Gold ETF: How It Works, What It Costs, and What Investors Miss

A gold ETF is a SEBI-regulated mutual fund scheme. Each unit represents a specific quantity of physical gold held by the AMC in secured vaults. The gold must meet defined purity standards. NAV reflects domestic gold prices and changes throughout trading hours.

This is different from digital gold, which is sold through third-party platforms and does not fall under mutual fund regulation. It is also different from a Gold Fund of Fund, which invests in a gold ETF rather than directly holding gold, and can be invested in through SIP without a demat account.

Gold ETFs track domestic gold prices, which are derived from international prices but adjusted for currency movement. When the rupee weakens against the dollar, domestic gold prices rise even if international gold prices remain flat. This currency effect is a built-in feature, not a flaw. For Indian investors, domestic gold price movement reflects the real cost of acquiring gold in India.

This is why comparing a gold ETF's performance to international gold (in USD) can be misleading. The relevant benchmark is the domestic gold price.

The Sovereign Gold Bond's interest income and tax-free maturity make it attractive for long-term holders, but its limited secondary market liquidity means selling before maturity can be difficult. Gold ETFs offer more flexibility on entry and exit but provide no interest income.

All gold ETFs track the same underlying asset, so differences in performance come down to three factors:

Tracking error

This measures how closely the ETF follows domestic gold prices. A lower tracking error means the ETF's returns more closely match actual gold price movements. Over multiple years, even small tracking errors compound.

Expense ratio

The annual cost charged by the AMC. For a fund tracking a single asset with no active management, a lower expense ratio directly translates into better returns for the investor.

Liquidity on exchange

For ETFs, the trading volume on exchange matters. A low-volume ETF may have a wide bid-ask spread, meaning the price at which you can actually buy or sell differs from the displayed NAV. Higher-volume ETFs tend to trade closer to their NAV.

Gold ETF units are listed securities. Following Budget 2024 changes effective July 23, 2024:

• Units held for 12 months or less: STCG at applicable income slab rate

• Units held for more than 12 months: LTCG at 12.5% without indexation

The holding period threshold for gold ETFs is 12 months (since they are listed units), unlike physical gold which uses a 24-month threshold. Tax provisions may change. Investors should verify current rules before redeeming.

Gold ETF units can be converted into physical gold

Retail investors cannot redeem gold ETF units into physical gold. Redemptions are settled in cash at prevailing market prices. Physical delivery is limited to authorised participants operating at an institutional level.

A gold ETF SIP works the same as an equity fund SIP

Direct gold ETFs do not support traditional SIP structures because they trade on exchanges like stocks. A Gold Fund of Fund allows SIP investments through mutual fund platforms, but adds one layer of expense ratio since the fund of fund has its own cost in addition to the underlying ETF cost.

The DSP Gold ETF tracks the domestic price of physical gold, with each unit backed by gold held in trust.