Gold – That Shiny, Problematic Object

Did you know that gold ETF prices & their NAVs saw abnormal divergence in April? Abaneeta Chakraborty explains why this happened.

Gold ingots in Russia. (Photographer: Andrey Rudakov/Bloomberg)
Gold ingots in Russia. (Photographer: Andrey Rudakov/Bloomberg)

I cannot claim that I have listened to all budget speeches carefully. For some reason, however, I distinctly remember P Chidambaram urging Indians in 2013-2014, to control our “uncontrolled passion” for gold. It was a major culprit contributing to our current account deficit. In the import bill, it was second only to oil, the demand for which is fairly inelastic – hence this bid.

It may be interesting to note that since then, the Reserve Bank of India has increased its gold reserves from 557 tonnes to 653 tonnes i.e, a whopping 95,000 Kilograms. Why, you may ask? Mostly to diversify its foreign exchange reserves. After all, gold is a reserve of purchasing power and fiat currencies are not.

Households may want to keep gold for the same reason but the government continues to discourage us. Sovereign gold bond schemes were launched a few years ago. Initially, it got no attention. I had almost forgotten about them until the current issue caught some steam.

The structure promises to pay the bearer, the price movement in gold over the holding period of eight years plus a 2.5% interest per annum. Also, it is denominated in grams. They are, however, not backed by gold. Naturally - If the government had to import gold to back the bonds, that would defeat the very purpose of issuing them.

A common man’s way to make peace with this is to look at how much reserves the RBI has. Many have come to me with this misconception. For some reason, to them, it seems like a hedge. Allow me to reiterate that it is not! The gold on RBI’s balance sheet is part of the country’s foreign exchange reserves. It does not belong to you and me. Contrast this to say a gold exchange-traded fund where the asset management company creates units against a real reserve of gold, stored with a custodian.

By now, it may have become clear that sovereign gold bonds are more sovereign bonds than gold bonds. It is the Indian Government borrowing at 2.5% above gold price movements – gold that it does not have as a back-up, to sell when needed and hence, is assuming a price risk. If you are an investor, you may say that it does not matter to you because the sovereign will not default on you. Hence, what happens in the background is not of any interest – to you.

It does matter, however.

If gold keeps appreciating the way it recently has, at the time of maturity of these bonds, coming on top of all other fiscal pressures, Government of India may have to print money to pay its citizens.

The more it does so, the less valuable the Indian rupee becomes. Interestingly, this makes gold even more valuable turning this whole thing into an ugly, self-fulfilling prophecy.

What the government really is doing here is controlling the current account deficit at the cost of devaluing its home currency, and shifting the problem on to the fiscal side. In the current scenario, this structure needs some serious rethinking if the government does not want to axe its own foot.

I have always preferred to hold gold via exchange-traded funds. They are backed by Gold and may be liquidated at any time. I do not need to hold it for eight years – I am not clever enough to take such a long view. For that matter, I am not clever enough to take even a short view. So, I like my investments to be liquid.

Gold ETFs Are A Different Animal From Equity ETFs

Let me explain why. India does not have an electronic spot exchange for gold. The price of gold is determined largely by the demand and supply among the participants of the Indian Bullion and Jewellers’ Association. These traders, in turn, form the group of market makers who supply physical gold to AMCs when they create units of gold ETFs.

What Gold ETFs are faithfully supposed to do is to track the price of gold that is traded. In the absence of an electronic exchange, SEBI has mandated a methodology of calculating NAV by taking the price from the London Bullion Markets Association – popularly known as the LBMA AM price.

Usually, the closing price of the ETF—determined by demand and supply of physical gold—and the NAV of the ETFs (determined by LBMA price) are just a few basis points apart, allowing SEBI to say that its methodology of NAV calculation in the absence of an exchange has worked quite well.

Until recently.

Sometime in early April, some serious divergence occurred. During the lockdown, gold was not listed among essential items and the movement of physical gold had become difficult. Some fund houses’ ETF prices started trading at abnormal premiums.

Here is some data:

What Does This Mean For You?

  • If you have bought gold, either in physical form or via an ETF or a Fund of Funds any time from April 13 to April 21, you could have bought it at an artificial price, which then corrected because that premium eventually had to go away. So, there may have been days when you lost in percentages while the NAV was rising!
  • This also means that you should not try buying ETFs from fund houses that have extremely low trading volumes as is obvious from the above table. If you happen to buy at a 15% premium over where the real NAV should be, that would mean you would have to give up 15% returns soon because they don’t belong to you.

How Can You Prevent This Tragedy From Recurring?

Allow me to illustrate this with Nippon Gold Bees simply because they are the oldest (launched in 2007) and have the highest trading volumes.

You can look at the live price of the ETF here.

And the indicative real-time NAV (INAV) here.

As long as the difference is a few basis points, you are good to go.

Everyone slipped a bit during this period but when it comes to an instrument like this – one where the pricing of the ETF and the NAV calculation follow different methodologies, I am inclined to go with the one that has consistently higher volumes. A sudden surge in demand will have a far larger impact cost on Gold ETFs that have lower volumes.

To conclude, allow me to highlight the often missed issue here –the creation of a spot exchange for gold is long due. Instead of discouraging Indian households from diversifying their balance sheets, while central banks around the world are doing the converse, let us attempt to move away from the ‘Zaveri Bazaar’ price. Gold ETFs will become even more efficient vehicles going forward and help us individuals avoid gold in physical form. Gold prices may keep increasing whether we are able to keep a lid on our “uncontrolled passion” or not. Schemes like sovereign gold bonds serve well to divert attention in the short-run but in my opinion, do not address anything systemic or significant.

Abaneeta Chakraborty has close to two decades of experience in managing money for ultra-HNI families, and founded the firm Abanwill Consultants LLP in 2017 to provide independent views on investing. She is also Visiting Faculty at Praxis Business School. This review of gold ETFs, follows a independent study by the author, of long-series price and NAV data of all the products in category.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.

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