Should I Invest in a Gold ETF ?
This post is inspired by a question that I received this week from one of my friends.
She asked me, "Rohit, I have bought some physical gold bullion. But I think, buying physical gold these days is risky. Would you please suggest an alternative solution to overcome this challenge?"
That's when I told her, 'the best alternative to physical gold is a gold ETF'
I myself invest in gold ETFs.
And I have my own reasons to do so.
Of course, every investment has its pros and cons.
And a gold ETF is not an exception.
So I decided to write this post, so that you can get some clarity about gold ETFs.
Specifically, I want to discuss the pros and cons of investing in a gold ETF.
Because, I believe, you should not invest in something that you do not understand.
Before we discuss gold ETF, let's first understand, why gold in the first place.
Why should we consider adding gold to our investment portfolio?
Well, gold comes with a very long history and it is less likely to lose value compared to a paper currency.
I consider gold as real money.
I am convinced, based on my research, that the paper currency system that exists in the world today, is likely to fail.
There is too much money printing happening and it is not likely to sustain in the long run.
Something will break eventually.
That's where the value of gold comes in.
If you study history, you will find that, whenever paper currency starts to lose value, people start shifting their capital to hard assets like gold and silver.
We can say, people start moving from false money to real money.
Gold is a very good hedge against inflation.
Rising commodity prices also means rising gold prices.
Gold is very liquid.
It is easy to convert gold into cash, unlike other assets like real estate, where it might take months to liquidate, if at all there is a buyer in the first place.
Moreover, throughout history, gold has always been considered as a sign of wealth.
Instinctively, human beings have always known the value of gold.
Gold is also an insurance.
It is an insurance against mismanagement of the economies by the governments of the world.
It is an insurance against an economic crisis.
It is an insurance against easy monetary policies or reckless money printing.
When the system gets flooded with a lot of paper money, that is when the value of gold increases.
Gold cannot be printed or created out of thin air.
It is scarce and that's why it has got value.
Gold cannot be artificially created.
In uncertain economic times, people like to hold their wealth in gold.
There are many other benefits to owning gold.
But these were the few that I wanted to point out to you.
Now let us turn our attention to gold ETFs.
As per my friend's question, she feels uncomfortable buying physical gold bullion right now.
So the next best alternative is a gold ETF.
So why gold ETF ?
Let's try to understand the benefits of owning gold ETF shares.
The simplest definition I can give you is that, it is like owning digital gold.
You own gold but it is not in physical form.
It is digital.
It is there in your demat account.
The first benefit is that, a gold ETF simply tracks the domestic price of physical gold.
So you are getting a direct exposure to the gold price, which is exactly you want, when you are buying gold.
Next, gold ETF is a passive investment.
It is not actively managed by a fund manager.
Unlike most equity mutual funds, which are actively managed, there is a risk that the fund manager might mess up or the fund manager might take some bad decisions with regards to managing the portfolio.
That risk you don't have with a gold ETF, because gold ETF is a passive investment, designed to track the domestic price of physical gold.
Since it is digital gold, you don't have any risk of theft.
You also don't have any storage cost as well.
Next, an ETF is nothing but an exchange traded fund.
You get a lot of liquidity.
And by liquidity, I mean the ease of buying and selling.
It is just like buying and selling stocks on the stock exchange.
You can do the same with gold ETF shares.
Moreover, for a gold ETF in a particular country, the price is the same for the gold ETF shares across that country, which is a great benefit.
If you go to buy physical gold, you will find one price in one city and you will find a different price in some other city.
The price may vary depending on the location within the same country.
That doesn't happen with a gold ETF, because it is traded on a national exchange.
For example, in India, the gold ETF is traded on the National Stock Exchange and the Bombay Stock Exchange.
There is transparency as far as gold holdings are concerned.
You have to open a demat account.
You also have to go through a client verification process.
Plus, all the records are stored digitally.
You have proof of exactly how much gold you own.
That's what I mean by transparency.
Very important point to note here is that, all these transactions in gold ETFs are regulated transactions.
So, for example, in India, you have the SEBI (Securities and Exchange Board of India), which is a regulatory body that keeps a watch on the activities of mutual funds and ETFs.
Regulation is always good for investors.
In fact, regulation always exists to protect the best interests of investors.
When you own a gold ETF, you don't have to pay any premium or any making charges, which you will most likely incur when you are buying physical gold.
That's another very good advantage of owning gold ETF shares.
And of course, the purity of gold is guaranteed when you own gold ETF shares.
It is mentioned in the ETF product document.
The product document of a gold ETF will have all the details regarding that gold ETF.
You will find that, gold ETF shares are backed by physical gold.
How much is this backing, depends on country to country and market to market.
Just to give you a quick example, let's say there is one gold ETF share that is backed by a one gram of physical gold.
That's called gold backing.
When you own gold ETF shares, you know exactly in grams, how much you own.
Although you own it digitally, you know in terms of weight, how much you own.
Moreover, gold ETF is also good from a tax point of view, because when you buy gold ETF shares, you don't have to pay any value added tax, you don't have to pay sales tax, you don't have to pay any wealth tax as opposed to physical gold.
Another benefit is that, gold ETFs can also be used as a collateral for loan.
