The Best Way to Hold Gold

Is it better to hold physical gold in the form of coins or bars or an ETF? How does an ETF reflect the price of gold?
- Dosabhai Dastoor

There are three ways by which you can have an exposure to gold. But to answer your query accurately, one would need to know why you want to hold gold. Do you plan to buy gold to convert it into jewellery at a later date? Or are you buying it purely for investment purposes?

Today, the value of gold is increasingly driven by the demand and supply of paper gold in financial markets. It is a financial asset and is clearly subject to the same volatility as other financial assets as investor interest flows in or out.

If you are looking at converting the metal into jewellery, then the best option available is to buy gold physically in the form of bars and coins. Even if you are looking at it purely from an investment point of view, you could consider this option. While there is no substitute to owning the "real thing", the issue is with storage, safety and insurance. Affordability is also an issue, an investor may not be able to afford to buy bar. Moreover, if you make your purchase from a bank, the latter will not buy it back. To sell your investment, you will have to approach a goldsmith or jeweller and be prepared to pay a margin amount when doing so.

One way to invest in gold is to buy into the stocks of gold mining companies. Two funds that fulfil such an objective are AIG World Gold and DSP BlackRock World Gold Fund. On the one hand, this is a risky way to take a position in gold. Gold mining companies face issues such as exploration risks, risk of depletion of reserves, decline in production, mounting production costs which would eat into profits (and the stock price) and labour issues. On the flip side, they embody a neat trait called leverage. Gold stocks can provide positive leverage to gold of (an estimated) 5.4 to 1. What this means is that for every 1 per cent rise in gold, there is a 5.4 per cent rise in the stock. These funds seem to act as a sort of high-beta versions of the gold price itself. However, these stocks can dip in value much faster than a decline in the price of gold.

When you buy into such a stock, issues such as PE ratio, the hedging policy of each company, M&A activity, financial performance and other such factors come into play. So the fortune of the stock of one gold mining company is quite different from the prospect of another.

Taking both the above into account, a Gold Exchange Traded Fund (ETF) stands out as the best bet. Unlike gold mining stocks, an ETF is a pure play on the price of gold. No other factors come into play. In terms of affordability, liquidity and convenience, the Gold ETF scores over holding gold in its pure form. Since you buy the units from the stock exchange, you can buy an amount you can actually afford. For instance, you may not be able to afford a bar, but you could invest in a few units of a Gold ETF. All you have to do is own a demat account and buy and sell the units on a stock exchange.

Finally, let's look at the tax implication. Gold ETF units held for more than a year qualify for long-term capital gains whereas the holding period in physical form has to be three years to qualify for long-term capital gains. Also, gold held in paper form is not liable for wealth tax.

How Gold ETFs Work
The Gold ETF fund will purchase a large amount of gold, maintaining the physical metal in storage. It will then issue shares in baskets, the idea here being that the value of the shares will increase with the price of gold bullion. If the price of gold goes up by 10 per cent then individual shares would increase in value by the same 10 per cent. Essentially, a gold ETF trades like a stock and its worth is meant to track a percentage of an ounce of gold. For example, a unit of a Gold ETF may be fixed at a value of 1/10th an ounce of gold. These units can be bought and sold on the stock exchange.

This article was originally published on December 07, 2010.