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Mutual Funds - Should you buy gold savings funds or restrict yourself to gold ETFs?

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All gold savings funds have underperformed the ETFs in their portfolios in the past three months. Gold ETFs are a good investment option but you need to have a demat account and a trading account to buy them. If you want to avoid these hassles, you can invest in gold savings funds. These are fund of funds (FoF) that invest in gold ETFs.

However, this adds another layer of charges for the buyer and eats into his overall returns. All gold savings funds have underperformed the ETFs in their portfolios in the past three months (see table Gold savings funds).

Some like Birla Sun Life Gold have fallen behind by a significant margin, while others like Kotak Gold are very closely following their ETFs. Even so, an average underperformance of more than 1% in three months raises a fundamental question. Should investors consider this breed of mutual funds or restrict themselves to the underlying gold ETFs? Before we come to that, let us examine the reasons why these gold savings funds have underperformed.

Additional costs

Since gold savings funds invest in gold ETFs, it is only logical that they will underperform the gold ETFs slightly. But this is not the only reason for them lagging behind. Funds do not have a free hand in levying this extra charge. To protect the interests of investors, Sebi has capped the total charge at 1.5% a year. This includes the expense ratio of the gold savings fund as well as that of the underlying gold ETF put together. Given that most ETFs have an expense ratio of around 1%, the gold savings funds are able to charge only 50 basis points (bps) as additional expenses at the FoF level.

Cash component

Many gold savings funds also underperform because of a larger cash holding in their portfolios. As can be seen from the table, the larger the cash holding in the schemes portfolio, the greater is the underperformance. To be fair, a fund cannot be fully invested in gold. Some amount of cash is needed to pay for speedy redemptions. Since the creation and redemption of units from the underlying gold ETF is restricted to 1 kg of gold, these gold savings funds hold cash till that level of cash holding is achieved. Funds can manage this time lag by buying from the market as soon as they get inflows. "We buy directly when the inflow is big enough, else, it is managed by buying from the exchange," says Lakshmi Iyer, head of fixed income and products, Kotak Mutual Fund.

Price difference

In many cases, the underperformance is also because the underlying ETF is not trading in accordance with its NAVs. Sebi rules say that a gold savings fund can invest only in ETFs from its own fund house. Here again, deft management can tide over the problem. If the gold ETF is quoting at a discount to the NAV, the fund manager should buy from the exchange instead of going through the creation of units.

The emergence of gold savings funds was expected to increase the liquidity in the underlying gold ETFs and bring the market prices close to their NAVs. But this has not happened. Since the NAVs of the gold savings funds are computed on the basis of the market price of gold ETFs and not their NAVs, investors have to pay an additional price for this anomaly as well. So, its best to avoid gold savings schemes whose underlying ETFs are trading close to their NAVs.

Increased volatility

The NAV of the ETF is not always to be ignored. In some rare cases it can be the basis of calculating the gold savings funds NAV. If the underlying ETF is not traded at all for a day, the NAV computation is based on fair valuation. Though the method varies among fund houses, the most common practice is to use the underlying scheme NAV for calculation. This means the NAV calculation of gold savings fund can happen based on the NAV of gold ETF on some day and the market price of gold ETF for some other day (which may be trading at a discount or premium to its NAV).

Exit load

In addition to the extra layer of AMC fee, gold savings funds also charge an exit load if you withdraw from the scheme within a year. While the general practice is to charge 1% exit load for up to 365 days, some fund houses charge more (see table Gold savings funds).

No physical gold

Another disadvantage with gold savings fund is that, unlike gold ETFs, you cant take physical delivery of gold. While most fund houses insist on 1 kg worth of ETFs for allowing physical delivery, only Motilal Oswal Gold ETF can be exchanged for as low as 10 grams of gold.

Should you invest in the funds ?

Despite their limitations and higher cost structure, gold savings funds are still useful for some investors, especially those who dont want to open a demat account and trading account. "Gold ETF investors usually ignore the costs related to demat accounts which can be significant if the holding value of the gold ETF is small," explains Rajesh Krishnamoorthy, managing director, Then again, being mutual funds, they extend all the benefits that a typical investor enjoys. "Gold savings funds also facilitate regular investment through the SIP route," says Chirag Mehta, fund manager, commodities, Quantum Mutual Fund. Though investors can do regular investing in gold ETFs as well, it requires a level of discipline and steely resolve that few small investors have. Whatever the reason, make sure you pick the gold savings fund that is tracking the underlying gold ETF closely.

Where is gold headed?

With gold prices ruling at higher levels, the consumption demand is contracting. During the April-June quarter, the global demand for gold fell 14%. The drop was sharper in India, with gold sales falling 20% to around Rs 51,000 crore. This was the second consecutive quarter to witness a drop in gold sales. A big dampener is the customs duty of 4%, which has depressed the demand for the yellow metal. Sales were hit as jewellers pulled down shutters to protest the 1% excise duty proposed by then finance minister Pranab Mukherjee in the budget.

Though it was later withdrawn, the stir hit sales. The fall in demand is also due to the lack of purchasing power in the US and Europe due to the ongoing recession. Also, global investors are chasing US and German treasury bonds, taking the benchmark yields to sub-zero levels. However, demand has recently perked up for gold ETFs in the domestic markets. After several months of profit booking and outflows, gold ETFs witnessed a net inflow of Rs 95 crore in July. The trend is mirrored in foreign markets as well, where central banks are shifting to gold. In the initial years of the US housing crisis, global central bankers shifted a part of their reserves to the euro. But with Europe too in a crisis, there is a rush to get the money out of the troubled euro and into the safety of gold.

The following factors could trigger another rally in gold:

* Another stimulus package in the US, which will push down the dollar.

* If Israel attacks Iran, global crude oil prices would flare up.

* Crude oil is at $116 levels. If the government increases prices, inflation would rise.

* A downgrading of India by credit agencies would boost gold.

Source : ET Bureau back