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Session 22: How to Smartly Invest in Gold?

We are glad to have you with us for our Twenty-second Session - How to Smartly Invest in Gold?

So let us now begin with our learning session today.

In contrast to other major asset classes, such as equities - which derive their value from the underlying businesses; or real estate - which could provide rental yields for you along with the potential for capital appreciation; or debt - which pays regular interest; gold possesses no such distinctive characteristic(s). But yet gold has always occupied centre stage in the evolution and development of the monetary system. This is because, gold is considered as a store of value due to its ability to counter inflation over the long run and act as a hedge during uncertain times. You see, gold as an asset class usually has a negative correlation with other asset classes and therefore can be of help in defence and act as a useful portfolio diversifier. Thus as an investor you must hold some portion of gold in the investment portfolio.

Mind you, there are a host of ways you could hold gold, but in this session we will tell you about the smart way of investing in gold. But before we do that, let's first understand why gold commands such importance.

Importance of Gold

  • (As mentioned earlier, gold has a...) Store of value (...because it's a long-lasting precious metal, used for exchange for over centuries. Moreover, as Governments in the developed economies have resorted to printing more money, which in turn reduces its value; gold has become bold, commanding a better value.)

  • (Recognising the store of value, gold acts as a...) Reserve Currency (...because central banks and Governments of various nations maintain gold reserves in order to secure their position during uncertain times. The central banks use these reserves as a guarantee to cash in their promises and pay their depositors and note holders.)

  • (Also, it is a...) Hedge against economic pressures (...such as inflation, deflation, current devaluations, fiscal strains, etc.; because of its tendency to be defensive and do well or remain bold during such times.)

  • (Further, it can be used for...) Pledging during emergency purpose (...Many banks and gold financing companies have started offering secured loans to individuals, who wish to pledge their gold at a reasonable interest rate, for a pre-specified tenure.)

  • (Likewise, gold can also enable...) Portfolio Diversification (...due to a negative correlation being usually depicted with other asset classes.)

Apart from what we just explained, gold also has some industrial demand too, since it is used in thermal and electrical conductors and also has medical utility. Similarly, there's demand for the precious yellow metal to make jewellery / ornaments. People in India have a special fascination and emotional attachment with gold and often buy them on auspicious occasions like marriage, festivals and social events. Moreover, many Indians like to hand down their gold to the next generation in the form of jewellery and ornaments. For investment purpose, conventionally, many people prefer to buy gold bars and coins in the physical form.

But here in this session we would like to defy the rationale of buying gold in the physical form and explain the smart way of holding this precious yellow metal, which in turn could yield you better returns.

Perils of investing in physical gold

If you are a hard-core believer of investing in physical gold, the only advantages that it can offer you are "touch, feel and see" along with the choice of converting the gold coins and bars collected by you into jewellery at some point in time. However this fascination of investing in gold in the physical form has some disadvantages. Like...

  • High holding cost (...You see, holding gold in a physical form comes at a high holding cost. It refers to the cost of holding a security. Hence, the locker rent that one pays for stacking gold in the bank locker constitutes the holding cost.)

  • Quality (...Unless the gold that you buy is from a reliable source or is 'hallmarked', the quality of the same is always under question. It often happens that when you buy a certain amount of gold (either coins or bars or jewellery) from a jeweller and sell it years later to another, the quality of gold is questioned, thereby possibly resulting in loss of its true value.)

  • (It may also happen that the jeweller or the bank may sell gold at a...) Premium ( the market price - which usually ranges from 5% - 10% inclusive of making charges in the case of jewellers, and up to 15% in the case of banks. So in that sense, the pricing of gold varies depending on the vendor and it is ultimately you who are at loss since you are acquiring gold at a higher price.)

  • Re-sale value (...As explained earlier...while selling your physical gold, you must have encountered some horrendous experiences of your gold merchant telling you "this is not 100% pure - it has some mixing", thus questioning the quality of the gold held by you. Moreover, if the quality of the gold held by you is of the finest purity or 'hallmarked', then while converting gold into jewellery, making charges are deducted. And as far as banks are concerned they will refuse to buy-back your gold as they are not allowed to do so due to RBI regulation.)