That's an added benefit.
Another point is that, unlike mutual funds, which can have entry and exit loads, which is a cost to the investor, the gold ETF does not have an entry and exit load, because you are trading it in the market.
I would say, gold ETF is relatively low risk, because when you buy a stock of a company, there is market risk, because if the market goes down, the stock might also go down.
But there is additional risk with stocks, in a sense that if the management of a company takes really bad decisions with respect to the operations of the company, then you have that management risk, which can adversely impact your investment in that stock.
That doesn't happen with gold ETF, because gold ETFs are simply tracking the domestic price of physical gold.
There is no active portfolio management here.
So, in that sense, I am saying that gold ETF is relatively less risky.
It does have risk, but it is relatively low.
It has risk in terms of the gold price going up and down.
And of course, we can hold these gold ETF shares for as long as we want.
Just because it is digital doesn't mean that, there is a time limit on holding the shares.
This can be held for as long as we want, just like we can hold the stocks for as long as we want.
And the name itself is suggesting that, it is an exchange traded fund, meaning I can buy it now and sell it within minutes on the exchange.
So, it's easy to instantly find a buyer for gold ETF shares.
There is constant trading happening on the exchange.
This is very much unlike mutual funds, where the price per unit of a mutual fund is decided after the day is closed.
So, for traditional mutual funds, there is one price on a particular day.
In the case of gold exchange traded fund or any other exchange traded fund for that matter, the price is going up and down continuously.
The price of a gold ETF is based on the demand and supply for the shares.
Those were the most important benefits of owning gold ETF shares.
Mind you, I might not invest in a gold ETF, just because it has all of these benefits.
For me, just one or two benefits might suffice.
For example, the ability to track the gold price and liquidity is enough for me.
The tax benefit might not be as appealing to me as an investor.
There are pros and cons of any investment.
So let's try to understand, what should we be concerned about when we are investing in a gold ETF?
The number one concern is counter-party risk.
What is counter-party risk?
Well, when I buy physical gold, then that is my money with me.
But when I buy a digital gold, then that is not my money with me.
That is my money with someone else.
This means that, there is a counter-party to that transaction.
When I buy physical gold and hold that gold with me, there is no counter-party after the transaction is complete.
Nobody owes me anything after the transaction is done.
One way to understand counter-party risk is, a simple fixed deposit investment.
You might see the money in your internet banking account or your mobile banking app.
But at the end of the day, that money is with your bank.
The bank control controls it, not you.
Your fixed deposit simply represents a liability of your bank.
They are liable to pay you money against your fixed deposit, that you have with them.
And as we all know, banks do go bankrupt.
History is filled with examples of banks going bankrupt globally.
This is called as counter-party risk.
Moreover, there are chances that, liquidity in gold ETF shares might dry down.
By drying up of liquidity, I mean, we may not be able to find a buyer for those shares.
This is very less likely to happen.
But we just need to be aware of this risk, because what we are investing in here, is just a paper asset, not a physical asset like a gold coin.
Same concept applies to stocks of companies.
Another point to consider is that, when we sell gold ETF shares, we don't get gold, we get cash, which at the end of the day, is just paper currency.
And we know that, paper currency is not real money.
So, by investing in a gold ETF, all we are doing is that, we are getting exposure to the price of gold.
It is not actual gold.
It is not actual physical gold.
Anything that is digital is always subject to hacking risk.
If my account gets hacked, then anybody can do a transaction on my behalf.
You can't do that with my physical gold coin, because my gold is with me.
My gold is not on the internet.
Anyways, in summary, I would say that the benefits of investing in a gold ETF far outweigh the disadvantages of investing in a gold ETF.
I myself put my money in gold ETFs, but it is never more than 10% of my net investable assets.
And by net investable assets, I mean the amount of money that I have allocated to build my financial portfolio, which is there to help me achieve my financial goals.
So, my investment in physical gold and gold ETF combined will always be less than 10% of my net investable assets.
I know exactly how much risk I am taking.
In general, I feel that gold or gold ETF combined should not be more than 10% of our net investable assets.
That was my little take on gold ETF.
Mind you, I am not making a case for or against gold ETF shares.
All I am doing here is trying to educate you about gold ETFs, so that you can make informed decisions.
I invest in a gold ETF, because I have my own reasons for doing so.
And just because I own gold ETF shares, doesn't mean that you have to own them too.
You have to take a call based on your understanding of gold ETFs, not because someone told you to do so.
You have to take full responsibility of your financial portfolio.
Even if you are hiring an investment advisor, at the end of the day, you are the one who is responsible.
So, take educated financial decisions.
And I am here to help you do that.
You have to become a smart investor to earn better returns on your portfolio.
Talking about investing, if you are truly serious about achieving financial freedom in your life, then you will need to either start creating or start buying assets, because ultimately it is your assets that will give you the passive income you need.
Creating assets is whole another story, which will require more advanced training.
As far as buying assets is concerned, here you will have to become an investor, not just an average investor, but a professional investor.
When you start investing, you start creating assets and it is these assets that will give you your cashflow in the long run.
And it is this cashflow which we call as passive income, that will make you financially free.
Rohit Musale, CFA
19 December 2022