Gold is one of the most popular precious metals, and has been a favourite investment all throughout history. It has limited industrial application, but is highly demanded for its ornamental and retail purposes. However, the world obsession with gold as a safe haven and a possession to lean on dates back to the latter part of the nineteenth century when the Gold Standard was implemented. Discontinued by most countries during the period of World War 1 & 2, it was reintroduced in 1944 as the Bretton Woods system, where the US dollar was pegged against gold. This system gradually suspended by the world after US announced its transition to fiat currency. However, gold still remains a popular investment worldwide, as a hedge against currency and stock market slumps.
Price of gold
The price of gold, like other commodities, is driven by demand and supply. The demand for gold mainly arises from jewellery and bullion savings, with a small proportion in industrial and dental production. This means that most of the gold above the ground exists in liquid form, and is easily transferable back into the gold market. Hence, the demand for mining of gold is limited. As observed by Warren buffet, the total amount of gold existing above the ground could fit into a cube of just 20 meters! According to the World Gold council, the annual mining of gold in the last few years has been roughly 2,500 tonnes, out of which 2,000 tonnes goes into jewellery and industrial uses, while 500 tonnes goes to retail investors and gold ETFs.
Central banks all over the world also hold gold reserves, and can influence the price of gold by increasing reserves or offloading. In 2006, China had expressed interest in increasing its gold reserves in line with other Central banks. During the Eurozone crisis in 2011, Chinese investors gradually shifted investment from Euro to gold, thus making China the largest consumer of gold. Apart from reserves, central banks also influence gold prices by their monetary policy. When interest rates increase, investors shift from gold to interest earning instruments, reducing the price of gold, and vice versa. However, this does not always hold true, as there are many other factors that influence gold prices.
Why gold is a preferred investment
The currencies of many major countries have suffered severe pressure over the years due to various reasons like fiscal deficits, inflation, geopolitical tensions, Eurozone crisis, etc. In spite of doubts on the efficacy of gold as a hedge, it has been historically observed that people have pursued gold in times of emergency, thus driving up the prices. Here are some of the reasons why gold is such a favourite among investors.
- Safe haven: One of the primary reasons why people invest in gold is because it offers a safe haven during an economic crisis. Gold is a proven hedge against stock market crash, as per a research conducted by Trinity College. The study observed that gold prices soared dramatically for 15 days after a market crash, implying that investors panicked, sold their stocks and bought gold. After the 15-day time period, gold prices lost value against rebounding stock prices.
- Inflation hedge: Gold has empirically established itself as a hedge against inflation. Periods of high inflation result in rundown of production activity and consequently, punish the stock markets. The money pulled out of stock markets is invested in gold, thus increasing the gold prices.
- Protection from currency depreciation: Decrease in the value of currency directly affects the price of gold. For example, during the sub-prime crisis of 2008 when the US dollar declined, the prices of gold nearly doubled. The inverse correlation between dollar and gold index can be seen in the chart below:
- Limited supply of gold: Most of the gold supply in the market since 1990s arose from sale of gold bullion by the Central Banks of the world. This offloading by Central Banks has greatly slowed down in 2008. Simultaneously, production of new gold from mining activity had been declining since 2000. It usually takes 5 to 10 years produce gold from a new mine. With all these limitations in the supply of gold, the prices are expected to rise in the long term, making gold a good investment for the future.
- Increase in demand for gold: The demand for gold has been steadfast in India due to cultural as well as saving purposes. In China too, gold has traditionally been a popular saving instrument. Emerging market economies like Thailand, Turkey, Indonesia, etc. have increased their demand for gold due to higher incomes and savings. Demand for gold has increased significantly among investors, and investments like Gold Funds and Gold Exchange Traded Funds (ETFs) have become increasingly popular. For example, SPDR Gold Trust became one of the largest ETFs in the U.S. Only 4 years after being launched, it became one of the world’s largest holders of gold bullion in 2008.
- Diversification function: Diversifying one’s portfolio essentially means putting money into various asset classes to reduce the risk arising from any one asset. Gold is therefore an excellent choice for diversification, as it is seen to have a negative correlation with most of the other securities. A good portfolio mix must have gold as one of its components as a hedge against concentrated exposure risk.
