Should You Invest In Gold Right Now? What Are The Options Available For Investing In Gold?

Amidst the COVID-19 fueled global turmoil, one asset class that has outshined is gold. As a result, a lot of investors have started investing in gold. But should you be investing in gold now?

In this ‘Ask the Expert’ session Vikram Dhawan, Fund Manager, Nippon Life India Asset Management, will help us decode the reasons for this amazing run of gold.

Can you talk about the reasons behind this huge bull run gold is seeing?

Dhawan: One has to appreciate the long term, medium-term, and short term factors that are in play with regards to the ongoing bull run. Let’s first talk about the long term factors. 20 years back, post the Asian crisis rather the Asian currency crisis, and since the crisis happened because the so-called wider economy ran out of US dollar reserves, that time the thought process was to tank everything else and buy US dollars. So even gold was dumped and the US dollar became very coveted. The situation became so bad in the late 90s and the gold prices were so low that the central bank had to sign an agreement called the Washington Agreement in which they limited the sale of gold so that the price does not go any lower.

Fast forward 20 years, all central banks today realized one thing that whenever the US is hit by an economic crisis, the US federal reserve does not hesitate to bring down the interest rate. It not only reduces the returns on the dollar asset but it also creates a lot of imbalances. So we have seen the dollar is not as coveted or as invincible as it was 20 years back. Obviously, this is a slight sentiment shift but not a tectonic shift, as still there is no substitute for the dollar. But it is still the best option in terms of central bank reserve. Now, the 2019 rally was all about the central bank buying where there was an attempt to de-dollarize the asset in a partial way. There was also a strategic buying by Russia or China which feared that if the geo-political or the trade tensions flared up then they would like to have some strategic assets in their central banks.

Also, we have seen in the past 4 to 5 decades, a trend of structural decline in the interest rates. Now for the fact that we have been living in a deflationary world for the past few decades and deflation is going down, and gold being an inflationary hedge, fall in interest rates or fall in inflation is bad for gold, but we have to appreciate a few understated attributes of gold. Gold is a liquid asset and it does not have any credit risk. Inflationary spiral comes with a lot of stress in the credit and bond markets, so you would like to hold on to gold whether there is inflation or not just to reduce the risk against such stresses.

Also, the mine supply which has been very strong in the past decade due to the overhang of higher prices that extended till 2011, typically it takes anywhere between three to six years for the mine to be conceived and start production. Now the mine supply might level off or it might go down also. The reason is, the mining industry is in a bit of a crisis because even though the interest rates are low they don’t have access to cheap funding as a lot of traditional investors in the mining industry have shrunk their balance sheets. And not to mention the environmental challenges. The byproducts of gold are arsenic and cyanide, two most lethal substances known to man.

The other factors which are contributing to the gold rally are the advent of the gold funds and ETF. Now with the advent of the gold fund and ETF, the common grounds of investors’ liquidity and ease of investing are sorted out. Today you can participate in the gold market with any amount of money, small or big. For example, if you buy a gold bar and then sell it in the market then there can be an erosion of anywhere between 5% to 10%, for a coin, it’s 10% to 15%. What these ETFs do is create ease of investing in gold and take care of the liquidity.

Now, let’s talk about where it can go from here. Do you think this rise will continue or we are at the last stage of the gold rush?

Dhawan: As long as the majority of the long term factors are in play, it would be a good opportunity for investors who are looking to invest in gold for the long term. Either from the point of view of absolute returns or portfolio diversification. Obviously, nothing can go in a straight line, gold is also vulnerable to bull and bear markets.

The medium-term factor can be physical demand. For example, due to the COVID-19 crisis, the physical demand in India and China, which constitute 50% of global demand, was very weak. In the month of July, we saw some demand coming up. Now we have to see whether the demand comes up during the festive season in India, or during the Chinese New Year in February. We have to wait and see how much of the demand we lost permanently. Also while the physical demand for gold vanished from India and China, the western world is buying gold in all forms. It is an all-time high in the western world. And you might see Indian investors imitating their western counterparts.

Another thing that is working in support of gold is the shift in medium-term sentiment over US dollars. There is a forecast of the dollar falling further. I think it will be very interesting, you have to appreciate the two bright spots in the global economy China and Germany which are the largest exporters to the US, so you can see some backlash in Euro or Yen if the dollar falls. It’s an interesting time for the currency markets, though all won’t be in the negatives. But volatility in the currency markets leads to volatility in gold prices.

