Why should you consider investing in gold through ETFs? MintGenie explains

Those seeking to diversify their investment portfolio might contemplate allocating funds to gold. Gold has been a favoured investment for its ability to safeguard wealth and provide stability during periods of economic uncertainty.

The idea to invest in gold has picked up with many asset management companies (AMCs) launching new fund offers (NFOs) in gold ETFs recently. Even Baroda BNP Paribas mutual fund house launched its Baroda BNP Paribas Gold ETF on November 28, 2023, thus, adding to the list of AMCs allowing prospective investors to invest in gold through exchange-traded funds (ETFs).

Repeated instances in historical data consistently demonstrate that gold serves as a reliable safeguard against inflation. Its value typically increases when the purchasing power of fiat currencies declines. This is attributed to gold being a tangible asset unaffected by the same inflationary forces that impact paper money.

Many investors opt for physical gold and SGB investments, not realizing how the benefits of putting money in gold ETFs far surpass the advantages of investing in the former.

Cons of investing in physical gold

In our country, the conventional method of acquiring gold involves purchasing gold jewellery or acquiring gold coins and bullion. Investing in physical gold has maintained popularity for centuries, primarily owing to its perceived stability and value retention.

Despite the various potential benefits associated with physical gold, it carries certain drawbacks that investors need to thoroughly evaluate before deciding to make a purchase. Below are some of the primary drawbacks associated with investing in physical gold:

Costs related to storage and security: Securely storing physical gold necessitates either a home safe or a bank safe deposit box, both of which come with additional expenses. These costs can erode potential returns and diminish overall profitability.

Making charges: When considering gold jewellery as an investment or asset, one factor to be mindful of is the making charges. Making charges can significantly vary based on design and craftsmanship, but they contribute no investment value; you will only receive the value of pure gold.

Restrictions on liquidity: Liquidating physical gold can be a more time-consuming and less convenient process compared to selling other assets such as stocks or exchange-traded funds. Identifying a trustworthy buyer and engaging in negotiations for a fair price can prove challenging, particularly when dealing with larger quantities of gold.

Insurance costs: Insurance against theft, loss, or damage is essential for safeguarding physical gold. However, the associated premiums contribute to the overall cost of holding gold and can become substantial, particularly for larger investments.

Costs associated with gold transport: The transportation of physical gold, especially in substantial quantities, can incur high expenses and may require additional security measures. This complexity and costliness can pose challenges when moving gold between locations or selling it to a buyer in a different area.

Zero income generation: Unlike stocks or bonds, physical gold doesn’t produce any income, such as dividends or interest. Consequently, investors depend exclusively on price appreciation for potential returns.

Potential foregone gains: Investing in physical gold involves directing funds away from other potential investments, such as stocks, bonds, or real estate. This may result in missed opportunities for higher returns in alternative asset classes.

Drawbacks of investing in SGBs

Sovereign Gold Bonds (SGBs) are government-backed securities that provide investors with a means to engage in the gold market without the necessity of acquiring and storing physical gold. Issued by the Reserve Bank of India (RBI), SGBs are denominated in grams of gold. They offer a fixed rate of interest, presently at 2.50 per cent per annum, and the redemption value of the bond is tied to the prevailing price of gold. The bonds have a maturity period of eight years, and investors have the option to exit starting from the fifth year, which can be exercised on the interest payment dates.

Nevertheless, investing in SGBs also has its drawbacks, implying that this type of investment carries its own inherent risks, including:

Restricted capital appreciation: No doubt, SGBs provide a fixed interest rate, typically around 2.5 per cent per annum, guaranteed by the government of India. While this fixed interest rate ensures a consistent income stream for investors, it constrains the potential for capital appreciation compared to physical gold.

In contrast, physical gold doesn’t offer guaranteed returns and its price is subject to fluctuations based on supply and demand. This implies a higher potential for capital appreciation with physical gold, albeit with increased risk.

Inherent exposure to inflation risk: The fixed interest rate offered on SGBs may not always keep pace with inflation, leading to a potential erosion of the real value of the investment over time. Inflation reflects the rate at which the purchasing power of money diminishes, implying that the same amount of money can purchase fewer goods and services as time progresses.

For example, if you invest in SGBs with a fixed interest rate of 2.5 per cent per annum and inflation is running at five per cent, you would effectively experience a negative real return on your investment. In this scenario, the purchasing power of your investment would decrease, leaving you with less money to acquire goods and services in the future.

