Which is a better way to invest in Gold?

Paper gold is a way to invest in gold where you do not have to worry about security, making charges, GST, etc. Plus, the appreciation of paper gold is higher than physical gold; because all of the charges mentioned above are not part of it.

Historical Returns of Different Asset Classes

But before we explore investment options, let's first understand whether it makes sense to add gold in your portfolio:

Historical Return of Asset Classes

For starters, do not take these numbers at face value. Over longer horizons, all the values normalize. The point we are trying to make here is having only equity in the portfolio may not always be a good idea. In the current market fall, when all Indian indices went down, only two asset classes i.e. Gold and Government Bond. In technical terms, this is called Negative Co-relation. And your portfolio should have asset classes with this negative co-relation.

But no one knows how to time the market so that we enter and exit each asset class at the exact right time. Hence, if you have a mix of these asset classes; then the downside of the portfolio will be significantly lesser compared to the market.

How much of the total portfolio should be in Gold?

On a portfolio level, do not let the total exposure increase above 15-20%. Remember that gold is an asset class mainly used for hedging. This means that when every other asset class in the world goes down, gold goes up. This makes gold a prefect hedge because it will reduce the fall of your portfolio. Hence, limit it's exposure to 20%.

The importance of this addition gets clear when we are in a situation like today where the economic outlook is weak and stock markets are either falling or stagnant.

Different ways to make Gold Investment

Now that we know why gold is an essential part of the portfolio, Let's look at some of the options to make gold investment except physical gold of course.

Sovereign Gold Bond

Sovereign Gold Bonds are government-backed bonds that can be bought in the denomination of grams. This is just like buying physical gold but in the form of bonds. This was started by the government to encourage people to buy paper gold instead of physical gold.

Since these are issued by RBI, there practically no risk associated with it except the movement of gold price. The minimum investment for SGB is 1 gm and the maximum is 4 kg for an individual investor. This limit is for one financial year.

Pros:

With the government-backed structure of SGB, it is as safe as it gets.
There is also an incentive of 2.5% interest payout per annum if you invest in SGB. This interest is paid semi-annually. This is simply an additional income over and above the appreciation of gold prices.
These bonds have a lock-in period of 8 years with an early redemption option from the 5th year on coupon payment dates if you hold the bond in physical form. But, these are also tradable in the secondary market since if you wish to exit before maturity, you can do so if the bonds are held in demat form.
On Maturity i.e. after 8 years, the capital gains are completely tax-free.

Cons:

The lock-in of 8 years can be excessive for investors who have no visibility of the near future.
Taxation of interest and capital gain can be unfavorable. The interest of 2.5% pa is taxable at the slab rate. If you sell the bond before 3 years, then any capital gain during that period will be taxed as per the slab rate. And if the bond is sold after 3 years, then it will be taxed at 20% with indexation benefit.

Gold ETFs:

Gold ETFs are one of the most used investment vehicles for investment in gold. In India, there are various options for gold ETF are available. Mostly all of these ETFs track the domestic price of gold and hence the returns would be in alignment with it.

Since there is not much difference between the gold ETFs in India, the selection should be based on two factors:

Tracking Error: Tracking error is basically a difference between returns given by gold and that of the fund. This difference should as low as possible. That means, your fund returns should mirror the movement of domestic gold price
Expense Ratio: The Gold ETFs follow the gold price and not actively managed. Hence, their expense ratios are very minimal. Hence, while selecting the fund, you should give preference to the fund with a lesser expense ratio.

However, You can only invest in Gold ETFs if you have a demat account. Since these ETFs are actively traded in the secondary markets, they have a price and they have a NAV. In the Ideal world, NAV and price should be the same. But if there is higher demand, the price may be more than the NAV and vice versa.

Here's the chart for Nippon India ETF Gold BeEs with its price and NAV:

Difference Between Price & NAV

This chart is for the last month. It is clear that NAV and Price can move in the opposite direction depending on demand and supply.

So, what if you want a fund with no lock-in and without the requirement of a demat account; then the next option is for you:

Gold Mutual Funds

These are similar to gold ETFs, except for the demat account. Gold Funds have no lock-in period. That means there is complete liquidity in these funds. Most of the gold funds invest in their ETF counterparts.

The difference in returns would only be due to the tracking error and expense ratio. Hence, these two things need to be looked at before making an investment. These funds are very easy to buy and can be bought at a very small ticket size starting 500.

These give all the benefits of investing in gold without the worry about their security.

Gold Funds with past returns

Do note that taxation of physical gold, gold ETF, and gold mutual funds is exactly the same. i.e. If you sell before 3 years, then any capital gain during that period will be taxed as per the slab rate. And if the fund/gold is sold after 3 years, then it will be taxed at 20% with indexation benefit.

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