What exactly is a gold ETF and why do investors prefer it?

We may historically observe that there is an inverse relationship between the performance of the stock market and gold prices, especially during recessions and economic crises. When the stock market is crashing, the gold prices move upwards and vice versa.

Gold hit an all-time high when the world was hit by Covid-19 and now trades at almost 20% less than the highs when the economy is stabilizing. The COVID-19 global health crisis has thrown the world into a state of financial and economic crisis, and it has been invariably seen that when economies are plunging, the prices of gold reach record highs. For example, be it the economic crisis in 2001, the financial crisis in 2008, or the recent 2020 pandemic; we see investors flocking towards the haven of the glittering yellow metal when most markets are plummeting to their doom. This is because gold is considered to be a reliable and safe investment as the chances of gold losing its worth are very low.

The Gold ETF has caught the fancy of investors since it was launched in India. A Gold ETF is an exchange-traded fund (ETF) that aims to track the domestic physical gold price. They are passive investment instruments representing physical gold in dematerialised form.

Physical gold v/s Gold ETF

Physical gold attracts indirect taxes such as GST at the rate of 3% on the purchase and sale value, whereas this cost is saved in the ETF transactions as ETFs are securities and securities are specifically excluded from GST. Further, Buying and selling rates for physical Gold is different in order to cover the liquidation and other costs that are incurred in the trading of physical gold. Whereas, buying and selling rates are the same for Gold ETFs at the time of redemption of Gold ETF. Gold ETF is a commodity exchange-traded fund, where the only underlying asset is gold. We are aware of Equity ETF, where a pool of money is gathered from investors by an asset management company (AMC) to invest in shares, so is the case here in Gold ETF. The difference is instead of shares they invest in pure gold as the underlying.  The physical gold acquired is stored in vaults of custodian banks and works as the underlying from which the units derive value. The gold is held under the custody of banks valued periodically according to SEBI guidelines.

When you deal in Gold ETFs, the purity is assured as the sector is organized and 99.5% purity is the standard. As an investor, you need to buy a minimum of 1 unit of gold – equal to 1 gram of gold – to start trading in gold ETFs. Therefore, investors who do not have sufficient funds to invest in gold can also thinking of investing in Gold ETF.

Another advantage is not like Sovereign Gold Bonds, no maximum limit is fixed for buying gold ETF and no lock-in period for trading them. However, it is mandatory for investors in Gold ETF to maintain a Demat account and they can be purchased only through Digital Mode. Therefore, unlike the risk of holding physical gold, there is no risk of theft in the case of Gold ETF.

Gold ETFs are essentially open-ended mutual fund schemes, which are based on ever-fluctuating gold prices. Gold ETFs are listed on the exchanges and can be bought and sold directly like shares. Buying and selling the units works just like equities – you can trade through your stockbroker or ETF fund manager. They are traded on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).

Tax implication:

Investors of ETF may benefit from indexation for Long Term Capital Gain (LTCG) tax, if they transfer their bond after 36 months and before it matures. If you sell gold ETF in less than 36 months, you generate short-term capital gains. These gains are taxed at the income tax slab rates applicable to you.

Buying and selling procedure:

The investor has to authorise payment at the market rate of the day for Gold ETF units through his linked bank account.  The units of the gold ETF are credited to his Demat account bought at the market rate. The investors in the Gold ETF can encash them by trading the units through a stock exchange. Even, some funds of Gold ETF arrange physical delivery of Gold for quantities of above 1 kg of gold during withdrawal from mutual funds. There is no entry/exit load when you buy/sell gold ETFs via your trading account. But there are three important costs that investors must consider – (1) expense ratio for managing the ETF funds, (2) broker cost, and (3) tracking error (tracking error occurs because of the fund’s expenses and cash holdings, thus not reflecting the actual gold rates).

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