Gold Funds and Gold ETFs
These are the two most common forms of retail investments in gold in India. Gold ETFs are stock-like units that derive value from underlying gold prices. These units are traded on the stock exchanges and are highly liquid. Retail investors need a demat account for trading in gold ETFs. Gold funds, on the other hand, are essentially mutual fund schemes that invest in Gold ETFs and other related assets like gold mining companies. Gold Funds, being mutual funds, do not require a Demat account.
Various Asset Management Companies in India offer both ETFs and Mutual Funds which the investor can choose from. For more information on Gold ETFs and Gold Funds, visit Finbingo.
- How can I invest in gold? There are many ways one can invest in gold, few of which are: a. Physical possession, through jewellery or bullion gold: This is the most traditional form of investing in gold. It is also the most inefficient due to storage costs, making charges, chances of theft, etc. b. Gold ETFs: Gold ETFs are listed like stock on the exchanges. This is a smart way to invest in gold, as ETFs are liquid, low cost and have minimal tracking error of the gold price. c. Gold Mutual Funds: These invest in physical gold or gold ETFs or gold mining stocks or all of the three. Gold Mutual funds have a higher expense ratio than gold ETFs as they are actively managed. d. Gold Options and Futures: These are favourites for institutional investors and companies who use gold contracts to hedge their risks, and also for traders who indulge in speculation. e. Stocks of gold mining companies: Increase in gold prices would lead to incentive for increasing the supply of gold, and raise profits for gold mining companies.
- What are the differences between gold ETFs and Gold Funds? The main differences between Gold ETFs and Gold Funds are listed below:
|Parameters||Gold ETFs||Gold Funds|
|Price||They closely track the international gold price, and are transparent.||They invest in Gold and other related assets, so the NAV depends not just on Gold but other assets too.|
|Mode of investment||These can be bought from the exchange, and require a demat account.||These can be bought directly from the Fund house, and do not require demat account.|
|Systematic Investment Plan option||SIP option is not available||SIP option is available|
|Minimum investment||₹1000 as monthly SIP||1 unit = 1 gram of gold (2500-3000)|
|Cost||No entry or exit load Lower expense ratio||Exit load may be levied up to one year Higher Fund Management Charges|
|Liquidity||Can be bought and sold any time during the trading hours at market prices, as they are listed on the exchange||Are not traded on the exchange, hence can be bought or redeemed only at the closing NAV of that day.|
How do Gold Futures and Options work?
Gold options and futures are a good investment strategy for more experienced investors. Gold Futures is a legally binding contract for delivery of gold at a predetermined price in the future. The quantity, quality, time and place of delivery of the gold is standardized by the futures exchange. Only the price of the contract is market determined. Options, on the other hand, allow investors to speculate on the future price movement of gold, and give an option to the investor to honour the contract or not, by charging a premium. A “call,” gives you the option to buy at an agreed price, if you believe that the price will rise. A “put,” gives you the option to sell at an agreed price, and you believe that the price of gold will fall. Gold futures and options are designed for highly experienced investors. It requires a comprehensive understanding of the markets to trade in these derivatives. However, if you are aware of the risks associated with investing in futures and options, they can provide a huge opportunity for profits. 4. What is the tax treatment for Gold ETFs and Gold Funds? For Gold ETFs and Gold Funds, holding period less than 3 years attracts a Short-Term Capital Gain (STCG) tax, which is as per the investors income tax slab rate. Long-term Capital Gains (LTCG) tax is applicable for a period of more than 3 years, and is 10% without indexation, and 20% with indexation. 5. Is it the right time to buy gold? 6. How much gold should I have in my portfolio?
(The above two questions can be answered by SMEs in line with Finbingo recommendations) To know more about gold, how to invest in gold and other precious metals, and their suitability to your investment profile, check out our Wealth Wizard on Finbingo. Finbingo gives you highly customized recommendations based on top-class research. Explore the world of financial planning with ease and confidence on Finbingo. To register, click here.