Also, the short term factor that can lead to money coming out of the gold market is — once the COVID-19 vaccine comes you will see some money coming off the table. But for the long term investor, as long as the long term trends are in play any steep correction would be a good opportunity to buy for a longer-term.

Why should people invest in gold? Is it just a hedge or you actually make some returns out of gold?

Dhawan: There is a standing joke regarding gold especially in India — whenever there is an economic crisis, the Indian households who are the largest holders of gold tend to outperform everybody, including Warren Buffet. Even though I have been in this business for some time and have a strong affinity towards gold, since gold does not pay any dividend or interest, the fact that people are buying gold and placing their money in that asset class shows how much lack of trust has crept into the mind of investors and how they want to diversify their risks. Even though they are heavily invested in the capital markets, there is a bit of mistrust. And history has shown that investments have gone wrong, and gold has done better.

From the point of view that it does not give you anything and it just lies there — it cannot be a coincidence that during the three economic crises, people’s faith has been in gold. That is why one should not ignore gold.

Now those who want to invest in gold, there are a lot of options. There is digital gold, ETFs, sovereign gold bond, physical gold. Can you talk about where an investor should invest and why?

Dhawan: Every investor should keep three buckets of gold — consumption, investment and insurance.

In the consumption bucket, they can keep jewelry, coins, bars, etc. But while the feel-good factor for physical gold is much higher, it is not a very good investment unless you are not investing in a very large size. When you are buying physical gold you are paying the making charge also, which you will never recover unless you are holding on gold in a very large scale. Also today the inverters have become very aware, so if you want to sell a bar, the buyer would ask you to give him the certificate, origin certificate and so many things. So keep the physical gold in the consumption bucket.

In the investment bucket, you can have an ETF, gold saving funds and sovereign gold bonds, etc. There you have to see what kind of liquidity you want to have in your portfolio. While gold sovereign bonds are a good product, they are still a niche product, it does not have patronage or participation from institutions. So till that time, there will be limited liquidity and you will have to worry about how liquid is your combined portfolio.

In regards to the insurance bucket, many people actually avoid keeping gold in that. I will tell you why you need to keep gold in your rainy-day bucket. For rainy days, you typically have fixed deposits and insurance policy, but if you have a gold ETF or gold fund in that, they would be the first ones that you can redeem during emergencies. Insurance policies will take time, you can’t touch fixed deposits because you will have to pay a penalty on that.

So this should be the thought process for allocating your money in gold.

One of the options is digital gold, and one thing that is touted as a negative is the expense ratio, also you have to pay a GST. Now do these things affect your returns if you are investing in the long term?

While digital gold is a very good innovation, it is not under any regulatory oversight. Like sovereign gold bonds are under RBI regulations and we are under SEBI regulations, if it’s a bank it’s again under the purview of RBI. So there are very little things that can go wrong in the structure that mutual funds provide. Unless there is clarity on regulation for digital gold and which regulatory body you can go to if anything goes wrong, till then it would be an accessory to the entire market.

Let’s talk about sovereign golds now. Are there any risks involved in the case of sovereign gold bonds?

Dhawan: One of the reasons why people like gold is, especially the central banks, HNI, institutions, and individual investors also, it does not have any sovereign or credit risk. Obviously, it’s more of theoretical risk, and we do not want the Indian government not to honor its sovereign responsibilities but I think that is where the difference in pricing may be observed. While an ETF is backed by physical gold, the sovereign gold bond will have sovereign risk. That’s theoretical, but that is how we are seeing premium discounts on it. And also the limited liquidity. But you have the additional interest rate and tax benefit for the sovereign gold bond. It’s a trade-off actually.

Can you expand a little more on this trade-off?

Dhawan: It is not so much of a sovereign risk issue besides the pricing and the market discovery of the prices. It is more to do with the investment objective of the investor. If you are an investor looking towards gold in terms of absolute returns, then maybe you would want to allocate some money in sovereign gold bonds. But again there is a holding period and the limited liquidity. The whole purpose of sovereign gold is to hold it till maturity for the tax benefit. If you look at it from the perspective of diversification of your portfolio, then the gold funds or the ETF give you a better trade-off vis-a-vis liquidity. Because you may want to change the allocation of each asset including gold, and the ease of doing will outplay the other benefits of the sovereign gold bond.

