Gold is often viewed by different people in different ways. The enthusiasts will always vouch for the purchase of gold saying that its value will never fall, promptly buying physical gold (read ‘Jewellery”). This is one investment that the lady of the house will invariably support! However, Gold prices have seen far too many fluctuations in the last few years prompting many investors to reject it as an investment class (compared to other Mutual Fund categories) with a lot of risks and no commensurate return.
Gold neither provides the excitement of Equity nor does it give “assured” returns of Debt Mutual Funds. Hence, we have more of a lukewarm response to a suggestion of investing a part of the funds into Gold. Does Gold merit a place in the portfolio, for reasons other than social and religious purposes? There are many reasons why Gold should form part of your portfolio
Hedge against Inflation
Gold is mainly seen as a “store of value”. It should be looked at as an alternative to currency. While currency can be printed (and demonetized) at will, Gold is the warehouse where you stock the value of your money. In other words, as currency loses value (what economists and now common men and women understand as Inflation), one needs to protect its purchasing power by converting the “cash” into gold. Gold provides the hedge against inflation. As the purchasing power of currency falls, everything becomes expensive in money terms. You no longer get your favorite vegetable for Rs.2/ kg. The cup of tea that refreshes is now in double digits. The story is similar for almost everything. However, you cannot store value in a cup of tea or in vegetables. These items are perishable and hence, the value is lost if we stock up on them as protection against inflation.
However, with Gold, it works like a bank in which you deposit the value of your currency and when you withdraw, you get the same value back. To use a very simplistic example, if Rs.100 can buy 10 chocolates in year X but only 9 chocolates in year X+1, it means the currency has lost value. If you do not wish to buy chocolates in year X but store your money to buy it in year X+1, you actually lose out, as you get lesser chocolates. However, if you buy gold with your Rs.100 in year X, and you sell the gold in year X+1, you will get money with which you will be able to buy 10 chocolates. The price of gold would have increased by the same proportion as the fall in the value of the rupee. Thus, Gold is a hedge against inflation.
Thus, we see gold as a protection against the risk that prices of various items would go up (which means loss of purchasing power of the currency). If one invests in gold, one is protected against this risk as the value of gold would also go up proportionately.
Gold is arguably the most liquid of all non-cash instruments. Irrespective of where you are in the world, locating someone who will readily offer cash in exchange for gold is not difficult. Transparency on the price of gold in the global markets, clarity with respect to purity of gold (18 karat/22 karat/24 karat) along with certifications (BIS/Hallmark) has made it easy even for retail investors to trade in gold.
Source of Diversification
One of the important lessons learnt in school was “not to keep all eggs in one basket”. The jargon equivalent of this in financial markets is called “diversification”. Diversification essentially means spreading out the investments across different asset categories such that the loss is one asset category is offset by a gain in another. However, if we spread across different asset categories which behave in a similar fashion, (i.e. gain in one is accompanied by a gain in another and loss in one is accompanied by a loss in another), then there is no benefit of diversification. In order to achieve the goal of spreading risk, one needs to diversify across asset categories that are “negatively correlated” or has “low correlation”.
A negative correlation means that the rise or gain in one asset category is usually accompanied by a fall or loss in another asset category. Low correlation implies that the rise or fall is not in similar proportion. Gold tends to have negative or low correlations to most assets usually held by institutional and individual investors whether it is in good times or bad. Gold in a portfolio can reduce the volatility of the portfolio without necessarily sacrificing expected returns.
Protection in Financial Distress
Gold is the last bastion of value. Investors hold on to Gold knowing that, when everything else fails to work, gold can get them out of trouble. As uncertainty increases, investors prefer to “store” value until relative clarity emerges. Thus, when every other asset class is losing value, the price of Gold increases. Thus, Gold helps in protecting the value of the portfolio. Recent history such as Brexit, Trump becoming president, the rising trends of referendums and their results, combined with an increase in debt, liquidity driven asset inflation and currency wars do not point towards a stable global economy. There are risks that cannot be wished away. Markets in general and equity markets, in particular, are vulnerable to such macro disruptions. In this context, the yellow metal is likely to shine bright amongst all chaos.
Thus, Gold should be part of every risk averse investor’s portfolio. Nothing untoward may happen and Gold might just return the equivalent of inflation. However, if there is a crisis waiting to unfold, Gold will be the protection your portfolio will need.
How do I invest in Gold?
