Knowledge Cafe

Why Gold should be a part of your Portfolio?

As we all know, diversification is an important aspect of an investment strategy as it allows an investor to maintain the right balance between asset classes of different correlations. However, many of us rely mainly on equities and debt instruments alone to achieve diversification in our portfolios. Though we Indians always fancy owning gold for various cultural and emotional reasons, not many of us consider it to be a part of the portfolio while deciding on the asset allocation. The truth, however, is that gold can be an integral part of the portfolio as it has a negative correlation with the other preferred asset classes such as equities and debt.

This is mainly because the fundamental factors that impact other asset classes don’t affect gold considerably. The sources of demand for gold are far more diverse and that explains the independence of the gold prices as well as the robust demand over the years. A wide range of buyers like the jewellery sector, financial institutions, manufacturers of industrial products as well as various investment channels  including coins and bars,  futures and options as well as gold ETFs (Exchange Traded Funds) also make liquidity risk very low.

Clearly, there is a need for investors to achieve more effective diversification by including alternative investments such as gold in the portfolio. Besides, gold enjoys the reputation of being the protector of wealth against a monster called “inflation”. In other words, gold has the potential to maintain its purchasing power over the longer term through both inflationary and deflationary periods. Besides, gold also has the potential to provide impressive returns over a sustained buoyant period, as is currently the case.

Gold is unique as it does not carry a credit risk. However, there are a few risks such as risk of price fluctuation. As regards the factors that impact the gold prices, demand and supply factors do not always have the same impact as they do on other commodities as gold has a hybrid nature. It can be said that gold is both a commodity as well as currency. Many countries, central banks and individual investors maintain gold in vast reserves. As a result, the price of gold is often dictated by its relative value to the currencies rather than just on demand and supply.

Some of the other factors that can influence gold prices are currency movements as well as oil prices. Indian gold demand is supported by cultural and religious traditions which are not directly linked to global economic trends.

A major issue for investors who may like to include gold in their portfolios is to choose the right way to invest in gold. For example, while holding physical gold has its own problems, buying gold futures has its own risks. Thankfully, today mutual funds offer investors a few effective choices that can eliminate many risks that one has to face while holding physical gold.

Firstly, there are Gold Exchange Traded funds (GETFs). An exchange traded fund with gold as its underlying asset is called Gold ETF. There are many advantages of investing in GETFs. For example, gold storage and other costs are shared with other investors. GETFs allow investment in gold in small denominations thereby allowing retail investors to participate. In the secondary market, the minimum lot is one unit. This allows an investor to accumulate units over time and take advantage of “averaging”. Further, investing in paper gold is more tax efficient than investing in physical gold. Also, gold held in paper form is not liable for wealth tax.

GETFs bring in a level of transparency in gold transactions. These are passively managed funds and are designed to provide returns that would closely track the returns from physical gold in the spot market. An investor can buy and redeem the units through the stock exchanges.

Another option for investors to invest is through “fund of funds” launched by domestic mutual funds to invest in gold mining companies through an international fund.  Investing in a scheme like this provides investors access to fund manager’s expertise and active fund management, which is not available in GETFs. Also investing in gold mining companies offer investors the upside opportunity through organic/M&A growth as well as leverage the increasing price of gold. In other words, investors benefit as the profitability of gold mining companies increases with a rise in gold prices.

The most recent addition to these options is a new breed of open-ended “fund of funds” that invest in domestic gold ETFs. These funds allow investors to invest in gold ETFs without having a demat account and without having to approach a stock broker. Besides, those who intend to invest in Gold ETFs through a SIP route can do so in these funds, whereas Gold ETFs do not provide this facility.   While Reliance Mutual fund was the first fund to launch this fund in February 2011, Kotak Mutual Fund too is launching a fund in this category. Considering the mass appeal of this product, many more mutual funds (MFs) can be expected to join the band wagon soon.

As is evident, MFs offer a variety of hassle free options for investors. Therefore, if you decide to include gold in your portfolio, make sure mutual funds are an integral part of your game plan.