What’s the best way to invest in gold?
Physical gold, jewelry, gold ETFs, mutual funds, or government gold bonds?
In this post, let’s leave out physical gold and jewelry and focus on financial investments in gold.
In this post, let’s compare the various characteristics of gold bonds and gold ETFs (and gold mutual funds) and evaluate which is the better choice.
# 1 Government Gold Bonds Versus Gold ETFs: Lock-in and Maturity
Not tied to gold ETFs and gold mutual funds. No concept of maturity, either in gold ETFs or gold mutual funds. You can keep these investments for life.
Gold ETFs also have no exit load concept. Gold mutual funds can have a low exit load in the event of early exits.
When it comes to gold bonds, there are technically no ties. You can sell the bonds on the secondary market at any time. Also no exit penalty. However, if you want to keep the bonds in physical format (rather than demat format) and don’t want to convert them to demat format, you will have to wait until early payout windows or due dates to get your money back.
In addition, gold bonds will mature in 8 years (from the date of issue). Hence, you can hold for life. You can then invest in another tranche of gold bonds if you wish.
Slight edge to gold ETFs
# 2 SGB vs Gold ETFs: Liquidity
Gold ETFs need to be bought and sold on the secondary market (unless you are a big player and can buy / redeem directly from the AMC).
Gold bonds, on the other hand, can be bought on both the primary and secondary markets. Even if you want to get out, you can SELL on the secondary market or REDEEM from RBI during certain periods of time.
From a purely secondary market liquidity point of view, gold ETFs are likely to perform better, as there are only a few ETFs (currently 10-12).
On the other hand, there are already 50 gold bond issues and the RBI adds a new gold bond issue every month. Hence, the supply and demand for gold bonds can be distributed across different issues of gold bonds. Volumes for various bond issues can be found on the NSE website. Some bonds are larger in volume than others.
Note: I’ve seen gold bonds trade at both a discount and a premium on the underlying gold price. Ideally, gold bonds should trade at a premium to the underlying gold price because of the additional interest component. But the markets are markets. There are many other factors that affect supply and demand. We discussed some of these factors in my post on buying gold bonds in the secondary market.
By the way, gold ETFs will also have a price-NAV difference problem.
Gold ETFs are the likely winner here.
Gold mutual funds might be an even better choice here because you buy from AMC and sell to AMC. And the AMC has to offer unlimited liquidity.
# 3 Sovereign Gold Bonds vs. Gold ETFs: Interest Income
Sovereign gold bonds are a clear winner here.
You earn an interest income of 2.5% pa on gold bonds. Note that the interest rate can be different for each tranche. When the gold bonds were issued in 2015, the interest rate used to be 2.75% pa. RBI has issued the most recent tranches at 2.5% pa
Please understand that you can buy government bonds from the secondary market at a price that differs from the issue price. The interest is calculated on the issue price of the respective gold bond (and not on your purchase price). For example, RBI issues a gold bond tranche at Rs 5,000 per share. They manage to buy the same gold bonds at Rs 4,500. The interest is calculated at Rs 5,000.
No other form of gold investment (physical gold, gold mutual funds, golf ETF) offers you interest income.
Winner: State Gold Bonds
# 4 Gold ETFs vs SGBs: Taxes
Taxation is the same for gold ETFs, gold mutual funds, and government gold bonds.
If you sell for up to 3 years before holding, the resulting capital gains will be taxed at your marginal tax rate.
If you sell after a holding period of more than 3 years, the resulting capital gains after indexation will be 20%.
However, the SGBs have two additional beneficial improvements:
First, there is interest income that is taxed at your marginal tax rate.
Second, there are two ways in which you can exit your position in gold bonds. Sell or Redeem.
You are selling government bonds to a fellow investor. You REDEEM the SGB with the RBI.
The profits from SGBs are only taxable if you sell to a co-investor.
Redemption at RBI (either on the due date or at specified early withdrawal windows) is tax-free. And this gives gold bonds a great advantage if you are a long term investor. You buy at 2,000 and at maturity the gold bond price is 5,000. Technically, you have a profit of Rs 3,000. However, such profit is not taxable.
There is no way you can avoid this tax on such capital gain in gold ETFs or gold mutual funds.
Winner: State Gold Bonds
# 5 SGBs Vs. Gold ETFs Vs. Gold Mutual Funds: Expense Ratio and Return
Both Sovereign Gold Bonds and Gold ETFs (Gold Investment Fund) track the price of gold. Differences in performance therefore arise due to higher expenses or transaction costs.
