The idea of purchasing and owning gold has always enjoyed a special place in the mindspace of most Indians. Gold ownership has always been viewed as a symbol of status in India. Most of the gold owned by individuals in India takes the form of physical holdings and family heirlooms which are handed down across generations. But, from the perspective of constructing an investment portfolio, there is a world of difference between purchasing and investing in gold. And we must develop the right perceptions about investing in gold, before we actually go ahead and include gold in our investment portfolios. Therefore in today’s post I’m going to delve deep into the subject of investing in gold. Right from talking about how purchasing physical gold is different from investing in gold, the avenues we can use to invest in gold and how to effectively employ gold as an asset class in our investment portfolios.
The first aspect that we need to understand when looking to operate with exposure to gold in our portfolios is that purchasing gold in its physical form is completely different from investing in gold. Whenever we purchase physical gold, we must remember that most purchases of physical gold are usually consumed for personal use. This makes physical gold a consumption oriented asset, not a growth oriented investment asset. Moreover holding physical gold comes with other drawbacks such as risk of theft, risk of impurity and making charges. This means that we must purchase physical gold only when we want to accumulate it for present or future use. On the other hand, investing in gold involves the act of tracking the prices of gold on a real time basis in order to profit from changes in gold prices. And it would be possible for us to do this only when we gain exposure to gold through digital and non physical means such as gold mutual funds, gold ETFs and Sovereign Gold Bonds (SGBs). This goes to show that digital means are the only viable means to invest in gold. Therefore, when assessing portfolio exposure to gold we must only take stock of non physical gold instruments such as mutual funds, ETFs and bonds and exclude all forms of physical gold we have on hand.
Having understood how accumulating gold is different from investing in gold, let us now look at the various avenues investors can make use of to invest in gold. Gold mutual funds and gold ETFs are two of the major avenues for investors to gain portfolio exposure to gold. Both of them are ideal options for investors who wish to gain exposure to gold in a phased, systematic manner. Both of these avenues broadly work with the same mechanism but have subtle differences. Any money invested in a gold ETF is used to buy 99.5% pure gold bullion. These purchases are denominated in grams and reflected as ETF units in the investor's portfolio. Therefore, holding one unit of a gold ETF is equivalent to holding one gram of physical gold. On the other hand gold mutual funds put money given to them by investors into gold ETFs. Therefore, while gold ETFs directly purchase physical gold, gold mutual funds give investors exposure to gold using ETFs as a vehicle. Therefore, price movements in these two products are heavily dependent on gold prices in the physical market. A major point of difference between the two is that investors must have a demat account to transact gold ETFs, while there is no such compulsion when it comes to gold mutual funds. Gains from gold mutual funds and ETFs are subject to tax at applicable slab rates. Look at the infographic below to understand the structure of a gold ETF.
Another very viable avenue through which investors can gain exposure to gold in their portfolio is the Sovereign Gold Bond. Sovereign Gold Bonds (SGBs) are offered by the Reserve Bank Of India in multiple tranches at regular intervals during a particular financial year. Interested investors are given a set window within which to purchase and invest in such bonds. These bonds come with a tenure of eight years and a lock in period of five years. Investors are compensated for this lack of liquidity through the fact that gains made on the redemption of these bonds at the end of the eight year tenure are completely free from tax. They can also be traded in the secondary market through stock exchanges if they are held in demat form. Also, SGBs offer investors interest at the rate of 2.5% on the initial amount invested. But this interest amount is taxable in the hands of the investor at applicable slab rates. Therefore, these bonds serve as an ideal avenue for investors who wish to invest a lumpsum amount in gold. They are also ideal for those who wish to accumulate gold for a long term goal such as a child’s marriage which is more than eight years away. They can also serve as collateral securities against which investors can avail loans. Finally, from the standpoint of taxability these bonds are ideal for those who come under the lower tax brackets or those who fall outside the purview of the tax net completely.
Let us now look at the kind of long term returns gold generates as an asset class along with the best way to employ gold as an asset class within our portfolios. As an asset class, gold has broadly beaten inflation by about 1-2% over the long term. Such returns can at best be termed as inflation linked returns rather than inflation beating returns. Therefore gold cannot be included in an investment portfolio to play the role of a wealth creator. But we often forget that wealth protection has an equally important role to play in the process of wealth creation. And this is where gold comes in. Gold is a safe haven that most investors flock to during an economic crisis. Also, gold as an asset class enjoys a low degree of correlation with asset classes such as equity and debt. This means gold as an asset class performs relatively well during periods where other major asset classes such as equity and debt underperform. Therefore, gold should be employed to play the role of a wealth protector in a portfolio through an added layer of diversification at the asset class level. To derive the most value from the gold component of our portfolios, we must ensure that our exposure to gold does not exceed 10% of our overall portfolios. We must also moderate our return expectations from gold and treat returns from our gold component as a bonus.
To put everything together, purchasing and accumalating gold for personal use is different from investing in gold to profit from variations in gold prices. Only digital and non physical forms of gold should be counted when assessing portfolio exposure to gold. Gold mutual funds and ETFs are ideal for those who wish to systematically build a position in gold. Sovereign Gold Bonds are best suited for those who fall outside the purview of income tax or wish to accumulate gold for a financial goal that falls due after 8 or more years. Given that long term returns from gold as an asset class are inflation linked (inflation +1-2%) at best, gold as an asset class would be most useful when employed as a portfolio hedge to serve as a safety net during times of an economic crisis. It would also benefit our portfolios by adding another level of diversification at the asset class level. This means that gold is best employed within our portfolios as a wealth protector and not a wealth creator. Therefore, those of us who wish to employ gold as an asset class within our portfolios must moderate return expectations from gold and treat any returns from gold as a bonus. Understanding and employing gold in this manner within our portfolios would automatically help us optimise portfolio returns a lot better.