Avoid gold funds for now

Since the impending import duty cuts may lead to a fall in gold prices, buying ETFs and gold funds now is not a good option.

Mutual funds allow investors to buy gold as exchange-traded funds (ETF) or fund of funds (FoF) that invest in ETFs. Both are paper gold, but there are a few differences. A gold ETF unit typically represents one gram of pure gold and is bought from the exchange where it is listed. You need a trading account and a demat account to invest in a gold ETF. The charges comprise 0.5-1% brokerage to the intermediary and the expense ratio deducted by the fund house. Gold funds charge an additional 0.25%-0.5% over the cost of the underlying gold ETF, making them more expensive. However, there is no brokerage involved, except for an exit load, if you sell before the minimum period. Also, there is no cost of the demat account.

In addition to these unavoidable costs, at times, the buyers of gold ETFs have to pay more for their purchases. The market price of gold ETFs varies markedly from its net asset value (NAV), especially for gold ETFs that have very low traded volumes. The price of the ETF may not reflect the price of the underlying gold, possibly impacting your return.

Last year, the gap between the market price and the NAV of gold ETFs had widened even further after the government imposed restrictions on gold import. The NAV of gold ETFs is based on the landed price of gold--the sum of the international price of gold converted into local currency plus import duty. Earlier, the domestic price of gold was only at a slight premium to the landed price of gold. But the premium shot up after the import curbs, leading to a spike in the market price of gold ETFs. This boosted the returns from gold funds.

The new government, however, has taken measures to reduce the curbs, causing a slight fall in the premium. This is also partly the reason why gold funds have lost more value than gold ETFs over the past year. As the market price of gold ETFs has fallen, the NAV of the gold funds invested in these ETFs has come down. While the market price of ETFs has moved slightly closer to the NAV due to a fall in premium, the NAV of ETFs has only fallen to the extent of decline in domestic landed price of gold, whereas the decline in gold fund NAV also includes the fall in market price of underlying gold ETFs. Simply put, the difference in the return is due to the change in the premium. The premium is reflected in the gold fund NAV, but not in gold ETF.

Is it a good investment?

Import duty cuts have not been effected yet, but are likely to be introduced once the current account deficit situation is brought under control. This will lead to a further fall in the price of gold. So, buying gold ETFs or FoFs at this juncture may not be a good idea.

However, experts maintain that investors should stick to their chosen asset allocation, no matter what the circumstances. So, if your plan requires 10% allocation to gold, maintain it.

All asset classes go through cycles. Instead of moving from one asset class to another chasing performance, investors should maintain their asset allocation. Those whose allocation has gone beyond the optimum level may consider reducing their positions gradually.