Is there any risk in a gold ETF?

by Manshu on September 21, 2010

in ETF

Hell yeah!

End of post – all of you can go home now!

No, just kidding – I got this question in a comment yesterday, and I thought I’d do a quick post on it due to the immense popularity of gold ETFs, and the confusion that surround it.

ETFs are like mutual funds that also trade in the stock market, and you can think of gold ETFs as mutual funds that don’t hold stocks of other companies but rather hold gold deposits.

The price of mutual funds depend on the price of the stocks they hold, and the price of a gold ETF depends on the price of gold.

If gold prices fall then price of gold ETFs will fall, and there will be a loss on your investment. So, the fall in the price of gold is one of the main risks you need to worry about.

Now, it is quite likely that folks are telling you that gold prices never fall, it is an ultra safe investment, countries around the world are debasing their currency by printing money, the days of fiat money are over, this time is different therefore gold will never fall in value, and by virtue of that gold ETFs are risk free, but these are merely opinions.

Gold prices can continue to rise, or they can drop like a stone – no one knows for sure – remember that a lot of people thought that house prices never fall, but look what happened there.

There is risk in gold investment, especially now when retail investors are so keenly interested in it, and you should tread this with caution, you can make money, but you can lose money as well.

The original comment also had a question on how can you buy a gold ETF, which is answered here, and another one on how much profit should be expected, and I can honestly say that if I knew how much profit is to be expected then I wouldn’t waste my time writing this blog.

{ 34 comments… read them below or add one }

TIP Guy September 21, 2010 at 7:55 am

Hi Manshu,

love this line, “….if I knew how much profit is to be expected then I wouldn’t waste my time writing this blog.”

Best Wishes,

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Manshu September 21, 2010 at 10:33 am

Yeah, it’s crazy how people go off giving advice esp on TV on which stock or MF to buy, what percentage gain to expect, and even the time frame without so much as a warning that this is merely conjecture!

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Steven and Debra September 22, 2010 at 1:46 pm

One concern many have with gold ETFs is that they may not own the amount of physical metal represented by the total of ETF purchaser’s deposits. It’s a different version of “where’s the beef.”

If a person is simply trading gold, on a short term basis, the gold ETFs would probably be okay, but if the purpose of the purchase is to provide long-term insurance or hedge protection against a global currency debasement, this may not be the best way to go. If the gold ETFs practice fractional reserve type transactions just like the central banks do, one utilizing gold ETFs may literally be jumping out of the frying pan into the fire.

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Gold ETF October 5, 2010 at 12:28 am

Hey Manshu,

I agree with most everything you have said here, NOBODY can see the future but one of the things you might look for as a clue to when gold prices are going to reverse (it will sooner or later, everything does) is a large single day move, up big, like 50 dollars or more, then a close below where it opened at that day. A massive push higher during the day then a sell off and a lower close is usually a good sign of a top.

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Ed Liston December 3, 2010 at 8:59 am

Someone just asked me the other day: What happens when you buy Gold ETF from, say, a company like Benchmark, and then for whatever reason, the company Benchmark winds up and dies. What happens to your investment, then?

Difference with physical gold is, of course, that were you to buy physical gold from a jeweler, and then the jeweler ups and closes shop, you still have the physical gold in hand.

Related questions: 1. How secure is a long term investment in Gold ETF, especially in India where corporate accountability is a concept out there in the limbo?

2. No one can predict whether gold price will fall or not in the short term (1 year, even). But how about a long term prediction, say, for 20 years?

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mickey December 31, 2010 at 2:26 am

An interesting article on the Gold ETFs and what one can expect from it. I am sure gold prices will only rise and never fall.
It is the most preferred investment and is easy to do online at the flick of a key. All you need to do is open a (1) Demat Account (linked to your savings account) and a (2) Trading account, both possible at the nearest branch of a reputed bank like HDFC or ICICI. Within a week or so, you can buy the gold units (one unit =one gram) at the flick of a computer key. You can also instruct bank officials to buy a Gold ETF unit for you offline (there are tele-broking offices attached to the banks).
And whenever you wish to sell your gold, you need not go a jeweller nor worry about the price you will fetch for the accumulated units. All you have to do is click a few keys and the units are sold within seconds, with the money being transferred directly to your savings account. You can also sell units offline by giving standing instructions to the bank officials. Now isnt that a simple way of making your money grow !!