  • Tax (...If you are a gold bug then you would also be taxed by wealth tax on the value of the physical gold held by you. Also, you attract the provisions of the Income Tax Act, depending upon on how you have sold your gold holdings.)

Now having known the demerits of investing in physical gold - which may have made you jittery - let us move a step ahead and discover a better or a smarter way of investing in gold that is the unconventional way.

The first one under that is...

Gold Exchange Traded Funds (Gold ETFs)

Before we explain Gold Exchange Traded Fund, let's first understand what is meant by Exchange Traded Funds (ETFs). ETFs are mutual fund schemes that are listed and traded on a stock exchange. They represent ownership in an underlying security, commodity or asset. Hence given that background...

  • Gold ETF is an instrument representing ownership of gold asset (...Gold is held on your behalf by an appointed custodian for the ETF.)

  • They are open-ended funds that track prices of gold (...and each unit of gold in the fund that you buy is approximately equivalent to 1 gram of gold. Some funds even offer units equivalent to ½ gram of gold.)

  • Gold ETFs are traded on the stock exchange (...and hence can be bought like stocks on a real-time basis)

  • (But...) To own units of gold ETFs you need to have a demat account along with a share trading account

  • (When you buy gold ETF, you get...) A contract indicating your ownership of gold (...equivalent to the rupee amount of your investment. You never get to see or receive delivery of the gold you own. So, now one may ask - what's the advantage if I can't touch, feel and see the precious yellow metal.)

Well, Gold ETFs offer a host of benefits...

Advantages of investing in Gold ETFs

  • Convenience (...In the absence of physical delivery they are easy to hold. Being traded on the stock exchange they can be easily bought and sold at the market value. Moreover, you do not have to worry about the storage and security aspects that are typically associated with investing in physical gold.)

  • Low cost (...Being in the non-physical form, it reduces your holding cost, in the form of locker rent, which otherwise you would have defrayed for holding gold in a physical form. The only cost that you will be incurring here is the cost of maintaining a demat account and a trading account with a broker, and the nominal brokerage for each transaction.)

  • Quality (...You do not have to worry about the quality of the gold that you own; because as per the Securities and Exchange Board of India (SEBI) regulations, the purity of underlying gold in GETFs should be 0.995 fineness and above.)

  • No premium (...Unlike physical gold where many of you may have encountered the horrendous experience of the gold vendor charging a premium; transacting in Gold ETFs is at the prevailing market price.)

  • Resale value (...As mentioned earlier, since gold ETFs are traded on the exchange they can be easily sold in the secondary market on a real-time basis, i.e. at the prevailing market price during the trading hours of the exchange. This is convenient and precludes you from encountering horrifying experiences, which you otherwise face while selling physical gold where the jeweller doubts the quality of gold held by you - and therefore pays you a less price, while in the case of jewellery deducts making charges that are added while buying gold. And as far as banks are concerned, they refuse to buy back gold (due to RBI regulation).)

  • Taxation (...Holding gold ETFs does not attract wealth tax. From an income tax point of view, the tax implications of gold ETFs and debt mutual funds as per the existing tax structure are the same. Short-term capital gains are taxed as per your income tax slab, while the long term capital gain, if any, is liable to long-term capital gains tax at 20% (after allowing for indexation benefit) or 10% (without indexation benefit), whichever is less.)

The second unconventional way to invest in gold is through...

Gold Funds

  • Gold funds are Fund of Fund schemes which invest their corpus into an underlying Gold ETF

  • They benchmark their performance against the prices of physical gold (...Hence by doing so, they attempt to provide returns that closely correspond to the returns of its underlying Gold ETFs.)

  • (So...) Gold funds are passively managed

  • (And one need not have a demat account to own gold funds since...) Units of gold funds (i.e. your holdings in gold) are allotted in a paper form which are reflected in the mutual fund account statement

  • (However...) Annual expenses charged by Gold funds may be comparatively higher than what are charged for Gold ETFs (...but yet lower as against the cost of owning gold in the physical form.)

  • The cost includes fund management cost along with the cost of Gold ETFs

  • Gold funds, along with lump sum investing, also offer investors the Systematic Investment Plan (SIP) mode (...which is an effective and convenient way of investing regularly in gold.)