Sovereign risk: Being government-backed securities, SGBs are exposed to sovereign risk. Sovereign risk pertains to the possibility that the government of India, the issuer of SGBs, might fail to meet its obligations, indicating a potential inability to repay the principal amount or fulfill interest payments to investors.

Benefiting from investing in gold ETFs

Investing in gold has become increasingly popular, and gold ETFs offer a convenient avenue for such investments without the need to purchase and safeguard physical gold bullion. These financial instruments closely follow the price of gold in its purest state. Each unit of a Gold ETF corresponds to one gram of gold, and these ETFs are supported by physical gold, specifically 99.5 per cent pure gold bars.

The value of ETF units is determined by the current market price of physical gold. The advantages of investing in gold ETFs include:

Price matters: Gold ETFs present a more economical avenue for gold investment when contrasted with physical gold. The cost-effectiveness stems from the numerous expenses associated with acquiring and maintaining physical gold, including making charges, wealth tax, and VAT. These additional costs can inflate the purchase price by as much as 20-30 per cent of the total value of gold jewellery. In contrast, gold ETFs, focusing on gold investment, often have a cost ratio as low as one per cent and brokerage fees of 0.5 per cent or less.

Easy liquidity: Gold ETFs are exceptionally liquid financial instruments, readily tradable on stock exchanges. This implies that investors can swiftly convert their gold assets into cash without encountering any confinement or waiting periods. Additionally, gold ETFs rank among the most actively traded assets on prominent stock exchanges, fostering a substantial pool of buyers and sellers. This dynamic market ensures a continuous presence of orders, promoting market liquidity. 

Now compare this with SGBs that come with a lock-in period of five years or can be redeemed only after eight long years. Storing and selling physical gold entails a high-risk factor, as investors lose out on making charges while also fearing the risk of the amount (liquid cash received on sale) being looted on the way.

Versatility of entry and exit: Gold ETFs can be acquired and digitally stored in your Demat account through online transactions. These ETFs are managed by asset management companies and are traded on stock exchanges, allowing you the flexibility to enter or exit at your discretion. The functionality of gold ETFs mirrors that of physical gold, even in the Demat format. Moreover, these ETFs are actively traded on secondary markets, specifically over-the-counter (OTC) markets that operate independently of conventional stock exchanges. This additional trading avenue expands the options for investors to buy and sell gold ETFs, contributing to their accessibility and liquidity.

Compare this to physical gold and SGB investments, wherein hassles mar both entry and exit points of buying and selling gold.

Small investments possible: Gold ETFs provide a cost-efficient means of investing in gold due to their fractional ownership feature. With the ability to buy or sell as little as one unit of the ETF, representing a fraction of a gram of gold, it contrasts with physical gold investments that usually require the purchase of a full bullion bar, often a more expensive proposition.

Hassle-free holding: The electronic storage of units in a Demat account eliminates the risk of theft associated with physical possession. Opting for a Demat account provides a secure and convenient method for holding gold ETFs, mitigating the concerns related to the storage of physical gold. This approach also allows investors to avoid incurring safety deposit locker charges that would typically be associated with securely holding and storing the metal in its physical form.

Live trading: Gold ETF prices are actively updated and traded in real-time on stock exchanges, akin to stocks. Consequently, the value of a gold ETF experiences fluctuations throughout the day in response to changes in supply and demand.

This real-time trading characteristic renders gold ETFs highly liquid investments, allowing for easy buying or selling at any point during the trading day. This liquidity stands as a significant advantage of gold ETFs over physical gold, which may present challenges in terms of quick transactions.

The instantaneous updates in prices also empower investors to monitor the real-time value of their gold ETF holdings. Given the ease of buying and selling gold ETFs throughout the trading day, investors can leverage these ETFs for hedging against inflation or market volatility. In essence, the real-time trading feature of gold ETFs offers a convenient and transparent investment option for those seeking exposure to gold.

Gold is frequently regarded as an uncorrelated asset, indicating that its price fluctuations typically occur independently of other asset classes like stocks and bonds. This offers a significant diversification advantage to an investment portfolio, contributing to an overall risk reduction. It elucidates the growing trend among individuals who are now diversifying their investments by allocating a greater portion of their earnings to gold. 

Nevertheless, the manner in which you invest in gold is crucial, considering the numerous factors associated with the acquisition, retention, and sale of gold.