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A Golden Memoir

Gold ETFs & Gold Equity Funds are different in many ways

Gold funds are too diverse to be clubbed into one single category. Right now we have five Gold Exchange Traded Funds (ETFs): Gold Benchmark ETF, Kotak Gold ETF, Quantum Gold, Reliance Gold ETF and UTI Gold ETF. These are all alike, even in their expense ratio of 1. The structure of these funds is mandated in a manner that they all generate exactly the same amount of return, the difference being in the decimal point. So it really does not matter which one you pick should you decide to invest in a Gold ETF.

In the other sub category, we have two gold equity funds — AIG World Gold Fund and DSP BlackRock World Gold Fund. These are funds that buy the stocks of gold mining companies. Should you invest in such a fund, you would not need a demat account. But you would need one if you opted for an ETF. Now we have one more option — a mutual fund that offers a combination of equity, debt and gold. UTI Wealth Builder Fund-Series II will invest in a diversified portfolio of equity and equity related instruments as well as Gold ETFs. It also has a debt and money market component.

Since the latter is still in the NFO stage (closing on November 19, 2008) let’s focus on the two existing sub-categories. What is glaring is the difference in performance by ETFs and gold equity funds (see table below). What investors must realise is that the two products (ETFs & gold equity funds) are inherently very different, so are their risk and return capability.

Gold stocks can provide much more leverage to the rising gold price than gold itself. So in boom times, such a gold equity fund can deliver impressively — much, much higher than an ETF. On the flip side, they also carry company-specific and industry-related risks. For instance, risks related to exploration, depletion of reserves, rising production costs, labour problems and political risks (depending in which country the mines are located).

And this year, these risks became a reality for some mining companies. Higher raw material and energy costs in 2008 raised the overall cost of production. Naturally this squeezed their profit margins.

Newmont Mining Corp., the world’s second-largest gold miner, stated in September that cost pressures were constraining the development of one of its projects. Its third quarter results in October revealed that profits fell just over 50 per cent, hurt by a decline in gold and copper shipment volumes and higher production costs. AngloGold Ashanti — another gold mining company, reported that total cash costs for the quarter at $486/ounce, were higher than the prior quarter’s $434/ounce due to input cost inflation, annual wage increases, higher power tariffs and inventory adjustments. Kinross Gold, Canadian-based gold mining company, also announced that costs per ounce rose to $406, up from $383 in the quarter from the previous year.

Barrick Gold Corp., the world’s largest gold producer, reported a 26 percent drop in net income. But this was also largely due to $97 million in special charges related to investments in Russian-based Highland Gold Mining Ltd and in junior gold mining companies. But another Canadian gold miner Yamana Gold saw its profits surge on the back of gold production climbing 45 per cent and copper output increasing by 33 per cent. However, the company did state that the increase in prices for precious metals was partly offset by an increase in consumable prices of inputs into the operating process.

On top of it, the global equity turmoil and fears of a recession have also hit the global equity market. It would be foolish to believe that these stocks would escape the carnage. Newmont Mining Corp. saw a 63 per cent dip in its stock price from January to October. Yamana Gold saw 74 per cent decline from March to November.

And, if that was not enough, the gold price has not exactly been moving along a smooth path. It was a few months ago when we saw the price of gold move from around $740 to over $920/ounce. But in October, the price of gold fell below $700/ounce for the first time in more than a year. As a result, many mining stocks on Wall Street hit fresh 52-week lows. Yet, after plummeting to its weakest in a year, it bounced back this week on stronger crude prices, a recovery in equities, a firmer Euro (against the dollar) and tightness in the physical gold supply. By early November, it picked up to over $750/ounce.

Gold equity funds are susceptible to many factors — the sentiment in the equity markets, price of gold, as well as a host of company and industry related issues. On the other hand, ETFs only react to the price of gold. That would explain the difference in performance. So if you choose to invest in gold via the mutual fund route, ensure that you make an informed decision.