Gold ETFs vs gold FoFs: What investors can do amid investment restrictions

Gold remains an important consideration for investors looking to diversify their portfolios. But temporary restrictions on fresh investments in certain gold funds have raised questions about available alternatives.

Rishikesh Palve, Director of Products at Anand Rathi Wealth, in an interview to The Federal, explains how gold ETFs differ from gold fund of funds (FoFs), the options available to investors, and why asset allocation matters more than chasing rising prices.

Edited excerpts:

What are gold ETFs and gold FoFs, and why have mutual fund houses restricted fresh investments in them? What does this mean for investors?

A gold fund of funds (FoF) is a mutual fund that invests in a basket of exchange-traded funds (ETFs) that track gold. It is structured like other mutual funds, but instead of directly investing in physical gold, it invests in gold ETFs.

Recently, asset management companies (AMCs), or mutual fund houses, paused fresh investments in gold FoFs. These restrictions apply to systematic investment plans (SIPs), switch-ins and lump-sum investments.

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The decision comes amid a significant increase in gold imports, a rise in the dollar's value and a depreciation of the rupee. These factors have contributed to the decision to pause fresh investments in gold FoFs. Investors will not be able to make fresh investments in the affected funds for the time being. However, existing SIPs can continue, and investors can redeem their existing investments. The restrictions apply to fresh investments and do not prevent investors from accessing their existing money.

How are gold ETFs different from gold FoFs, and which is more suitable for retail investors?

A gold ETF is traded on a stock exchange, much like shares. Investors can buy and sell units of a gold ETF on the exchange. The ETF provides exposure to domestic gold prices through its underlying gold holdings.

A gold FoF, on the other hand, does not directly invest in gold. It invests in gold ETFs, effectively providing investors with exposure to a basket of these funds.

There are three broad points of difference between the two:-

1. A gold ETF provides exposure to gold through its underlying holdings, while a gold FoF invests in ETFs.

2. Their investment structures differ: ETFs are traded on stock exchanges, whereas FoFs are mutual funds that invest in ETFs.

3. Their taxation is the same under the tax treatment discussed here.

Both attract long-term capital gains tax at 12.5% when held for more than one year, while gains on holdings of less than one year are taxed at the investor's applicable income-tax slab rate.

If investors cannot make fresh investments in gold FoFs, what alternatives can they consider?

The first option is physical gold. However, buying physical gold comes with its own challenges. Investors have to pay GST and making charges. When they sell it, they may receive a lower price than expected, and storage is another major concern.

The second option is gold ETFs. These are still available to investors. However, increased demand could lead to a premium in their market price. For someone who wants exposure to gold without buying and storing physical gold, ETFs can be a convenient option.

The third option is sovereign gold bonds (SGBs). The government and the Reserve Bank of India (RBI) stopped issuing fresh SGBs in February 2024. However, investors can still purchase existing bonds through the secondary market.

Should investors buy physical gold now, or are there better investment options given the current market situation?

The first thing to understand is the role gold should play in a portfolio.

Gold should be viewed as a substitute for debt, not equity. When investors allocate money to debt, they often do so to hedge their portfolios. Gold can serve a similar purpose when included as part of an investment portfolio.

If investors want to allocate some money to gold, that allocation should come from their debt investments. It should not come at the expense of their equity allocation.

The 80% allocation to equity should remain intact. Gold should not become a replacement for equity. Its role is to provide a hedge and help diversify the portfolio.

Are sovereign gold bonds still an option for fresh investors, and what are their limitations?

Sovereign gold bonds remain an option for investors who want to invest in gold, but the RBI has not issued fresh SGBs since February 2024.

Investors can still participate in the market by purchasing existing SGBs through the secondary market. Their taxation depends on the applicable tax rules.

SGBs can be a good option for investors considering gold exposure, but demand and availability in the secondary market can pose challenges. Investors may find it difficult to obtain the bonds they want at a suitable price.

How much gold should retail investors hold in their portfolios, and what mistakes should they avoid when gold prices are rising?

Investors should understand recency bias. Whenever an asset rises rapidly, they tend to believe the trend will continue and feel tempted to invest. We saw this when gold prices surged and when US equities were rising. Instead of succumbing to this bias, investors should adopt a strategic approach.

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The first step is to establish a long-term investment objective and then decide how to allocate the portfolio across asset classes such as equity, debt, gold and real estate. Gold should be considered a substitute for debt, not equity, because its intended role is to hedge the portfolio.

However, gold's actual risk characteristics must be considered. Although often viewed as a hedge, its volatility can be significant and its risk profile can sometimes be closer to that of equity than debt.

For an investor targeting long-term returns of around 12–13%, an illustrative portfolio could allocate 80% to equity, 5–10% to gold and the remaining 10–15% to debt.

Investors should also understand that gold involves risk. They should not assume that gold is a low-risk asset simply because it is commonly used as a hedge.

Ultimately, gold can help diversify a portfolio, but investors should weigh the costs, risks and liquidity of each option rather than chase rising prices.

(The content above is for information only, and does not constitute investment advice.)