’s Mines". Closer home in our country we have read of the ancient treasures of Gold and the many empires where gold was so common it was sold in the market places. We were a great nation trading in gold for centuries and attracting a number of invaders who mounted campaigns against us due to their lust for gold. Haven’t we heard the saying "He Who Has Gold Rules Over All". I would like to remind all of you that the team of Financial Planners at IndianMoney.com are always there for you to plan your gold exchange traded funds needs in a most effective and efficient manner. You can explore this unique Free Advisory Service just by giving a missed call on 022 6181 6111.

What are Gold Exchange Traded Funds

We are after all the World’s largest gold importer and it is very necessary for us to know all we can about the Gold ETF. These are basically open ended mutual fund schemes which invest the money collected from investors in Standard gold bullion of 99.5% purity. The investors unit holdings are listed on a stock exchange. These do not require any active management and are passively managed and provide returns in lieu of the physical gold in the spot market. Here a minimum of 1 unit can be purchased by the investor.

So How Do These Gold Exchange Traded Funds Work

Here a Gold ETF has its prospectus vetted by SEBI and collects funds from investors.Here these Gold ETF’s collect money from the investors and buy assets such as Gold, Debt or may retain a Cash component. They are in dematerialized form and units are issued to us Here a mutual fund house purchases gold from a bank. Here at current rates NAV of these Gold ETF may range from INR 2400-2600.An investor may purchase units say 1 gram, 10 grams or in kilograms. You need to have a demat account. Your purchased units are stored in dematerialized form or in your demat account. These are traded mainly bought and sold on a stock exchange such as the NSE. Here units can be easily converted into cash. These funds usually track the price of physical gold in the international market such as London Bullion Market .Here the custodians are responsible for purchasing and guaranteeing the purity of the gold. These also are responsible for the custody of the gold. This gold is 99.5% pure and is generally called 24 karat gold. This gold is fully insured and is not used for lending.

Why Do Different Gold ETF’s Have Different Values

  • Let us consider one unit of a gold exchange traded fund. This is equal to one gram of gold on the date of allotment. The current rates of physical gold per 10g are around INR 27000 - 28000 in the major metros of the country. But I have noticed that different Gold ETF’s have different values…Why Is This So?. Here we see that a certain Gold ETF has its NAV as INR 2495 per unit. Another would have an NAV of INR 2600 per unit. Here a Gold ETF owns cash, debt and money market instruments and of course gold. These funds have a Net Asset Value which is basically the total of all these assets divided by the number of outstanding units. Here the NAV of the fund is calculated after market hours as there is continuous change or movements in the asset base throughout the day. This makes computation of the NAV during market hours almost impossible. Here a Gold ETF trades on the Stock Exchange. As a result there is a different price at almost every instant during the trading hours. Here the NAV listed on the previous day was INR 2499 while the last traded price for that particular Gold ETF was INR 2494.Here it trades at a discount of about INR 5 at that point. There are a number of big market players who take advantage of these fluctuations in price for arbitrage opportunities. This brings the market price closer to the NAV price.
  • Another important factor for the difference in NAV is the tracking error. This is basically the difference between the Physical gold price and Gold ETF returns. This occurs due to large redemptions, recurring expenses, dividend payouts and so on. This tracking error is not expected to be higher than 2% under normal circumstances.
  • If a fund has started operations 1 year later than another Gold ETF and the expense ratio is same then the difference in NAV is because of tracking error. A fund with a lower tracking error has a higher NAV. If the fund has a higher exposure to the money market then the tracking error would be high.
  • Gold ETF invest a minimum of 95% of the corpus in gold and about 5% in money market instruments. They are passively managed and do not buy or sell gold to take advantage of fluctuations in gold price. Most of the gold ETF’s replicate the movement of gold by maintaining a very high corpus in gold .Gold ETF’s are not supposed to outperform gold.

Shouldn’t I Go For The Cheapest NAV As I Can Procure Maximum Number Of Units

Here many people compare the last traded price of 1 gold ETF with another gold ETF and arrive at the conclusion that the cheapest NAV is the best fund to purchase. Here the last traded price depends on the NAV. Here NAV depends on the assets such as Gold, Debt and Cash owned by the Gold ETF. Here comparing one with the other does not serve a purpose. Here a cheap NAV is one which trades at a significant discount to its NAV.

