I propose to invest in Gold ETFs (Exchange Traded Funds). What are the basic things I need to know about gold ETFs before investing in the same?

First and foremost, you need to know that Gold ETFs cannot be exchanged for physical gold. If you are a retail investor in gold ETF, you cannot actually exchange your ETF for gold. These gold ETFs are listed and therefore you can buy and sell the gold ETFs at any point of time in the normal equity markets. When you buy gold ETFs you pay cash and when you sell ETFs you realize cash. Of course, Mutual Funds do offer the facility of converting the ETF units to gold but that is limited only to those who hold beyond a certain quantity. Normally, those investors holding more than 500 gm equivalent of gold can approach the MF AMC for redemption to gold.

Secondly, remember that the NAV of your gold fund does not move exactly in tandem with the price of gold. If gold has moved up by 5% over the last 1 year, then your gold ETF returns will not exactly be 5%. There are 2 reasons for the difference. Firstly, operating and running a gold fund has a cost attached to it in terms of manpower, executing transactions, infrastructure costs etc. Hence, the net returns will be lower than the actual gold price movement. Secondly, there is something called the tracking error. Be it an index fund or a gold ETF, the fund makes an effort to track the underlying. However, practically there are small differences and that is called tracking error. That is why you must always prefer gold ETF with a lower reported tracking error.

Thirdly, an important point for you to note is that Gold is a hedge in bad times; not an investment in good times, and that should drive your investment in gold ETFs. Gold has managed to hold value better than other asset classes during bad periods. If you look at the history of gold, it gave extremely good returns between 2008 and 2011 when investors had lost faith in financial assets after the Lehman debacle. Similarly, gold did extremely well between 1971 and 1977 when global uncertainty was high in the light of the oil embargo. However, when equities have been in bullish mode, gold has rarely done well. Whether you buy physical gold or gold ETFs, you need to look at it as a hedge against bad times.

Fourthly, Gold ETFS is one of the various means of investing in gold and it is interesting investment because it saves you time, cost, administrative burden etc. When you calculate your overall gold exposure, you need to add up all your gold holdings. Be it in gold bars, coins, jewellery, gold bond and gold ETFs. It is normally recommended that your exposure to gold should be in the range of 8-12% and a bigger shift towards gold is not recommended. Depending on the uncertainty in the markets, one can tweak their overall gold holdings within the range mentioned above.

Fifthly, it needs to be remembered that Gold ETF saves you costs like storage, handling, conversion etc. That is largely true. Of course, when you buy gold ETF, some of the charges like storage, movement and custody get billed to your fund. That means you eventually pay for it. But the big cost you incur in physical gold is the loss you incur in terms of making charges, erosion in value, carat mismatch etc. With gold ETF, 10 gm means 10 gm. That is the advantage.

Sixthly, Gold ETFs are not risk-free, just as gold is not risk-free. It is just that they are a lot more liquid form of investment compared to physical gold. Neither gold, nor gold ETFs are risk-free. Of course, when you invest in gold ETFs issued by a SEBI registered MF, you have the comfort that your ETF units are backed by actual gold lying with the gold custodian bank. However, if the gold prices go down sharply in the Indian gold market, then the NAV of your gold ETF also goes down sharply. The price risk does exist in a Gold ETF too.

Is it really true that gold ETFs are more liquid? The answer is clearly in the affirmative. That is technically correct, but practically there are some caveats. Typically, different Mutual Fund AMCs have issued gold ETFs in India. If you look at the liquidity and trading data, not all these funds are equally liquid. In some cases, the gold ETFs are not very liquid. As retail investors you need to ensure that you invest in gold ETFs issued by established mutual funds with a track record of trading and liquidity in the markets.