Gold ETFs can now also invest in derivatives

  • The new portfolio of gold ETFs, which will include ETCDs, may be more volatile compared to the present portfolios, which only hold physical gold
  • Investors looking at gold for asset allocation needs or for tactical exposure may be willing to sign on for the change

The Securities and Exchange Board of India (Sebi), through a circular issued on 21 May, laid down the rules of investing for mutual funds with regard to exchange-traded commodity derivatives (ETCD). The rules apply to gold exchange-traded funds (ETFs) as well. This means that gold ETFs can now invest in ETCDs with gold as the underlying as part of their portfolio. Will investment in ETCDs change the profile of gold ETFs and what will be the impact on the return and risk features of these schemes?

What are gold ETFs?

Gold ETFs gave investors the option to invest in gold through mutual funds. ETFs invested in physical gold with each unit, typically, representing 1gm of gold. The physical gold is held with the custodian bank and is valued periodically, according to the market regulator’s guidelines.

The performance of a gold ETF is benchmarked against the domestic price of gold. Ideally, the returns from the scheme should match that of the benchmark. But there may be slight variations in the returns on account of the cash holdings and the costs involved in managing the ETF.

What has changed?

While gold ETFs are mandated to hold physical gold, Sebi had earlier allowed them to invest the in Gold Deposit Scheme (GDS) and, subsequently, in Gold Monetisation Schemes (GMS), to the extent of 20% of the assets under management (AUM) of the scheme.

The recent Sebi circular has added ETCDs, with gold as the underlying commodity, to the list of financial instruments that gold ETFs can invest in. The derivative contracts are available for trading on commodity exchanges MCX and NCDEX, and also on BSE and NSE. The exchange specifies the contract details such as the underlying, term, trading unit, margins and settlement procedures.

The total exposure of gold ETFs to gold-backed financial instruments have been capped at 50% of the net asset value of the scheme, of which 20% is the cap for GDS and GMS. The unutilized portion can be used for ETDCs.

Impact on portfolio

What is going to be the likely impact of allowing financial products, albeit with gold as the underlying security, as part of the portfolio of gold ETFs?

Lakshmi Iyer, head of fixed income at Kotak Asset Management Co. Ltd, sees savings in the costs of an ETF as the primary advantage from including financial products in the portfolio. She points to the storage costs incurred in holding physical gold which can be brought down by including financial products such as ETCDs.

However, there are rollover costs associated with ETCDs. Rollover refers to carrying forward a derivative position from one series to the next to maintain exposure in the commodity. There are costs involved in rolling over a position. “We are in the process of evaluating the relative cost advantage of storage costs and rollover costs and it will be an important factor to consider in whether we should include these instruments in the portfolio and to what extent," Iyer said.

Chirag Mehta, senior fund manager at Quantum Asset Management Co. Ltd, points to the possibility that since only a portion of the contract value has to be paid as margin at the time of buying the derivative, the remaining can be parked in a fixed instrument for the term of the contract and the returns earned can set off the rollover costs associated with ETCDs and may even provide some net savings on costs on storage for the ETFs. The reduction in costs will boost returns.

From a risk standpoint, ETCDs do not imply greater speculative risks for the funds. “Sebi has prescribed that the cumulative exposure across products should not exceed 100% of the net asset value of the scheme. This is good since it rules out the possibility of leverage and speculative activity," said Mehta. The price at which the contract will mature will reflect the benchmark even if there is interim volatility on account of demand and supply and other factors.

Mint take

Inclusion of a financial instrument in a gold ETF, albeit backed by gold, in an ETF is considered a change in the fundamental attribute of the scheme. A fund considering this has to take the approval of the trustees and provide existing investors the option to exit if they are uncomfortable with the change. Investors who see gold ETFs as an alternative to holding physical gold may not find the change acceptable. However, gold ETFs also see inflows from investors looking at gold for asset allocation needs or for tactical exposure. The latter may be willing to sign on for the change. Iyer refers to the falling AUMs in gold ETFs to make her point that investors may see the additional return possibility from the inclusion of products like GMS as an incentive.

Before taking the decision to stay invested or to invest in an ETF that is considering inclusion of such derivative products, remember that there may be some volatility in the new portfolio, which is a combination of physical gold and financial instruments, as compared to an erstwhile portfolio that only had physical gold.