An expensive hedging instrument

ETFs may be the best way to buy gold but not right now

The last week saw lots of action in the bullion market and especially in gold. Jewellers work overtime before Diwali when it is a near-religious obligation for many communities to buy gold. India has always been fascinated by the yellow metal and traditionally, a large chunk of year-end surpluses are invested in it.

Gold buying at Diwali, during marriages and other festivals, are among the reasons why India is the world’s largest gold consumer. It may be why gold prices reached fever peak in mid-October.

But the last few years have generally seen excellent returns for goldbugs.

Gold prices have risen 65 per cent since November 2008, and about 22 per cent since November 2009. In fact, since the invasion of Iraq in March 2003, gold has offered fantastic returns. In May 2003, when the invasion officially became occupation, gold was at $335 /ounce and it has risen steadily since, peaking at a record of $1376/ ounce on October 14, 2010. (A troy ounce=31 grams and in India, gold is priced in either 10 grams or traditionally, in 11.6 g =1 total unit)

Since May 2003, gold has delivered returns of 285 per cent. That beats most asset classes. The reasons for out-performance are not difficult to find. Gold is a haven in times of uncertainty and high inflation. When people start becoming nervous about currency weakness, or the cost of essential commodities, they hoard this otherwise unessential commodity. Iraq triggered a spike in crude price and the subprime crisis caused overall financial weakness.

Gold has some industrial uses but its key role is as a financial hedge. Any of the base metals and silver, palladium, and so on. among precious metals, are all more useful in industrial terms. Nevertheless, gold is so important it must be seen as an individual asset class. Most financial planners will advocate putting a certain proportion of savings into gold.

Should you be buying gold now? And if you buy gold, in what form should you buy it? The second question is easier to answer. If you want physical metal, the most efficient way is to buy gold futures in 1 kilogram lots on the MCX. A long futures position can be transformed into physical gold through delivery and the instrument has a window of trading opportunity as well.

If you wish to hold dematerialised gold-backed assets, the best way is to buy gold exchange-traded funds (ETFs). There are half a dozen gold ETFs listed on NSE. The Gold BEES floated by Benchmark is the most liquid and has the lowest expense ratio. An ETF is similar to demat equity in tax treatment and ease of trading. Profits from an ETF are long-term capital gains (LTCG) after one year, whereas physical gold assets are LTCG only after three years.

ETFs have expenses so the price is generally at 3-5 per cent discount compared to bullion. However, that is much more favourable than other forms of physical gold. If you buy coins from a bank, (guaranteeing purity), you pay around five per cent premium to the MCX bullion price.

You cannot sell gold to a bank. Selling to a jeweller means accepting a major discount of 10-20 per cent. Buying from a jeweller means uncertain quality. The margin differential gets even bigger, if you’re buying jewellery (as opposed to biscuits) since you’re charged for labour.

So if you’re seeking investment in gold, it’s probably best to focus on ETFs. If the global economy stays shaky, gold would remain a good hedge. It could also be a good long-term hedge against the next oil price spike.

Set against that, gold has some major strikes against it. One is simply that it's at historic high price levels. It is therefore, far more likely to have a downside than an upside. If you examine the price-history since 1972, when the dollar was free-floated off the gold standard, there were long periods when the metal traded flat.

It’s only specifically during crisis periods that it tends to rise above the $400/ounce mark. We’ve lived through a crisis of exceptional magnitude and any sustained recovery in global growth is liable to have a negative impact on gold prices.

Another serious objection to holding gold is that it doesn’t earn interest easily. It is an investment made purely in the hopes of capital gains. Any hedge costs money of course but the opportunity cost of holding gold adds up. The combination of high prices and the opportunity cost makes it look unattractive at the moment.