Why should you buy paper gold?

While gold ETFs offer investors a multitude of advantages in the form of affordability, tax benefits, liquidity and purity, investors still need to be watchful on the following counts

The festive season brings along numerous occasions to buy gold. Instead of purchasing a gold coin or bar from a local jeweller or the nearest bank branch, investors could look at buying gold in dematerialized form, which also serves as an avenue for income generation. There are three channels to invest in paper gold—gold exchange-traded funds, gold fund of funds (FoFs) and electronic gold (e-gold). Currently, 11 asset management companies offer 11 gold ETFs and three gold FoFs in India, while National Spot Exchange Ltd facilitates investments in e-gold.

Introduced in 2007, gold ETFs are open-ended schemes, which invest in standard gold bullion (0.995 purity). A gold ETF invests 90-100% of the funds in bullion and 0-10% in money-market instruments. It aims at offering returns in line with those provided by the domestic price of gold. The fund house appoints authorised participants, who purchase units from the mutual fund in exchange for actual pure gold in the initial phases. They facilitate secondary market trading of gold ETF units through the stock exchange.

Through gold ETFs, investors gain an avenue to participate in the gold bullion market without the necessity of taking physical delivery of gold and to buy and sell that participation through the trading of a security on a stock exchange.

While gold ETFs offer investors a multitude of advantages in the form of affordability, tax benefits, liquidity and purity, investors still need to be watchful on the following counts.

Rules of the game: 

To begin with, it is imperative that investors learn the basic rudiments of investing in gold ETFs. The investor’s holding, denoted in units (usually 1 unit is equal to 0.5 to 1g of gold), is listed on the stock exchange. There is no entry/exit load on gold ETFs bought or sold through the secondary market. However, an investor would be bearing a cost in terms of brokerage for trading gold ETF units. The price of the units in the secondary market will, to a great extent, reflect the price of one unit. The net asset value (NAV) of these schemes would reflect the value of underlying gold.

Tracking error: 

ETFs track indices by measuring the price and yield performance of various asset classes. However, they do not assure mirroring every movement seen in the underlying asset price. They largely seek to replicate the price movements, to the extent possible. When these funds lag behind, it gives rise to a tracking error. Performance of gold ETFs may differ from domestic gold prices due to expenses and other factors. Investors must watch movements in gold prices vis-à-vis the performance of gold ETFs to detect incidences of the error.

Fund house credentials: 

As gold ETFs follow gold prices, evaluating these funds may be largely based on the track record of the fund house, the processes it follows and the post-investment support it offers.

Hidden costs: The cost of purchasing ETFs on stock exchanges is also known as the impact cost. Investors should consider the impact cost and the cost (charges post-investing) structure offered by the fund house. As a thumb rule, they should always opt for the fund which charges the least recurring expenses.

Comparison with benchmark indices: Once the investor is clear about how to evaluate the fund house and the performance of the fund versus the underlying asset, he needs to look at the performance of the fund vis-à-vis the benchmark indices in the Indian equity market.

Comparison across gold ETFs: Investors need to have a relevant benchmark to evaluate performance of investment products with gold as the underlying investment. To aid such a comparison, CRISIL Research launched the CRISIL Gold index recently. The index has a base date of 2 January 2007 and is based on the landed price of 10g of gold in Mumbai. This index tracks the performance of gold prices in the domestic market. Investors can use this benchmark to assess the contribution of gold in the overall portfolio performance and reach an optimal asset allocation considering the risk profile, the financial environment and target returns.

Interestingly, during the 2008 financial crisis, gold prices rose by 28%, whereas the S&P CNX Nifty (Nifty) declined by 51%. While in the latest decline seen in 2011, equity markets (Nifty) have fallen over 18% till 30 August compared with a gain of 30% in gold prices during the same period.

Gold thus acts as an effective hedge especially during turbulent times and is considered as the safest haven for investments. Given the lower correlation to asset classes like equity, debt and other commodities, it becomes a suitable asset for diversification and asset allocation. Further, it has a positive correlation with inflation and hence can be a good hedge against rising prices.

If an investor is clear about investing in gold, there is every reason to include gold ETFs as an asset class in the portfolio, even as part of retirement planning. Nevertheless, they should maintain an optimum asset allocation mix depending on the risk profile and accordingly gold should not form too large a portion of the portfolio.

Source: http://www.livemint.com/2011/12/14211350/Why-should-you-buy-paper-gold.html