Gold ETFs have an administration fee. The expense ratio of gold ETFs can vary from 0.4% pa to 1% pa. This leads to a deterioration in performance.
Note: If you browse sites like ValueResearch, you will find that gold mutual funds (compared to gold ETFs) have low expense ratios. However, gold mutual funds typically invest in their own gold ETFs. For example, the HDFC Gold Fund will only invest in HDFC Gold ETF. Hence, a gold mutual fund will have a double cost incidence. Your own expense ratio and the ETF’s expense ratio.
When gold mutual funds or gold ETFs buy gold, they have to pay GST (currently 3%).. While they can get input credit for the paid GST, it is still a disadvantage for performance. I couldn’t gauge the impact. Please understand that GST applies when ETFs buy gold (and NOT when you buy gold mutual funds or gold ETFs).
Additionally, gold ETFs can have transaction costs (brokerage, etc.) and potentially impact costs if you buy in the secondary market.
You can see the effects. Check out the Nippon India Gold BeES underperformance versus domestic gold prices.
In contrast, government gold bonds accurately reflect the price (at least if you buy on the primary market and cash in at RBI).
No expense ratio on government gold bonds. There is no GST when buying government gold bonds. No transaction costs or impact costs, even if you buy on the primary market and redeem at RBI.
Lower SGB costs and interest income result in better returns versus gold ETFs and gold mutual funds.
Winner: Government gold bonds
Here is the summary of the comparison.
Which is a better choice?
Gold ETFs and gold mutual funds do better in terms of flexibility (lock-in and duration) and liquidity.
Gold bonds offer additional interest income and also do a little better in terms of taxation. Because of their lower cost, gold bonds are likely to produce much better returns than gold mutual funds and gold ETFs.
After examining all aspects, the government gold bond is the winner over gold ETFs and gold mutual funds.
When can sovereign gold bonds fail you?
When you invest in SGB, you are not buying gold. The government doesn’t buy gold to protect your investments.
All you buy is a promise from the Government of India that they will
- Pay 2.5% of the face value of the bond (the price at which the bond was originally issued by RBI) per year.
- When due, pay the amount equal to the prevailing gold price in rupees.
Essentially, in addition to the interest payments, the government gives you back the gold price in rupees when it is due. And so the government bears the price risk.
Gold ETFs don’t. Your investments in gold ETFs are protected by buying actual gold.
What if the government defaults?
Unlikely as there is no limit to the government’s ability to print money. Not so easy.
But what if the rupees collapse (lose value sharply) or India experiences hyperinflation?
The government does NOT make a commitment to give you gold, but rather to give you rupee equivalents of the prevailing price of gold. And rupee will be worthless in this scenario. A payment in rupees is therefore irrelevant. The rupee will no longer be a store of value. Your bank FDs or fixed income investments will be wiped out. Only real assets like real estate, gold, etc. (or claims to real assets like equity) retain their value.
You could say that the government has to give back the prevailing price of gold, no matter what the price. However, by the time the government pays it and you spend it, the rupee would have lost much of its value.
This is of course a hypothetical scenario. Pretty far fetched. But such hyperinflation episodes are more common than you think. Here are some episodes of hyperinflation over the past century, the most notable of which were in Germany after World War I.
Compare this to physical gold. This physical gold will continue to hold its value against the USD. You can migrate to another country with your gold and exchange your gold for a stable currency. I understand that getting gold out of the country is not easy. Even if you stay in India, your physical gold will be a good store of value (which retains its value against other assets) until the government figures out a new stable currency. Perhaps then gold will become currency (for a short time).
In such a scenario, gold ETFs may be a better option than gold bonds because your investment is backed by gold. There is also the option that you can convert your physical units into real gold. In addition, gold ETFs are not associated with a term. So you can choose to hold these units until the country is out of the crisis. Gold bonds have a maturity date.
I don’t want to indulge in scare tactics. These things are much more complicated than I would like to believe. Many second, third, and higher order effects will come into play. My knowledge or understanding of such matters is rather limited.
Speaking of which I don’t think India will go through such a phase. So I have all of my gold investments in government gold bonds. And even if something like this happens, we will have much bigger problems to deal with. Law and order will be a mess. Widespread panic. Many institutions will fail. The intent is merely to highlight a scenario where physical gold stocks are held above SGBs.