Inflation, or the general increase in prices, is the biggest worry in the Indian economy today so one of the big questions for investors is how to protect their overall returns from inflation. Traditionally one answer has been investing in gold and in this article we will look at gold as an investment and also discuss gold exchange-traded funds, a recently introduced investment product.

What are the pros and cons of investing in gold?

Probably the biggest factor behind the recent increase in the gold price is the fear of inflation for a number of reasons including rising prices of commodities like rice, wheat, oil, copper, aluminium etc all over the world.

In addition, the sub-prime problem in the US has led to less a credit crunch and poorly performing stock markets. This makes gold more attractive since stocks are traditionally an alternative hedge (protection) against inflation. This is because if inflation increases the price of gold also increases accordingly as a general rule of thumb.

Finally the weak dollar has also raised the price of gold and commodities in general. All these are broad trends which are likely to keep gold prices high in the near future.

Despite this there are some reasons to be cautious while investing in gold. Though gold has historically done very well for brief periods (like the late 1970s and the last few years), it has generally underperformed � given lower returns -- relative to stocks over the long run. Thus while gold is a hedge against inflation, stocks are an even better hedge in the long run, say a few decades.

• Gold ETFs: Five things you must know 

Additionally, the recent steep rise in gold price may stimulate additional supply from gold mines all over the world thus moderating future price increases. The bottom line is that gold is a useful investment vehicle but you shouldn't invest more than 5-10 per cent of your total investments in gold.

What are the different ways of investing in gold?

Let's say that based on the above factors you wish to invest in gold. What is the best way of doing this? One avenue is to purhcase gold physically in the form of jewellery or gold coins. However this means that you have to arrange to physically store the gold and keep it secure. In addition you have to ensure the purity of the gold you are buying. There are also significant transactions costs to converting your gold back to cash when you need it, particularly when it is stored in the form of jewellery.

However, now we van invest in gold in electronic form by buying into a product like gold exchange traded funds that help us avoid such problems.

Exchange-traded funds

A much better way of investing in gold is through a new financial product that was introduced in India in 2007: the gold exchange-traded fund (ETF). ETFs can be thought of as a mix of a mutual fund and a stock; like a mutual fund they are based on a portfolio of assets and like a stock they are traded on a daily basis on the stock exchanges.

• Now, a golden mutual fund

Gold ETF's are funds which are linked to the price of gold. In other words, the value of a gold ETF will increase or fall depending on the price of gold.

Gold ETF was launched in India in 2007 by Benchmark Asset Management Company with the Gold BeES which was listed on the National Stock Exchange. Other banks including Axis Bank and SBI [Get Quote] have also launched similar products.

Compared to actively managed mutual funds, Gold ETFs have a simple trading strategy of tracking the price of gold; therefore their expenses tend to be very low. Compared to physical gold, Gold ETFs offer much greater security and convenience as well as greater liquidity. You don't have to worry about how pure your gold is or how to keep it secure. If you need cash urgently or wish to move out of gold it's easy to sell your investment since ETFs are traded on a daily basis.

Conclusion