Limit your exposure to global gold funds

These could offer good returns in the short term but are too volatile for small investors

After years of losses, international funds focused on gold and gold miners are up sharply. In the past three months, DSP BlackRock World Gold Fund has given spectacular returns of 64.92 per cent and Kotak World Gold Fund is up 64.89 per cent. “Two factors have affected the performance of these funds. The underlying metal-gold witnessed a rally recently. Due to this, the stocks of gold miners are back in demand, leading to the stellar returns,” says Lakshmi Iyer, chief investment officer (debt) and head products at Kotak Asset Management.

When gold prices are low, companies shut mines as cost of production is higher than the prevailing price of the metal. When gold prices head north mines start becoming viable, which help companies report better profits. Stocks of such companies were battered for many years. With gold price rising, we are witnessing value buying in these stocks. “In the past few months, stock price of international gold mining companies are up between 80 and 200 per cent,” says Kaustubh Belapurkar, director-fund research, Morningstar India.

The rally is likely to continue in the short term. According to Iyer, the outlook for gold is positive given global economic uncertainties. There’s a perception that investors will increasingly look at gold as the US Federal Reserve defers its rate increase. More upside for gold means better returns on stocks of mining companies. There could still be some steam left in the recently started rally.

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But investors who want to benefit from this should be cautious, warn experts. These funds are also highly volatile. “When gold prices rise, stocks of mining companies rise much higher and when prices fall, miners’ stock price correction is far greater,” says Vidya Bala, head of mutual fund research at Fundsindia.com. The volatility is apparent in the returns of these funds.

Take DSP BlackRock World Gold Fund. It’s best one-month performance was between November and December 2008, when it returned 43.13 per cent. It also saw negative returns of -48.22 per cent around two months earlier, between September and October.

Investors also have to deal with three risks in these funds, says Bala. Returns from these funds are dependent on gold price movement. The investor will first need to have a view on the international movement of metal prices. These funds also invest in stocks, which mean they carry the risk associated with equities. And, there’s also currency exchange risk. Mutual funds investing internationally don’t hedge for currency risks. If the rupee appreciates, returns can get affected.

“Considering these three risks, it can get difficult for retail investors to invest in these funds. They can rather look at simpler options like domestic gold bonds," says Bala.

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But if you understand the risks and wish to take the exposure, don’t invest more than two per cent of the portfolio in these funds. “We advise investors to invest up to five per cent of the portfolio in gold as it is a hedge against inflation. If a savvy investor wants to invest in the international gold funds, he/she should not invest more than two per cent of the portfolio in them,” says Belapurkar.

As these are international funds, their taxation is similar to debt funds. This means, if you sell it within three years, the entire gain will be added to the income and taxed as per the slab. After three years, the investor needs to pay either 10 per cent tax without indexation or 20 per cent after accounting for inflation.