So the markets are spooked. Many central banks across the world are now offering negative interest rates, the bond market is just stagnant, and gold is back in vogue. For retail investors, purchasing physical gold in small quantities might be an option, but those who prefer to buy it in dematerialized form can turn to ETFs, futures, and mutual funds which are some of the options on the table.
Though exchange traded funds (ETFs) are highly convenient and require no specialized knowledge on your part, you should also look at futures as a gold investment strategy if you wish to be a profiteer from the surge in gold pricing.
Why Investing in a Gold ETF is Problematic
If you are a savvy investor with exposure to capital markets through various instruments, you should understand that the convenience of gold ETFs goes much beyond tracking of daily gold price movements. Taxation, excess fees, and inherent risks are just some of the problems.
- Added Risks – Gold ETFs are exposed to numerous factors that has absolutely nothing to do with gold price fluctuations. For instance, an asset management company managing the ETF can liquidate the gold holdings if the dollar holdings fall below a certain level or if 66.6 percent or more of a percentage of holders decide to liquidate the fund. The decision can be taken irrespective of the price of gold. The same thing can happen in case the NAV drops below a certain level.
- Endless and Mindless Fees – Gold inherently is a non-yielding or non-income generating investment asset. But running a fund costs money. The fund manager needs to be paid, marketing has costs, holding costs for the gold need to be satisfied, and so forth. And if the underlying asset is not generating any income, the expenses can be met by liquidating some of the gold holdings. The sale of these holdings again attracts a capital gains tax which again goes out of the pocket of the investor (but this is only if you made a profit off of your gold investment). Thus gold needs to appreciate over and above the inflation level by a significant margin to keep generating decent long term returns for you. The fees will always eat into your profits though.
- Taxes at Play – In a gold ETF, the fund management company is the actual owner of the gold. On the other hand, money put in by the investors who buy into the ETF get investments categorized as “collectibles”. Because of this, the profits are categorized differently and taxed at a ridiculous rate of 28% for long term capital gains which some people believe is against the constitution since that is double taxation considering everyone already pays income taxes but this is a different topic as well. Investors usually therefore quit the fund before a year is up to avoid paying higher taxes.
Straightforward Gold Futures
Now that we know what the hidden risks of gold ETFs are, is there an alternative to them that enables you to own gold as an investment? Yes, and gold futures is the answer. Now consider this:
- In terms of a gold ETF, you need to be aware of the entry and exit load and the time of the entry or exit accordingly or you could end up paying higher fees. Futures on the other hand do not come with any these types of costs. You buy them whenever you want and sell them at your discretion.
- If you have invested in a gold ETF, someone else is betting your money according to their own investing principles.
- The dreaded taxes in case of gold futures are clearly divided in short and long term categories which is as simple as black and white.
- In a gold ETF, your investment is deemed a collectible investment, thus you will never actually own any gold. But in case of gold futures, you can own the gold any time you want.
Treat Gold as a Hedging Tool
Irrespective of what instrument you are using for investing in gold, the precious metal should never be treated as an income generating investment under any circumstances. You should treat gold as a hedging tool that provides high liquidity and protects your entire portfolio from complete erosion. Ideally, gold could be more than 10% of your investment portfolio if you are an aggressive investor but around 5% if you are a passive or conservative investor.
Historically, gold has managed to beat inflation and provide decent returns over a long term investment period. For short term investment periods, the returns have been varied. In some cases, the prices dropped drastically or even jumped by 50%. This is call volatility.
Gold ETFs though are seemingly simple and track gold prices, hidden risks make this investment avenue less attractive. Futures though do not have any of these hidden risks, but your contract value can become zero and even generate losses if you fail to time the market accurately. Which direction you take is your proclivity. Of course you could go both directions.