Brokerage And Fees Involved in Gold ETF’s

Here a brokerage of 0.4%-0.5% is charged for each transaction of the Gold ETF. We have to pay annual maintenance charges for the demat account. Here the expense ratio in a Gold ETF can be around 1% of the amount and an extra 0.5% in case of fund of funds. Here the fund house incurs costs when it stores the physical gold with the custodian. This may translate to a range of 0.1-0.4% which is added in the expense ratio .Hence depending on the fund house the expense ratio may vary from 0.5-1.5% .There is no entry load only brokerage commission charged by the broker when you purchase units .Management costs up to a maximum amount of 1.5% held. No exit loads charged .Only a selling side commission. Here Gold ETF can put or maintain part of their gold holdings with banks and earn a nominal rate of interest. This means better returns for investors. Here Gold ETF’s in the year 2012 generated returns to their investors in the range of 10-11%.However the outlook this year is bleak as only 3-4% is expected as returns.. However with Gold One Never Knows...

Advantages Of Gold Exchange Traded Funds

  • Here in India mainly in rural areas many people hide their gold Jewellery in Cupboards or so called secret safe areas. Many of them would be shocked to find their gold savings stolen. Many times these jewellery items would be stolen by close relatives or family members. Here in gold ETF the returns are similar to Physical Gold and rest assured they cannot be stolen. Here if gold and jewellery is stored in the bank locker we have to pay charges. Not so for ETF’s.
  • There is no case of being cheated and sold impure gold like in physical gold and jewellery. Here depending on the ETF fund we invest, 10 units of these funds are similar to holding 10g of Physical gold. There is no need to worry about the quality of gold held as it is 99.5% pure at 24 karats.
  • Here if you want to sell physical gold you might have to search for a buyer. Gold ETF are very liquid and can be sold on the market at anytime. Also you might not realize the full value or the market value of the physical gold.
  • With physical gold it might not be possible to buy a single gram of gold. This is possible with gold ETF. This makes gold ETF very affordable.
  • A Gold ETF can be bought or sold anytime during market hours. Here physical gold such as coins or jewellery may not be sold easily and banks might not take back gold coins even when purchased from them.

Disadvantages Of Gold Exchange Traded Funds

  • They Aren’t The Real Thing: No matter how much you praise an ETF it remains in paper .Physical Gold is the real gold. Even in times of uncertain political conditions and upheaval gold remains valued and in demand.
  • Gold is an asset diversifier. Gold has not been correlated to the movement in equities. It tends to move in the opposite direction to equities .It has been noticed that when equities start hurting and share prices fall gold value rises.
  • Gold is an inflation hedge .Its value always remains intact .Gold is durable. It lasts.
  • Gold is mainly used as a reserve currency by the central banks. Its value doesn’t depend on economic policies or inflation. It retains its value even if the value of the dollar goes down.

Tax Implications Of Gold ETF

  • The Gold ETF’s are treated as gold for tax purposes. The Gold ETF needs to be held for at least 3 years to avail tax benefits under exemption from long term capital gains tax under section 54 F or Section 54 EC. of the Income Tax act 1956.
  • You will have to pay wealth tax on the market value of Gold ETF lying in your account as on March 31st of that year. The tax payable is 1% of the market value of these assets exceeding 30 Lakhs

Here I would like to end this article by asking you to avail of this unique opportunity to invest and earn returns by using the Gold Exchange Traded Fund. No matter that the price of gold is now falling these funds gave stupendous returns in the period from 2008 to 2012.They exceeded the returns of most asset classes. Imagine if you had invested in Gold ETF in the year 2008.What would have been your returns at the end of 2012? "There Is Nothing Wrong With Men Possessing Gold .The Wrong Comes When Gold Possesses Men".

IndianMoney.com Research Team

The research team at IndianMoney.com comprises of certified and experienced professionals who share the company's vision to make every Indian financially literate by equipping every Indian with right and unbiased advice. IndianMoney.com research team provides newsletters, articles, videos and FAQs on various financial products and concepts only to help you make wise financial decisions.

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