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mickey December 31, 2010 at 2:34 am

Another point I would like to make is that physical GOLD is so difficult to sell. In fact, people feel that gold is sold only in times of crisis.
So the GOLD ETFs provide us with an opportunity to freely trade in Gold — buy and sell whenever we want to.
An added advantage is the safety of your gold — in physical form, gold can be stolen and you will have to ensure that it is properly stored in lockers (with multiple visits to check your property)… but in ETF form, the gold is COMPLETELY SAFE..

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Mrs.Pradeepa Ganesh January 5, 2011 at 1:18 am

I agree with ur words.. how can i buy gold etf in online? How can i select banks or share agencies?

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Manshu January 5, 2011 at 4:38 am

You can buy them like shares, so if you have bought shares online, then you can use the same platform for this.

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kavita February 20, 2011 at 2:15 am

hi manshu. i wanna buy gold etf nd m totally new to dis. so will u plz tell me dat how can i buy nd which one should i buy?

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Manshu February 20, 2011 at 5:08 pm

Kavita,

You can look at GOLDBEES from Benchmark which is a good gold ETF, and you can buy this like any other share in the stock market. Have you ever bought a share?

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MOHAMAD IFTIKHAR January 14, 2011 at 12:15 am

Would like to know the procedure for online purchase of gold ETFs & the best & least expensive agency to purchase from.

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Manshu January 14, 2011 at 8:58 am

This is exactly like buying shares. You need to open a demat account and a trading account, then log in to that trading account or call up your broker, select the gold ETF you want to buy and execute the trade. The ETF will be credited to your demat account, and you can sell it in much the same way as you sell the shares.

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MSSetty March 21, 2011 at 10:43 am

This is the right time to buy gold etf at this current gold price?
Is there to chance to go down the gold price
If i purchased,how long can i hold it for safer side?

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Manshu March 21, 2011 at 10:57 am

There is no one who knows for sure whether it will go up or down. People have been looking at past prices going back a decade and saying that gold will go up, but the same people don’t take into account the fact that prices have been down for a good two decades before that.

Please see how gold fits in your overall investment plan and make any decisions based on that.

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Rakesh May 3, 2011 at 3:00 am

Nice article and a series of comment.
I have a simple query. I was going to buy gold coin from Post Office or Tanishq but just read about this ETF and checked various ETF NAV via nseindia. I am surprised to see how different houses are trading with different rates. When the gold price is fixed why a difference in NAV? It means there are some partial risks involved ETFs. ICICI is trading @2240 while Benchmar/ UTI are @2180.
Are there any risks involved other than Gold priceing?

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Manshu May 3, 2011 at 12:48 pm

Here is a detailed post on why gold ETF prices are different:

http://www.onemint.com/2011/02/15/why-do-different-gold-etfs-have-different-prices/

This post should give you an answer to your questions, and if you still need clarifications then please do leave a comment and I’ll answer if I can.

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Rakesh May 3, 2011 at 6:28 pm

Just read your another post and other comments and I think there is a general risk involved as with the MFs so I am deciding about moving to physical gold. As stated in one comment, I would wait for a better option in future at least we want to be sure that when we are going to sell, our one unit should be exactly equal to the 1 gram of Gold.
Thanks,
Rakesh

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Sudha May 5, 2011 at 10:57 pm

This is a really informative site for newbies like me. Thanks a lot! I have read a lot about E-gold, ETFs, etc. The financial experts are totally pushing for ETFs but this in itself makes me wary. Yet, trying to hold physical gold has its downsides.

What I don’t seem to get is in future, who’ll buy the ETF gold – which is essentially on paper – when one wants to sell? Does the ETF company buy it back, or how else? Whatever the gold rate in future, one could still trade the physical gold, isn’t it? In case I’ve missed an answer to this on this forum, please let me know.

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Manshu May 8, 2011 at 9:21 pm

Thank you for your kind comment Sudha.

In my opinion if you’re wary of it then you should keep away from it because you’ll never be at peace holding it, and ultimately that’s what matters.

Gold ETFs are backed by physical gold. All these companies should have an equivalent amount of gold with their respective custodians (Bank of Nova Scotia is the common custodian for most of them).

The ETF itself is traded on the secondary market like shares of a company, and the ETF company doesn’t buy it back. It will be bought by another trader. There are players called Authorized Participants that buy and sell ETFs from the ETF company or sponsor and then trade them on the exchange. So, there is a layer between the ETF sponsor and the retail investor. The bottom line is that the ETF units should be backed by physical gold, and the value of ETF units will always be brought close to those units by these APs whenever they see a market in-effeciency.

