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Adding sheen to your portfolio
Rishi Nathany
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July 09, 2007

India is the largest consumer of gold in the world with around 23 per cent of the annual gold demand is from here. Most Indians have been buying gold over the past few decades from their local goldsmiths. However, some attractive alternatives have presented themselves of late. Let us explore the different ways one can invest in gold.

Physical purchase

One can buy gold in various forms such as bars and coins from the neighbourhood goldsmith. However, there could be a purity issue as one cannot be sure of how many carat the gold is. Another alternative is buying it from banks. While purity would be guaranteed in buying gold from banks, the disadvantage is that banks generally sell gold at a substantial premium to market price, which can be as high as 10 per cent or more.

Also, they do not buy back gold bars or coins, forcing you to approach the local goldsmith. Therefore, apart from purity issues, local goldsmiths fare better than banks in terms of liquidity and accessibility.

Gold exchange traded funds

The Securities and Exchange Board of India has recently allowed gold ETFs in India. Typically, a gold ETF is a structured product where the fund invests its assets primarily in gold and tries to replicate market returns from the underlying commodity.

These funds invest 90 per cent or more in gold and the rest in debt or money market instruments. This gold is stored by custodians, which are generally banks. Against this physical asset, units are created, which are credited to investors in the dematerialised mode.

The ETF units are available for trading on the stock exchange, where investors can buy or sell them at market-related prices of gold. The deliveries also happen in the dematerialised mode. Benchmark and UTI Mutual Fund's ETFs are already traded while Kotak Mutual Fund has just completed its fund.

Gold ETFs are by far one of the most convenient and cost-effective ways for a lay investor to invest in gold. Unit sizes are as small as one gram of gold equivalents, which makes it extremely affordable. There is ample liquidity through online trading and brokerage rates are very low (about 0.25 per cent on delivery).

Gold ETF is an ideal route for an investor looking to start a systematic investment plan and invest a fixed amount every month in gold. Another advantage is that investments in gold ETFs are eligible for tax treatment like a debt mutual fund and subject to long term capital gains tax after one year against three years for physical gold.

The disadvantage is that these funds charge 1 per cent annual fund management fees along with actual transaction costs. Also, at present they do not allow investors to convert their units into physical gold.

Commodity exchanges

This avenue is open for investors having a higher investment corpus or greater risk profile. Gold contracts are heavily traded on commodity exchanges like MCX and NCDEX. Investors or traders going through these exchanges have two options.

First, they can buy near-month gold contracts and take delivery in the dematerialised mode. Secondly, they can opt to roll over their positions to the next month, without taking delivery, by paying an interest cost called contango.

Let us see how this works. Gold is currently traded in a lot size of 1 kg. Besides, a mini gold contract is also available, which is traded in a lot size of 100 grams. Investors seeking to take delivery can buy these contracts near the expiry date and seek delivery, either physical or in the dematerialised mode. If physical delivery is opted for, this will have to be undertaken at specified delivery centres of the exchange. In case of dematerialised deliveries, the gold is credited to the investor's dematerialised account.

Investors can thus buy gold at very low costs of brokerage at market prices. However, they have to pay nominal warehousing costs for the safekeeping of their underlying gold. In the second option, an investor can take exposure in gold future contracts by paying only 4 per cent of the contract value as margin.

Therefore, investors or traders can take a substantially higher exposure with their funds and can trade either ways, long or short, ie they can buy gold future contracts if they expect the price of gold to go up and sell if they expect prices to fall.

They can roll over their positions to the next month, if they feel the prices would go in their favour, by paying or receiving a cost of carry or interest, called contango, if they are long or short, respectively. This cost is currently around 12-14 per cent per annum. They can square off this trade when their price target has been achieved.

For example, let's say you buy the July gold futures contract at say Rs 8,600 per 10 gm. Your hunch comes true and the gold price rallies to Rs 9000 per 10 gm. You can book profits by selling the gold futures at any time before expiry of the contract, or you can roll over your position to the next contract if you feel it will go up further by paying contango of say Rs 100 per 10 gm.

Futures contracts enable investors or traders to buy and sell gold with very little funds and very low brokerage costs at market prices as you have to pay a small margin of 4 per cent. However, this sort of leveraged trading in futures is not recommended for lay investors, since it is highly specialised and increases risks manifold requiring a high appetite for risk and in-depth knowledge.

For small or regular investors, gold ETFs seem to be an ideal cost-effective investment avenue while commodity exchanges are more suited for investors or traders with larger funds and risk appetites. Physical gold has a lot of disadvantages in terms of transaction costs, safekeeping and purity. Moreover, it is subject to wealth tax, if applicable.

However, despite these drawbacks, it is seen that most investors, especially in smaller towns and villages, prefer buying physical gold, due to the sheer emotional security that it provides us.

The writer is director, Touchstone Wealth Planners

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