Gold ETFs are now a popular investment avenue, but they are flawed   

December 9, 2010

ETFs are supposed to track gold prices, but several have shown a significant variation in returns from the actual change in gold prices

The phenomenal rally in gold prices continues to attract attention to the yellow metal. Gold exchange traded funds (ETFs) are enjoying their time under the sun, with investors keen to get in on some of the action through this route. At Moneylife Foundation seminars for investors, one of the key attractions is our presentation on gold. After we have elaborated our views on the metal, a question that comes up is: “What about gold ETFs?” As if gold ETFs are a different asset class. Many investors don’t seem to realise that returns from gold ETFs would be quite different from the returns on gold itself. Or would it? Moneylife dug into the details of gold ETFs and, as usual, has found something quite different from popular belief—in this case, even our assumption. No, gold ETFs don’t follow gold prices. They lag them, in fact!

Currently, there are nine gold ETFs available in the market. For all the glitter that gold ETFs seem to have, they suffer from a profound defect. ETFs are supposed to track the broader indices on which they are based—in this case, gold prices. The returns should mimic those provided by the underlying asset, subject to a slight deviation known as ‘tracking error’. This deviation in returns occurs on account of the impact of trading, fund management costs, etc. However, several gold ETFs have shown a significant variation in returns from the actual change in gold prices—in this case, the continuous rise in gold futures prices on the commodity index of the Multi Commodity Exchange of India.

Take, for instance, the SBI Gold ETF which has delivered 21% annualised returns since its launch in May 2009. Gold futures prices have surged 24% over this period, translating into a huge tracking error of 3%. Reliance Gold ETF has also failed to track gold futures prices accurately. It has clocked 22% returns since its launch in November 2007, while gold futures have gained 25% over the same period. Quantum Gold Fund and Religare Gold ETF have also exhibited a tracking error of 2% since their inception.

Gold ETFs, on the whole, have delivered absolute returns of 20% over the past one year. Meanwhile, gold futures prices were up 23%. Even over a period of two years, gold ETFs have yielded 58% compared to 61% rise in gold prices. Over three years, the picture gets even more skewed, with gold ETFs having delivered 87% returns compared to a 94% rise in gold prices.

This is simply alarming, given that reducing the tracking error is like a religion for ETF companies. The only reason why these gold ETFs have exhibited such high tracking errors could be that the fund managers tried to time their buying and selling, ending up with lower returns. Or that the underlying gold market, where the gold ETFs are investing, is so inefficient that there is a huge impact cost of their transactions. Investors would do well to keep this in mind while considering investing in gold ETFs. Also, since gold ETFs are not highly traded, if you try to buy them on the exchanges you will incur unnecessary impact cost. And then, when gold prices are crashing and you are ‘advised’ to get out, you will have to sell at a price much lower than actual gold prices. Also, remember, a lot of people will try to sell at the same time.


That leads us to our final point. No matter what anyone says, you should know that gold can go down sharply in a short span of time. This can happen especially when the dollar is strong, inflation is low and real interest rates are high. Essentially, investing in gold is like betting on the movement of the dollar and the rupee. Unless you are an expert on currency markets, gold or gold ETFs are not the right investment avenue for you. — Moneylife Digital Team