Advantages of investing in Gold Funds

Being fund of fund schemes with Gold ETFs as the underlying scheme, Gold funds have most of the advantages offered by Gold ETFs, but with the additional benefits of...

  • Added convenience (...One need not necessarily have a demat account to invest in gold via Gold funds; as units of Gold funds are allotted in a paper form which are reflected in the mutual fund account statement.)

  • (Since holding a demat account is not necessary, it further...) Reduces holding cost as one does not have to incur charges such as:

    • Annual maintenance charge for holding a demat account

    • Delivery brokerage charges

    • Transaction charges (while investing in demat mode)

  • Liquidity is not restrained by the fund ( you can subscribe and redeem units on all business days directly from the AMC at the prevailing NAV and not have to depend on the liquidity on the exchange as in the case of Gold ETFs)

  • Through the SIP mode of investing it also provides investors with advantages such as:

  • Discipline while investing

  • Rupee-cost averaging

  • Compounding

As far as tax implications are concerned, they are just as in the case of Gold ETFs which we explained earlier.

Points to evaluate while exploring the smart
ways of investing in gold ...

  • Percentage of gold holdings (...Ideally while investing, gold ETFs should hold significant portion of the portfolio in gold, and a gold fund in gold ETF; - and not hold much cash, or else the impact may be seen on performance.)

  • (For this purpose one should see the...) Tracking error (...It would help you evaluate how much the Gold ETF has deviated from returns generated by the benchmark, due to the Gold ETF's holding in gold and cash respectively.)

  • (Then you must see the...) Expense ratio (...This is because gold ETF with a lower expense ratio would translate into relatively higher returns.)

  • (If you want to invest in Gold funds being appealed by the added benefits they offer, you should see the...) Performance Track Record of Gold ETF to judge how much returns you can expect (...This is because, as learnt earlier, the returns of a Gold fund would closely correspond to that of its underlying Gold ETF.)

Now before we end our learning session today, here are some points you need to remember...

Points to Remember...

  • Gold is a store of value (Recognising the store of value, central banks across the world have maintained gold reserve in order to secure their position during uncertain times.)

  • (So...) Gold is also used as reserve currency

  • Gold acts as a hedge during uncertainties

  • (Thus...) Gold can be an effective Portfolio diversifier

  • (But...) Avoid investing in gold in the physical form

  • Investing in physical gold carries with it high holding cost

  • (Moreover...) You also tend to pay more than the market price due to the premium charged by jewellers and banks

  • (Also...) If the physical gold that you've bought is not from a reliable source then its quality can come under question

  • Gold ETF and Gold fund are unconventional and smart ways of investing in gold

  • Gold ETFs are listed on the stock exchange

  • (While...) Gold funds are open-ended Fund of Fund schemes

  • Both Gold ETF and Gold funds benchmark their performance against the prices of physical gold

  • By buying into Gold ETFs and Gold funds you represent ownership of gold asset (...but your holdings are either in demat or paper form)

  • Gold ETFs and Gold funds are convenient ways to invest in gold

  • (Moreover...) The cost of investing in them is low and quality is not questionable

  • (Also...) Transacting in Gold ETF is at the prevailing market price, while in the case of mutual funds it is at the prevailing NAV (...So there's no question of paying a premium or fetching less at the time of sale.)

  • Gold funds offer you the option to invest via the SIP mode (...which is not available in the case of gold ETFs.)

  • (And last but not the least...) While investing in gold the smart way, you should evaluate: percentage of gold holdings, tracking error, expense ratio and the performance track record

So to end our learning exercise today, we now invite you to test your learning by taking up this simple quiz (and win exciting prizes!)

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Disclaimer: The contents of this document are only for informative purposes and are not to be used or considered to be an offer to sell or buy units of Franklin Templeton Mutual Fund schemes. This video is for information purposes only, provided on an 'as is' basis. Nothing in it should be construed as personal financial advice. You are responsible for your own investment decisions and you should seek advice concerning suitability from your investment adviser regarding any of the investments mentioned. The video is for personal non-commercial use only and may not be copied, stored, redistributed or broadcast in any way. We recommend you read the complete Terms of Use.

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