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Sudha May 9, 2011 at 7:32 am

Thanks, Manshu, for those details. If I may please ask for a further explanation – you say there is an Authorized Participant who’ll buy the ETFs; but for example, tomorrow if gold prices are in a sudden tumble, and everyone owning ETFs is scrambling to sell, it will still benefit such APs to buy? Is it because they’ll get it at a lower price & then the price will again pick up?? I mean, why would it benefit them to buy – speculation, like in shares? Thanks in advance!

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Manshu May 9, 2011 at 10:55 am

Let’s look at something that happened last week in the silver market in US Sudha since that provides a good example of what happens in times of stress.

Silver crashed about 30% last week, and though there are no silver ETFs in India, there are silver ETFs in US that fell by about the same percentage which is quite huge for a commodity like silver in a week!

Now, if this were to happen in gold what would happen is that the gold sitting in everyone’s vault is lower by 30% now – whether in jewelery, or gold coin or gold bar form.

The gold ETFs will also fall by 30% because they are backed by underlying gold that is there with the custodians. If the gold ETF fall by more than that – say 50% then the APs know that the gold in the vault has only fallen by 30% so they can buy gold ETFs from the market and exchange that for gold since they can exchange this gold a lot cheaper now.

This kind of mechanism ensures that if the physical asset falls, then the ETF doesn’t fall too far beyond the value of the underlying asset.

The only situation where I think this won’t be the case is if there is fraud – for example if you found out that the ETFs don’t actually hold as much gold as they claim they do, or if the clearing houses fail, which I don’t think has ever happened.

Whether there will be fraud or not – someone like me will have no idea about that kind of thing, and while there are others who claim to know about such things; I think that perhaps their confidence is misplaced 🙂

Does this make sense Sudha – do you have any more questions?

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Sudha May 11, 2011 at 10:57 pm

Very clear, Manshu. Thanks heaps for going into the details. You make all that jargon so simplified, it feels good to actually be able to understand these complexities and make a proper decision.

Yeah, the silver crash did come to mind. Think a balance between holding some physical gold and some in ETFs may work, considering there is an ETF buffer of sorts. Everyone recommends the GoldBEES. So, will look into that and consider. Thanks again, Manshu. Really appreciate!

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Sudha May 11, 2011 at 11:10 pm

Do excuse, Manshu – one tubelight question (kept reading it as the same figure). Why would the ETF fall below the gold value – where you say if the ETF falls by 50%, the APs know the vault gold has only fallen by 30%. It would/should falls as much as the gold value does – because the ETF reflects the gold fall?? Or would because of some expense ratio & some other small print stuff?

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Manshu May 17, 2011 at 12:29 pm

It shouldn’t Sudha – I was trying to explain the self correcting feature of the product and hence took the example. In reality it shouldn’t fall so much. Only if something is broke will it fall so much.

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Sudha May 18, 2011 at 11:47 pm

Thanks, Manshu! Very clear now. Your inputs are such a big help. Wishing you the best always!

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Manshu May 19, 2011 at 4:16 pm

Great, glad to hear that! Wish you the best as well!

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Sanjeet May 18, 2011 at 4:11 am

Thanks Manshu for clarify the basic concept of “working of GOLD ETF”. Always wanted to know how it works.

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Manshu May 18, 2011 at 4:39 pm

Thanks for your comment Sanjeet!

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Sanjeet May 18, 2011 at 4:22 am

Manshu,

I also have question.

Is there any tax benefits for investing in Gold ETF? If so, please name them.

Thanks
Sanjeet

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Manshu May 18, 2011 at 4:39 pm

No, Sanjeet – there isn’t any tax benefit of a gold ETF. It has slightly more favorable treatment than physical gold, but there is no benefit. This post has details about tax treatment on gold ETF as well as other assets.

http://www.onemint.com/2011/04/11/capital-gains-and-dividend-taxes-on-shares-and-mutual-funds/

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Chipku February 3, 2012 at 2:52 pm

Hi Manshu..

Iam planning to invest some amount every month (say,5000 p.m)..for 4 years..to buy jewellery after 4 yrs for my marriage. I want it clearly for my marriage, and no ideas of using it as investment or selling.

And i have seen gold fund scheme of Axis bank, where they credit ur monthly installment as gold of current market price. so which one will suit my needs? This scheme or ETF?

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Vijay April 16, 2013 at 2:22 pm

Hi Manshu,
Being new to Gold ETFs your simple explanation gave good information about Gold ETF as investment option. I was considering Gold ETF as my investment option. But gold price is presently in declining trend. Should i wait for reverse in trend or start investing?
Thanks in advance

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Manshu April 16, 2013 at 8:55 pm

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