1. Physical Gold:
Gold can be bought in the form of coins and bars. The coins come in different sizes (1 gram, 2 gram, 5 gram,10 gram, 20 gram and 50 gram in India, 14mm, 22mm, jewelleryetc diameter in the US, commemorative 1 US$ gold, and various such other forms). Bars are normally available in 100 grams. However, to cater to the need of retail investors, dealers in physical gold are willing to cut a part of the gold equivalent to buyer’s requirement. The advantage is that the gold is in the hands of the investor. However, there are many disadvantages of holding gold in physical form. It does not have utility value, can be lost (or stolen) and requires the investor to make arrangements for appropriately storing it. There can also be trust issues with respect to the quality of gold.
One way to create utility value for physical gold is to convert it into Jewellery. There is a huge demand for gold jewelry, which is actually a manifestation of a demand for holding gold as a store of value. More than 60% of demand for gold is towards jewellery. Apart from the other disadvantages of holding physical gold, the cost of holding increases on account of high making charges and wastage taken by jewellers. The resale price is also lower as the jeweller deducts a small commission on the prevailing gold price.
3. Gold Funds and Gold ETFs:
This is increasingly becoming the mode of holding Gold from an investment perspective. They allow investors by units of a gold fund on the stock exchange. The gold fund is a passive investment in gold. Let us understand this with the help of an example.
M/s Glitter Asset Management company comes up with a Gold Fund, wherein it offers units to investors at an initial price of Rs.10 per unit. A person willing to invest Rs.1000 in gold can buy 100 units of this fund while a person willing to invest say Rs.50,000 can buy 5000 units. Totally, the fund collects Rs.100 crores from all investors, issuing 10 crore units. Let us say, the price of gold on that particular day is Rs.2,50,000 per kilogram. The Gold fund buys 4,000 kgs of gold. In the next one month, gold prices shoot up to say, Rs.275,000 per kilogram. This means the value of gold held by our fund goes up to Rs.110 crores (4000 kg *Rs.275000 per kg). This translates into the value of 1 unit of the gold fund increasing to Rs.11 (Rs.110 crores of fund value / 10 crore units). Thus, a person who bought only 100 units of this fund sees an appreciation of 10% in his portfolio. If he wishes to sell his investment, he can redeem the units of this gold fund with the Asset Management Company at the prevailing NAV of Rs.11 per unit.
Thus, a gold fund facilitates small investors also to invest in gold. Since the fund is actually buying and selling the gold as well as holding the gold, there are no worries pertaining to quality of gold, storage and the risk of paying higher (making/ wastage, etc) or selling lower ( deductions). However, a small asset management fee has to be paid to the fund.
Gold ETFs are Gold Funds that are exchange traded funds. Investors can buy/ sell Gold on the stock exchange by buying/selling the Gold ETFs. Gold ETFs have all the advantages of a Gold Fund. However, investors need to open a Demat account for holding Gold ETFs.
E-gold can be bought on a commodity exchange through a member of the exchange. Each unit of e-gold is equivalent to one gram of physical gold and is held in the demat account. Like gold ETFs, e-gold units are fully backed by an equivalent quantity of gold kept with the custodian. The difference between a gold ETF and E-gold is that E-gold can be converted into physical gold at any time through a process of re-materialization.
5. Shares of Companies dealing in Gold
Shares of gold mining companies or companies that stock gold for trading purposes can be an alternative way of benefiting from the increase in the value of gold. Investors, in this case, are not only optimistic about the prospects of gold prices going up, they are also having full faith in the management of such companies.
6. Sovereign Gold Bonds
The government of India is offering Sovereign Gold Bonds at regular intervals. These bonds not only offer the investors returns equivalent to holding of gold but also offer a nominal interest (currently 2.5% p.a.) on the investment. Since money is lent to Government of India, it is absolutely safe. There is no need of opening a Demat account. Liquidity comes in the form of trading on the exchange. These bonds are exempt from Capital gains tax if held upto maturity. However, it is difficult to have a Systematic investment plan unless one is an active and alert investor.
Gold should be a part of every investor’s portfolio. However, its allocation should be around 10% to 15% of overall portfolio. One should not go overboard or overweight in this asset class. It should not be looked at as a trading opportunity. While Gold Funds and Sovereign Gold Bonds appear to be the best way of holding Gold, the choice really boils down to what one feels is convenient for oneself.