Gold Exchange-Traded Funds provide gold's stability without the hassles of physical ownership, while offering the flexibility of stocks

Gold has always been a traditional safe haven particularly in uncertain situations of geo-political tensions, financial and economic turmoil. Many generations have taken advantage of investing in the security of gold. However, even this traditional investment has witnessed considerable changes with the advent of financial innovation.

The newer generation can now take benefit of security provided by gold which is more convenient, cost effective and eliminates the hassles of physical ownership by investing in Gold Exchange-Traded Funds (ETFs). An ETF is an exchange traded passive fund that tracks any index, or a commodity.  In this case, a Gold ETF invests in gold bullion and tracks the physical gold price. One Gold ETF unit is equal to 1 gram of gold and is backed by physical gold of highest purity, making it a dematerialised form of physical gold.

This gives Gold ETFs twin advantage of security of gold investment in combination with flexibility of the stock market, as they are traded on stock exchanges like stocks of any listed companies and can be traded continuously at market prices. Upon redemption of a Gold ETF, investors receive cash equivalent instead of possession of physical gold.

To take maximum advantage of flexibility and security that a Gold ETF has to offer, it is advisable to take some safeguards to achieve maximum returns. The first lookout for an investor is to choose a Gold ETF with lower expense ratio. Expense ratio is the yearly management fee charged by the fund houses, which is usually a percentage of the fund’s assets under management (AUM) and is used by the fund house to cover their administrative, advertising and various other operational costs. A lower expense ratio is significant as it would eat less into the investors’ returns and result in higher net returns for them, maintaining the cost-advantage of Gold ETFs when compared to storage costs and making charges of physical gold. The second precaution for investors is to examine the tracking error.

Tracking error measures how closely the fund mirrors the underlying index or the commodity and how different is its performance from that of the benchmark. A low tracking error signifies how effectively the fund reflects the performance of the underlying asset and a high tracking error indicates a higher deviation. Tracking error is an extremely critical performance metric for investors due to a number of reasons. Firstly, it displays consistency of performance. A lower tracking error guarantees reliable tracking of the actual price changes of physical gold. Secondly, low tracking error resonates the efficiency of the fund management. This metric can be used by investors to identify the Gold ETFs that have better performance and provide higher returns. Thirdly, lower tracking errors indicate lower costs incurred by the fund managers, thereby leaving higher returns for investors to enjoy.

Having many benefits, one cannot stress enough on the importance of tracking error.

It is known that higher expense ratio and management fees can lead to deviation of the performance of Gold ETFs from the underlying assets, i.e., physical gold. In addition, investors should also be aware of the cash holdings of a Gold ETF. Higher cash holdings again lead to deviation in their performances.

Since ETFs are similar to stocks, liquidity is an important metric. Higher the liquidity of a Gold ETF, lower is the performance deviation. Regular rebalancing the portfolios is an important aspect of any fund, and in doing so Gold ETFs incur costs associated with sales/purchase of physical gold. This again contributes to tracking error.  Thirdly, like stocks and commodities, Gold ETFs are subject to market volatility. Since the underlying asset – physical gold – can be volatile due to geo-political conditions, economic and financial factors. Finally, while buying Gold ETFs, one should not forget to factor in the capital gains tax. Long-term capital gains, if held for more than 3 years, are taxed at 20 percent.

The investors, however can take the benefit of indexation. Short-term capital gains as usual are added to income and taxed at applicable tax slab rate. So, it would be prudent to understand the implications of taxation before investing in Gold ETFs. For young and modern investors, investing in Gold ETFs is a modern and efficient way to invest in gold. For them, Gold ETFs provide a winning combination of traditional security of gold with the benefits of stock market investing. Using an approach of regular and disciplined investing through systematic investment plans (SIPs), young investors can take the advantage of rupee cost averaging and alleviate the impact of market volatility. With varied benefits and much needed flexibility,  Gold ETFs can definitely substitute physical gold investment in one’s portfolio. Young generation should take advantage of this modern approach to gold investing with a long-term perspective.

(The writer is Associate Professor at Amity University, Noida. The views expressed are personal)