How much gold should one’s portfolio have? And should one consider gold held as jewelry as asset allocation?

One should hold jewelry in the consumption basket but it should not be a part of your investment portfolio.

You can broadly classify investors in gold in three categories. The tactical investor, the absolute return investor, and the diversification investor or the asset allocator.

So if you are a tactical investor, then the only thing that I would like to say is — be it gold or any other asset class, today most of the traffic in the commodities or equity exchanges is dominated by machines, they have been developed by spending millions of millions man-hour and millions and millions of dollars, so appreciate your odds if you want to invest money in gold from the short term trading perspective. If you do not have the requisite skills, then it is like getting up one day and challenging Roger Federer for a tennis match. But if you are good at it, then go for it.

Now for the absolute return investor and for the diversifier, there is a bit of a paradox there. Now an absolute return investor would only be concerned about his long term absolute returns. He or she is sector or asset class agnostic. If this kind of investor is holding too much debt in his portfolio, if you look at the historical returns from gold it is between debt and equity, he may want to add gold to try and increase his aggregate returns.

Similarly, for the portfolio diversifier, it works the other way around. He would be using gold to hedge the risk. So in his portfolio, the more risks he holds, the more he needs to allocate to gold. So you have to be very careful about your investment objective.

In terms of the numbers, I would take the leaf out of the latest analysis by the World Gold Council, in which they said that a typical Indian portfolio that is aiming for a 9% return in the long term if you allocate in gold somewhere between 6% to 17% it not only enhances your returns it also enhances the risk-weighted returns, i.e volatility of returns. Now from 6% to 17%, you can narrow it down to 5% to 15%. Again from the portfolio diversifier point of view, the higher the risk you have in your portfolio, then the higher the allocation of gold. So if you are holding a portfolio that is skewed toward risk, then 10% to 15% should be your allocation towards gold. And if your portfolio is skewed towards safety and you are holding too many high graded debt, then maybe 5% to 10% allocation towards gold.

A lot of people do not have gold in their portfolio and now want to add it. Do you think people should hold off from starting to accumulate now, even if it is for the long term?

Dhawan: We had three major economic crises and in all three times gold has stood the test of times and has shown its value as a hedge or a diversifier. That is a track record that can’t be ignored. Though it can’t be guaranteed in the future, it is a very profound track record.

Also when gold is not trying to enter into rallies, it is still giving you some returns. If you look at its long term returns, ie, for 20 or 50 years, it is still decent which is about 8% to 9%. So here is a hedge that is not a drag on your portfolio over a longer period of time but when you need it, it’s always there.

Again whether to buy it or not at this point in time, it depends on your investment objectives. Are you looking to buy it for a tactical reason — then you are also looking for an answer when to buy, so skip that. Are you buying gold for its long term track record? Are you buying for safety as gold does not have a credit risk? Does the liquidity of gold attract you towards it? Whether it was 2008, 2011 or 2020, while the capital markets were hitting the lower circuits and credit markets were freezing, you could still buy or sell gold. Yes, it was volatile, but you could buy or sell it. Gold is one of the most liquid asset classes and you don’t see it only trading on the exchange or physical market, it is a very deep and inter-bank market where the central banks are also participants. Or are you buying it for the inflation hedge or its store value?

In regards to the store of value, a gold bar of the size of your cell phone, which is 1 or 1.5 kgs, 10 years back it was Rs 30 lakh, today it would cost much more. It’s like putting a big chunk of money at one price, you may or may not get it right. A big chunk of gold in the previous peak which occurred in September 2013, when the gold hit a high of Rs 35,000 for 10 gm, even then also you would have made 6% annualized returns. But if you would have spread your bets over 6 to 12 months, you would have got double-digit returns. That is how you should approach the market. Be clear about why you are investing in gold, if it’s a trading opportunity then I can assure you there are a lot better trading opportunities than gold. In my two decades of experience, I have seen that people who have bought and held gold made much better returns than those investors who trade-in and trade out. It’s true for every asset class.

Originally published at https://www.etmoney.com.