Spotlight . Gold ETFs eye futures for that extra edge

In May 2019, market regulator SEBI came out with a circular allowing mutual funds (MFs) to participate in commodity derivatives. While letting all MFs that run hybrid and multi-asset schemes to invest in exchange- traded commodities of all but sensitive commodities, it made provision for MFs running gold ETFs to use exchange-traded commodity derivatives having gold as underlying. Thus, many MFs, including big names in gold ETFs, are in the process of selling some gold in their vault and replacing it with gold futures contract.

To understand the risks and returns for investors in gold ETFs, we spoke to experts from the industry and the fund managers of gold ETFs. Here is the gist of the discussion.

New face of gold ETFs

While earleir, every unit of a gold ETF was represented by a unit of physical gold all the time, it may not be so here on. However, the solace is that fund managers say they will take a call on investing in gold futures only if it is profitable for investors. They will watch out on loss in the arbitrage trade and if the cost of roll-over of the futures contract exceeds returns from the money that was saved by not investing in gold and was invested in liquid/overnight funds.

Let’s explain this. The first step to taking exposure to gold futures is to see whether the gold in the physical market is selling at the same price or at a premium to the price in the futures market.

Only if this is the case, Nitin Kabadi, Head - ETF business, ICICI Prudential AMC, says, the fund manager will even consider switching to futures from physical gold.

Such an opportunity existed in the market in March and April when due to Covid-19, movement of gold was restricted and imports were not happening, but demand for gold was going up, which pushed the metal into premium over the futures price.

Further, the other check point will be the returns of overnight funds, where MFs would have to park the money saved from not investing in physical gold (in futures contract, investment can be made with just 10 per cent of the contract value, so the rest 90 per cent is available for investing in other assets). The return in overnight funds is about 3.5 per cent now. So, if the returns the fund manager can make by investing 90 per cent in overnight funds are more than the cost of rollover (plus the brokerage) of the futures contract (one has to sell the contract on expiry and move to the next month contract), only then will she decide to make a switch from physical gold to gold futures.

Take away: By switching to gold futures, the returns will only improve in gold ETFs. The expertise of the fund manager will become relevant in gold ETF choices here on. Those who spot arbitrage opportunities in spot-and-future in gold before others in the market will generae higher returns than the rest. One needn’t be very worried about risk, as fund managers, will not get into gold futures if there will be loss for the ETF investor.

In cases of delivery

All gold ETFs give investors the option to redeem their units for physical gold in multiples of 1 kg.

Now, in a situation where an ETF has divested 50 per cent of its holding in gold and put money in gold futures, and one morning all its investors come asking for redemption of units for physical gold, there can be a problem for the ETF. But there is very less probability for such a situation.

However, note that even in futures contract, every two months when the contract expires, there is an option for the holder of the futures contract to take delivery from the exchange, and the ETF can meet its obligation to the investor.

There is one angle here that investors need to know: the cost vs returns of taking physical delivery of gold from ETFs.

First, as an investor, when you take delivery of gold from your gold ETF, the MF would want you to pay the difference between the NAV price and the market price of gold — this difference is because of the cash component in the gold ETFs of MFs (each unit of an ETF doesn’t exactly represent one gram of gold as the fund holds some cash, too).

Then, as you finish the KYC and go to the vault to take delivery of gold, you will have to pay GST of 3 per cent. Remember, at a later date, when you want to sell this gold and approach a jeweller, he will again charge 3 per cent GST, and because you are not a registered GST dealer, you will be losing out 6 per cent on returns because of GST.

Takeaway: You can still convert your ETF units into physical gold, as in gold futures contracts there is an option to take physical delivery at the expiry of the contract.

However, note that taking physical delivery of gold from ETF units is not a smart idea as you will lose out on returns by coughing up the difference between the NAV and market price of gold, and GST on the gold bars.

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