The Mysterious Premium of Gold Fund Returns | Value Research There's a strange reason why are gold funds generating higher returns than their underlying ETFs
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The Mysterious Premium of Gold Fund Returns

There's a strange reason why are gold funds generating higher returns than their underlying ETFs

Gold ETF funds and gold funds are both supposed to be good paper substitutes for buying physical gold, more or less approximating its returns . However, over the last few months, gold fund investors have been mystified by the divergence of returns between Indian gold ETFs and gold funds. On the face of it, there is no sensible reason for this. Typically, the gold fund of an AMC invests in the gold ETF of the same AMC. Therefore, one would expect the gold fund to have slightly lower returns because of additional expenses.

Taking one example, SBI Gold ETS has a three month return (loss) of -17 per cent. Logically, one would expect the SBI Gold Fund, which just invests in this ETF, to have returns of maybe -17.5 per cent. However, it's actual return over the same period is -4.5 per cent! Somehow, it did far better (rather, far less badly) than the underlying fund. A similar pattern is repeated in 10 out of 11 pairs of funds run by AMCs.

So what's the mystery? It turns out that this is a strange side effect of the recent upheaval in gold import duty and rules, in combination with the way gold funds are run and valued. It so happens that ever since the government raised the customs duty on gold and constricted its supply, gold ETFs have started trading on the markets at a significant premium to their NAV. Depending on supply and demand, there's always a little difference between the market price and the underlying NAV of any ETF. However, since August, as GoI has started squeezing gold imports, there has been a steadily increasing premium which is now an average of 9.94 per cent for all gold ETFs.

It so happens that when gold funds buy and sell units of the underlying gold ETF, the transaction is done at the market price of the ETF. However, for the ETF, the returns that are publicised are based on its NAV. It so happens that the gold ETF's NAV is not a real tradable number as that of, for example, equity-backed ETFs. Instead, it's a calculated number based on the international price of gold, and the various duties, taxes and expenses that it takes to get the gold into India. In unusual periods like the current one, when there is a disconnect between gold price and gold ETF NAV on one hand and the gold ETF's market price on the other, then this sort of an anomaly shows up. Which is why the difference of returns is there.

Essentially, the NAV reflects what the price of gold would have been had there been no effective quantitative restrictions on gold imports of the sort that the government has imposed. The NAV only takes into account the raised custom duty on gold. However, the restrictions on gold imports have created a supply-demand imbalance that has resulted in a premium, which is what comes out in the market price of the gold ETF.

However, as far as our view is concerned, the moral of the story is not that fund investors should start punting on what might look like an arbitrage opportunity. Instead, it should be clear that not only is gold an unsuitable investment, it is dangerous to trade in anything whose price and supply is being manipulated by the government's actions. The government has succeeded in reducing gold imports--or perhaps in diverting it into the hands of smugglers. Unfortunately, this has somehow taken us back to the days of decades past when people felt that since the government was working so hard to keep gold out of their hands, owning it becomes even more desirable.




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